NEGOTIATE, NEGOTIATE, NEGOTIATE

THREE SETS OF MAJOR NEGOTIATIONS ARE UNDER WAY

Condi Rice has been involved in negotiations concerning the "two state solution" in the Middle East for several years. She is preparing to hold a big pow wow with representatives of several Middle Eastern Countries. We know that big pow wows are not held to negotiate an agreement but to announce agreements that have already been reached. It seems unlikely that great progress has been made, but we should know more by November 14th.

We should all say an extra prayer or two for peace in the Middle East. Many of the battles in this part of the world have their roots in battles fought centuries ago. Some say there will never be relative peace in this part of the world but the truth is that peace has broken out in large parts of this area. Several countries in the area are progressing rapidly up the economic scale. One lesson from history is that well fed prosperous people are not as likely to initiate war with their neighbors. One of my reasons for believing so strongly in free trade is that neighbors who trade seldom go to war.


Negotiation Number 2

The negotiations continue between Iran and the International Atomic Energy folk. I never can remember the full name of the agency that is in the thick of the negotiations or even the head of the negotiations but progress has been made. Under the latest sanctions, the pressure on Iran to "make a deal" has increased. There is room for compromise. Russia, which is the supplier of nuclear equipment to Iran, does not have any desire for Iran to have nuclear weapon capability. Even China is too close to Iran for comfort. Over in North Korea, the USA will supervise the dismantling of the nuclear facilities. The world is a safer place when rouge governments are kept from having nuclear weapons. On September 6, 2007, Israel bombed the start of facilities in Syria. While the USA would prefer to reach a negotiated settlement, there is no doubt that either the USA or Israel will bomb the Iranian nuclear facilities before nuclear bomb capability is reached. As usual, an aerial campaign has limitations and the Iranian facilities have been spread out and hardened. I do not believe the situation will require bombing because I believe the Iranians have more to gain by negotiating peace. Scores of major projects, including projects to build out Iranian oil fields, will start soon after a compromise is reached. The USA has no problem with Iran use of uranium for the production of electricity. Russia has offered to supply the fuel for the plants. Countries such as Pakistan and India, which have nuclear capabilities, make leaders in Iran jealous but adding additional nuclear bombs in Iran does not solve other problems. Negotiations between the USA and India in regard to nuclear capacities are in progress.

Negotiation Number 3

The Bush administration is apparently focusing its budget and tax negotiations with Nancy Pelosi. Nancy has become know in the House of Representatives as the "Committee of One." She does not support the proposals made by Charlie Rangel's Ways and Means Committee. The word is that she especially desires to pass an energy bill this session. The problem is that the democratic solution to energy is the piling on of wasteful incentives. Hillary, for one, has openly declared war on oil company profits, saying that she will use these profits to fund alternative energy sources. As we know from Econ 101, the market will automatically find the most efficient resource allocation. Again, the current energy bill in Congress is an add on of CAFE standards, additional payments to farmers and other programs that actually harm the long term progress toward energy independence. For example, when the government forces people to buy cars that use less gas, they encourage people to drive more miles. A regulated price does not produce the same results as a free market price. Indeed, one of the seeds of the current problem is the price controls on US oil that were in place during the late 60's or early 70's. Can you imagine that at the time it was thought to be good policy to hold the price of US drilled oil to $4 per barrel!!

A statement was just released from the United Nations saying that the use of corn for fuel is a crime against humanity. I think I heard the official say that the 100 bushels required to make 13 gallons of ethanol is enough to feed a starving child for one year. The exact numbers do not matter because the point is valid; children are starving because wealthy people are paying to convert human food stocks to auto fuel.

WHAT IS CONGRESS WAITING TO DO?

One month after the start of the 2008 fiscal year, Congress has yet to submit a single budget bill to Bush. Obviously, there is still hope for a significant break through of some kind. It could be that democrats believe that they will ultimately force through the budget busting SCHIP bill (it was passed once again by the Senate late yesterday). Once Bush is defeated once, the logic goes, he will be weak and Congress can then steam roll through other measures. I doubt that the SCHIP will pass in its current form.

The more likely scenario is that a major compromise is still a possibility. The budget negotiations have been in progress for many months. Hank Paulson left his job at Goldman, one in which he reportedly earned about $200 million per year, in order to pass the real "mother of all tax bills." This would be a repeat of the big Regan (Kemp-Roth) compromise. As you may recall, in that case, Don Regan left a similarly powerful job as Chair of Merrill Lynch to negotiate what was the "mother of all tax bills" at the time.

As I have mentioned, based on the very powerful real estate market cycle, we are over due for a massive tax reform bill. Mike Huckabee is moving up on the right. He has become a dark horse possibility for the republican presidential nomination. He has proposed the eliminating the IRS. He would substitute a consumption tax. The Regan tax revolution began about 26 years ago. It has taken a lot of work and a lot of compromise to reach the point where a move to a relatively flat tax would not be risky or potentially too disruptive. The Ryan proposal, 10% tax on the first $100,000 of income and 25% on all over $100,000, with standard deductions but no itemized deductions, is a doable compromise. It would do away with the AMT while producing tax revenues equal to the current law. Of course, democrats would insist on a third bracket for the rich and tax payers would be given the option to take itemized deductions by filing under the current system. Huckabee has a great idea but the risk of a massive conversion is too great. The wisdom of the framers of the constitution is always most apparent when the boldest and most risky ideas gain momentum.

In the current political climate, a great compromise seems impossible. On the other hand, democrats know that despite their massive lead in the polls, that they are vulnerable. The "big issue" that brought them into power has turned. Progress in Iraq continues. The death rate has collapsed. It is too early to know for sure but it appears that the war will be a positive for republicans by the time the election rolls around. The left is not happy with the democratic leadership. No real progress has been made since the last election. Without compromise, there will be no progress. The best of government policy has always been a result of "ruling from the middle." Negotiators have no reason to suggest a deal is close or not. There is nothing to be won by coming close and there is much to be lost if expectations are raised immediately before all deals fall through. In any event, a budget compromise of significant magnitude must be reached. If you want to see a massive dump the incumbents movement, just let Congress try to leave town after only passing a "continuing resolution budget."

TOTAL WORLD MARKET FUNDS

A reader wants to know more about the "total world market funds" that I mentioned yesterday.

There are a number of funds that track the "total" world market. The word total might be inappropriate because there are always a few very small markets excluded. Vanguard is the market leader in very low cost index funds.

PLEASE NOTE: The US dollar is as cheap as it has ever been relative to the Euro and it is also very cheap relative to many other currencies. Even the Yuan has appreciated against the dollar during the past year. As such, I am a strong proponent of "buy the USA" right now. In particular I believe there are bubbles in the Chinese markets. As such, the "safe" way to invest right now is to focus on American stocks. Those who promote diversification on top of diversification disagree with concentrating on investments in any country but even most of these guys would say that if you are going to invest in only one country the USA would be the one.

Once again, I tell you that I am an aggressive investor. It is arrogant for anyone to believe that they are "smarter than the market" in the short run but history shows that there are those who can beat the market in the long run. I have made my share of mistakes but my record is strong. Over the next several years, the USA could prove to be the very best place to have all of ones funds.

OFFENSE AND DEFENSE

In any endeavor, it is easy to get caught up focusing on offense. A church friend of mine just reminded me of this truth when he told me about all the big gains he is enjoying. He named a number of high beta stocks he owns that have soared in recent weeks. I cautioned him and will caution you: remember to play defense.

How does one play defense in the stock market?

Most people would answer the above question with talk about bond allocations, cash allocations or portfolio diversification stories. All good answers but not answers that lead to championship results. If you play not to lose, you will have a hard time winning any championship. The more powerful answer is that one should buy the bigger companies when one is trying to keep running up the score without risking multiple interceptions. The offensive move is to buy the smaller stocks in the country that has the advantage. The problem is that the best time for small stocks, the years immediately after a major recession, has already come and gone during this cycle. Some small stocks will do very well during the years ahead but the proportion will shrink.

Near the end of the 1960's cycle, successful investors piled onto only 50 stocks, these were know as the "Nifty Fifty". At the end of the tech bubble of the 1990's, relatively few stocks had extreme valuations. Companies such as AOL were priced as if they would never stop their rapid growth.

Today, the big bubble is in China. Who knows how high a mountain will be climbed? I missed the big move but will not compound the mistake by "getting in near the top."

The bottom line is that the writer of this letter is currently very aggressive while buying many "defensive stocks." Once again, this is a different definition of defensive stocks that the popular definition. I am not buying consumer staples. I am not saying a recession is near. I am saying that big cap growth stocks, such as the top 100 stocks at the NASDAQ, are likely to do well over the next several years. Yes, I still have a massive overweight in the airline area and not even I can call this investment defensive. My overweight is in the "best of breed", CAL, and it is in American stocks but the company is highly leveraged in a volatile business. Investors should always seek out volatility in the "good times." Of course, volatility is a pocketbook breaker in "tough times."

Small international stocks are among the most volatile but, because I believe we are within 3 or 4 years of "tough" times, it is time to overweight the relatively safe haven of the USA and it is time to under weight international.

LEFT OF HILLARY

I continue to be amazed at how all the democratic candidates have run to the left of Hillary. Hillary has been able to run toward the center and has become the "most attractive of the liberals". Investors should pay attention to the coming election. The potential for moving the markets is great.

Got to run! Have a great weekend.

HOLD ON TO THE BUCKING BRONCO

With the Dow down 342 points, I feel compelled to sent out a pep talk.

You do not own the Dow. The big drop in the Dow is coming from "roll over" stocks. Big oil is having to pay high prices but can't raise its selling price to compensate. Big finance, no longer able to raise the funds to do company buyouts, is suffering the heartburn from prior deals. All the while, Microsoft, one of the biggies of the big cap growth stocks, has made the turn.


This bucking bronco is doing its best to buck off the weak riders. It is time to load up this pack horse with so much weight that he can't even buck anymore. BUY, BUY, BUY!

The mid cycle stock market "bottom" is near. I know how silly that sounds with the broad averages still near all time record levels but it is just the way this cycle is working out. The big fall in the Dow and the market averages will be composed of "old cycle stocks" falling off. The NASDAQ will continue to out perform and then suddenly the US Dollar will start to climb. When the climb in the dollar gets going, the flood of investments will start coming home. Those who are loaded up in international stocks will feel pain and gradually decide that China is fun no more. Foreign investors will join the party. It is going to be a grand old party. Today's drop is big enough to have follow through in the days ahead but don't try to take advantage of short term moves. The next big move to the upside is going to break through long dated resistance. You do not want to be on the wrong side of the next move.

Those who shorted oil futures will eventually prove to be very right but very early. Those who are short must find oil to deliver. They are not having fun. Once the level of futures contracts comes back out of the stratosphere, the oil markets will return to rationality. It is pretty amazing that there has been such incredible levels of speculation that even Exxon Mobil can make no money off the refining of oil to gasoline, the crack spread is too low to cover the cost.

In the past, when I wrote about China's plan to build 40 nuclear power plants, my readers seemed to yawn. Last week, when I reported that China will build an average of one new coal fired electricity plant per week for the next 10 years, at least a couple of readers were impressed. The fact that the Chinese are using electric train engines to haul the coal was icing on the cake. At least one reader found a few extra dollars and purchased shares in GE. In case you are not aware, GE makes train engines, turbine blades for power plants and airplane engines. The company also is one of the top corporate tax managers. The failure of Congress to reform taxes does not hurt GE because it uses every technique know to man to reduce its tax burden. The same reader just took a huge profit on Baidu. He may have sold this one early but you never go broke taking profits.

A new coal train is under construction in Wyoming. The USA will build 150 coal fired power plants over the next 10 years. Yes, I believe a carbon tax should be passed as a way to reduce the tax burden on income and as a way to increase the costs of burning the dirtiest of fuels, however, the energy demands of the world are huge. The passage of a carbon tax would increase the mix of nuclear plants while reducing the mix of coal plants. A lot of coal plants would still be built but the incentive to use clean coal technology would or at least should be a part of the carbon tax law.

It appears that most of these issues could be left as fodder for electioneering purposes. It appears that Charlie Rangel will go along with the suspension of the pay-go rules so that a one year patch to the AMT can go through without the passage of much of the democratic tax plan. In other words, the economy is too strong to be hurt by minor changes to the tax code. THE MOST RECENT YEAR OVER YEAR GROWTH IN PERSONAL DISPOSABLE INCOME WAS OVER 7%! With no additional declines in the price of gasoline, the American consumer is ready to spend, spend, spend.

The Don Hayes group presented a neat chart today (subscription required). It shows the change in wealth by averaging the change in average home price with the change in stock market value. Of course, it showed a huge drop from 2000 through most of 2002. Since 2002, prosperity has returned to America. Even the recent decline in home prices has been off set by the climb in stock prices.

The site uses the story of the Chinese Piano to make a powerful point. The price of new pianos, available from China has fallen so much that there is no longer a market for used pianos. Auction houses, churches and charities have stopped accepting pianos. One auction house recently worked 15 minutes to get a $20 bid just so they would not have to pay to remove the piano. Those who continue to focus on oil and gold to suggest that inflation is still raging tend to ignore the price of goods such as pianos. The common comment by inflation hawks is that the price of the things they buy, including food and energy continue to cost more. The fact is that the average American spent 6.3% of his disposable income on energy in 1980 and this percentage has fallen consistently in all the years hence. The number is now down to 4.2%. In regard to food, the decline has been far greater. If memory serves, the decline was from around 18% to the current level of about 6%. The percentage spent on recreation is close to the mirror image of the food expenditures.

Never before has a piano or thousands of other goods been so affordable. We live in good times. The news is bad but the times are good. BUY, BUY, BUY!

BELOW AVERAGE, AVERAGE AND ABOVE AVERAGE RETURNS

Few people are stock market "wizards." The good news is that one does not need to be a good stock picker to make lots of money. The asset allocation decision is the most important factor in investment success.

The bad news and the good news is that the great majority of investors achieve returns that are less than average. The reason this is good news is that the under performance of the many makes it very nice for those who decide to take above average returns.


The best way clear up the above comments is by way of examples. The actions of family A and family B tell the whole story.

A and B live almost identical lives. The primary bread winner in each family has the same job and makes the same money. Both families live in $300,000 homes in the same neighborhood. The big difference between the finances of the two families is that family A is paying off their home at a more rapid pace than family B. Family B has made smaller monthly payments each month but has invested the difference in a total world stock market index.

Family A has equity in their home of $200,000 and family B has equity of $100,000 in the home and another $100,000 equity in the whole world stock market index. Each home, being in a good community has appreciated just slightly above the average long term rate for homes and the stock market fund has also appreciated at just about average long term expectations. The following are the expected returns for the next 12 months.

Family A will see their home appreciate by 6% of $300,000 -- $18,000. Their return on equity will be $18,000 divided by $200,000 or 9%.

Family B will see their home appreciate by 6% of $300,000 -- $18,000. They will also see their stock account appreciate by 12% or $12,000. Family B will pay 6% of $100,000 or $6,000 more in interest on their home than family A. Thus the total return of family B will be $18,000 plus $12,000 minus $6,000 or $24,000. Their return on equity will be $24,000 divided by $200,000 or 12%.

The primary reason family A wants to get the home paid off early is for their "peace of mind." Forty years later, when family B has extra equity of $5,000,000, which is $6,000 invested and compounded annually for 40 years, I submit that it will be family B who has "peace of mind."

Family A feels good in the short run, family B feels good in the long run. Both have a huge advantage over family C because family C has run up $10,000 on credit cards. The annual cost of $1,800 could be invested at the stock market average of 12% to produce $19,000,000 during a lifetime. Family C gives up $19,000,000 in order to buy some stuff this year rather than waiting until next year.

In the examples above, Family A is the below average return investor, Family B is the average investor and Family C is the family who enjoys punishment. Now let's look at Family D, the family of high risk according to the jealous comments of A, B and C.

Family D also lives in the neighborhood in a $300,000 house. This family made the smallest down payment allowed and refinanced to a 30 year fixed rate loan when interest rates were low. They have zero equity in their home but they have $200,000 equity in the total world market index fund. Indeed, they actually own $250,000 of the fund and they have a $50,000 loan against the account. Over the next 12 months, again assuming returns equal to the long term averages, Family D will see their home appreciate $18,000. Their stock account will appreciate $30,000. They will pay $12,000 more in interest on their home than Family A (in this example I am using the payment toward the first $100,000 as the "owners rent"). They will pay another $3,000 in interest on the $50,000 stock loan. Their increase in net worth will be $18,000 plus $30,000 minus $12,000 minus $3,000 or $33,000. Their return on equity will be $33,000 divided by $200,000 or 16.5%.

The following are the returns achieved:

Family A 9%
Family B 12%
Family C 8.1%
Family D 16.5%

Like I said, family D will be perceived by the others as the family who takes high risk. The reality is that family D will achieve great wealth partly because family D has reduced its risk.

Let's suppose all four heads of household are laid off from work. Which families have a source of cash? Family B has $100,000 liquid and family D has $250,000 liquid!

Which family would have the negotiating power to miss a few house payments if push came to shove? If family A is behind on its house payments, it is in big trouble. The pressure in on his neighborhood banker to reduce non performing loans. If the bank forecloses on family A, the bank will get a non performing loan off the books without taking a financial loss. Family D will be last on the foreclosure list. Family D has no equity in the home so the bank will likely lose money should it foreclose on this loan.

Financial Advisors are by nature risk adverse. Big money is made by the Financial Advisor who can convince his clients to broadly diversify into high fee mutual funds. Many an advisor has built themselves annuities by accumulating large positions in funds. Year after year the advisor "earns" his fee without any additional work on his part. Advisors often promote Mutual Fund Families for "annuity reasons." If a client gets frustrated with the performance of one fund, they might switch to a different fund in the same family and keep the river of fees flowing to the investment advisor. Financial Advisors know that frogs will boil to death if heat is added to the pot slowly. They also know that rapid changes will cause the frogs to jump. Financial Advisors make big money off of those people who are willing to sit for years in funds that offer mediocre returns. Advisors frequently promote "lifestyle funds", "balanced funds", "income funds" and many other variations and combinations of "diversified" funds. The result is the problem noted by John Maynard Keynes so many years ago, that with maximum diversification there is no profit.

The moral of this story is that it is easy to be an above average investor. All one has to do is allocate ones assets for long term growth while avoiding paying high fees.

MORE WORDS ON THE TURN, TURN, TURN

I was asked if I thought Merrill Lynch is a good investment now that it has dropped so much in price. My answer is an emphatic NO!

On several occasions I have described the economic turn as being similar to turning around a battleship. It takes a long time to turn around an economy or a battleship and once the turn is made, each will run in the new direction a long way. In each sector, there are first half and second half stocks. In the financial sector the first half stocks are the big investment banks but in the second half it is the small regional bank. During the second half of the cycle, small companies grow their business. When they expand, they are likely to borrow funds. The typical small business will do its borrowing from the small regional bank. The merger and acquisition fee train will slow during the second half as the Merrill Lynch's of the world will not be involved when the typical small business opens one new factory.

Another reader wants to know how I can be so sure that there is abundant supplies of energy? My answer is that I have seen the coal trains leaving Wyoming and Colorado. Did you know that there are 150 new coal fired power plants projected for construction in the USA over the next 10 years? DID YOU KNOW THAT CHINA IS ADDING AN AVERAGE OF ONE NEW COAL FIRED ELECTRICAL PLANT PER WEEK? DID YOU KNOW THAT THE NUMBER OF GAS RIGS DRILLING FOR NATURAL GAS IN THE USA HAS FALLEN BY 95 IN RECENT WEEKS AND THE REASON IS THAT THERE IS NO MORE STORAGE ROOM FOR NATURAL GAS?

The fact that China is building electric train engines to haul their coal is perhaps the most powerful way for me to get my point across. The law of substitution is more powerful than the rules or regulations of any government. Yes, it is a time consuming process to replace transportation fuels. The first step is to continue the process of removing oil from the power generating equation. This process is well underway. Everyday, trillions of decisions are made to increase the us of electricity and to reduce the use of the internal combustion engine. Over the next several years, more and more oil refineries will come on line, but even more importantly, enough time will have passed for substitution projects to have "kicked-in."

At the turn in 1995, the price of oil or gold did not collapse at the first hint of the turn, however, by late in the year, the dollar was soaring in value and the price of gold and oil was falling. Over the past 5 years, oil in dollar terms has risen about 240% but in Euro Dollar terms it has risen half as much. Once the dollar starts to appreciate, it will be the Europeans that feel the heat of the price of oil.

GDP

This morning, the GDP report came in at 3.8%! No recession here! However, as we know from recent data and from the price of treasury securities, the economy has slowed. The risk of recession has grown. This is one of those "bad news is good news stories". The pressure is on the FOMC to reduce short term rates. A cut in these rates will provide the "fuel" for economic recovery from the mid cycle correction. Investors should be sure to remember that the market leads the economy by at least 6 to 9 months. The weakest of economic numbers this cycle will be reported over the next two quarters. The market is already looking past this economic down turn and to the boom, boom, boom of the election year. Join the party now. Don't sheepishly accept below average returns! There is safety in keeping more of your assets in liquid investments that perform best over the long term!

BUY, BUY, BUY!

AGAINST THE WALL IN LEFT FIELD?

Please tell me what you think. A few days ago, I wrote about carbon tax bills that are floating through Congress. I stated my opinion that Bush and Congress will meet in the middle to fix the Alternative Minimum Tax and help the environment at the same time. On a scale from 1 to 10, please let me know what you think. If you think a deal is certain, one that will result in higher taxes on fossil fuels, largely offset by tax reductions elsewhere, please send me a 10. If you think such a deal in the 2007 Congress is impossible send me a big zero. If your best guess is somewhere in between please respond accordingly. I will send the results of this "poll" only to those who respond.

Perhaps I am out in left field with my back to the wall, this might turn out to be an easy out or a home run! I have not read or heard of others making my argument.


One school of thought by strategists on both sides of the isle is that Democrats will wait until after the elections to make their big push for higher taxes. It does not seem to me that they have been all that shy so far. Also, there are lots of "goodies" in store for those who are willing to compromise now. The $495 BILLION defense appropriations bill that was just sent to conference, includes funding for all kinds of pet MULTI-BILLION DOLLAR military projects plus an extra $4 BILLION to police our Mexican Border. THREE BILLION of the FOUR is designated for the building of a 700 mile long fence. If this fence is ever built, it will do little to solve the problem and it will cost much more than THREE BILLION DOLLARS. One reason the cost will be much higher is cities along the border will fight it. The land for the fence will have to be taken through court proceedings. The government has the right of imminent domain but there will be costly battles fought. Besides, even if the fence is built it will not help solve the problem. Building such a fence is a great example of cutting off ones nose to spite ones face. To add insult to injury it is estimated that 4 or 5 red states will swing to blue if these misguided soles do not back off with the hate speech that surrounds the issue. Oh yes, the hate speech is disguised but the Hispanics can feel it in the air. The $495 BILLION DEFENSE BILL, which includes funding for lots of jobs in lots of congressional districts will not be sent to the President all by itself. The members who want the "goodies therein" will have to vote for a few bitter pills. Bush will ultimately accept a number of bitter pills to get a lot of other "stuff" passed.

ELECTIONS

The online betting services put the odds at 60% that the Democrats will sweep the House, Senate and Presidency in the 2008 elections. It could happen but the race for the Presidency has historically been a very close race. Neither Bill Clinton nor George Bush ever won the majority of votes. If Giuliani is the Republican nominee, conservatives threaten to back a third party candidate, throwing the race to the Democrats. Hillary is the odds on favorite to be the Democrat nominee; the right wing will ultimately go all out for the Republican nominee in order to defeat Hillary. Of course, Romney expects the right wing to fall in behind a Mormon if he is the nominee. It might be a close call as to what conservatives hate the most, abortions or Mormons! Yes, I know, it is not right to lump all Democrats or all Conservatives into one category but it sure can be fun.

It appears to me that Hillary has the nomination wrapped up. However, while Giuliani is well ahead in the national polls, Romney is leading the way in the early states. Romney has a nice lead in NH, IA, NV and MI. Giuliani is well ahead in SC and FL. Romney has wisely spent his money advertising in the early states. Giuliani has built on his national polling lead. My guess is that Giuliani wins but anything can happen.

Despite what the news media portrays, there is a large group of voters that believe the nations security is the most important issue. Most of these folk believe the Iraqi war will save American lives in the long run, many others do not believe but they want to believe. Based on recent success, in particular the recruitment of tens of thousands of Sunni's to the government side of the battle, the war could actually be a net plus for the Republican party by election time. Giuliani gains the most from improvements in Iraq because he is seen as the tough candidate who has worked at helping keep Americans safe from terrorism.

Another reason that conservatives will ultimately fall in line behind the Republican nominee is because they have fought a very long fight to "win" the Supreme Court and they will not throw this victory away lightly. Giuliani believes in reducing abortions as much as possible while leaving women with the right to choose. I profess to be a Christian Conservative but I am also a pragmatic libertarian economist. It is truth that most juries would not send a woman to jail for committing an abortion and it is wrong to pass laws that you are not willing to enforce. Abortions and drunkenness should both be discouraged but our experience has shown that the "cure of prohibition" is much worse than the disease.

The question posed comes down to the attitude of Congress. Will the conservatives hold-on to the immigration issue, which is a big winner for them in a number of congressional districts but which could easily cost them the Presidency and the Supreme Court? Are the Democrats so confident of a sweep that they will play "rope-a-dope" for the rest of the Bush term? Will incumbents risk alienating the public by continuing to be a "do nothing congress"?

Keep in mind that Democrats would likely pay a huge price if they were to fail to pass the 12 appropriations bills and the budget. The big game is between the Democrats and Bush. As we have all learned, divided government is almost always best. With Democrats in control of both houses of Congress, the Republican nominee has a much better shot than is currently commonly perceived. If you want to make a little money, sell the 60% contract at Trade Sports. In just a few months the public will begin to realize that the odds of a Democratic president are not much better than 50%.

The tougher bet is in regard to the new tax structure. Based on the real estate cycle, it is time for major income tax over haul. The real estate cycle has lasted an average of 18.3 years for centuries but this one has been one of the longer ones. The last three major peaks in residential sales momentum were in 1968, 1985 and 2005. The Reagan tax simplification was passed with an effective date of sometime near August 14, 1986, as best as I can recall. So, we have had 20 years between the last two peaks of the market but we are in the 21st year since the tax reform. I mention the prior cycle because the tax reform in that cycle was parceled out in small increments year after year with the biggest reforms not too long before the great recession of 1973-74. Several of the current bills being floated are clearly "anti real estate bills". One would eliminated many of the tax advantages of second home ownership and another would reduce the interest deduction for homes larger than a certain size.

Bush hopes any compromise will include making his reductions to the capital gains taxes permanent. The Democrats will go along only if rich pay more. Right now, the top 50% of tax payers pay better than 95% of all the income taxes paid. Because the current contest is for the nomination, the Presidential contenders are making a bigger deal out of soaking the rich than what they would actually try to accomplish once in office. So again, the deal that congress can make now might even be much better than the deal they could get with a Democrat in the White House. Putting the politics aside, the last thing our economy needs is confiscatory taxes. The fight is going to be interesting to watch!

Thanks in advance for sending me your estimate!

HAPPY, HAPPY, HAPPY

It does not take a new high on the Dow Jones Industrial average to make me happy, but it sure does not hurt. After talking about the mid cycle turn for more than a year, I look forward to changing the main topic of these missives. The mid cycle turn will soon be talked about in the past tense.

In 1969,with the Vietnam war was staring me in the face, I got a firsthand perspective of a "scarce resource economy." President Johnson had practiced the strategy of "guns and butter" and the central bank went along with his attempt to have super prosperity while fighting the war with one hand tied behind his back. Then Nixon and Ford fought the ensuing inflation wars with silly price controls. Many people who remember the "Whip Inflation Now" buttons of the Ford administration do not recall that Nixon also tried to use government mandates to hold down prices. Jimmy Carter gave up the fight and by 1980 the markets had witnessed 11 years of commodity markets offering a greater return than offered by the stock market.

The new head of the FOMC, Paul Volcker deserves much of the credit for "Whipping Inflation." Ronald Reagan should get the rest of the credit. President Reagan and Paul Volcker were willing to make the hard choices necessary.

The war in Iraq is a back yard brawl relative to the Vietnam War. Some 56,000 Americans died in Vietnam compared to some 3,800 in Iraq. Human life is most precious but the facts are still the facts. While there are parallels between the 1969 to 1980 time and today's markets, the prior period did not include the benefits of globalization and technological advance that we have today. Indeed, while it was Nixon who broke the ice with China, in or around 1972, the economic revolution in China and the rest of the under developed world has all happened during the past 20 years.

This commodity cycle is only seven years old. When the 1969 to 1980 cycle turned, it turned sharply. To date, this turn has been a slow turn and one that few have even noticed. With oil and gold sitting near all time high nominal prices, many market followers would laugh at me for saying that the turn is under way, but it is. One can see the turn by looking at the broad CRB index but the best place to see the turn is in the stock market. There has been a decisive turn in the market; growth is out performing value and this did not start yesterday. Indeed, growth has out performed value since July. If you plot the IVW index versus the IVE index you will see what I am talking about. Or you can simply look at a long term chart of the NASDAQ 100! This index has broken through resistance that goes all the way back to 2002, before 9/11/2001.

YES, I AM HAPPY, HAPPY, HAPPY. I HOPE YOU ARE TOO. THE PENDING DECISIONS OF CONGRESS SEEM TO BE HANGING OVER OUR HEADS LIKE THE SWORD OF DAMOCLES BUT I BELIEVE THIS IS ONLY A LAYER ON THE WALL OF WORRY THAT WILL BE CLIMBED! IT WILL NOT BE A SMOOTH CLIMB SO HANG ON TO YOUR HATS AND TO THE SADDLE HORN AT THE SAME TIME!

FOLLOW UP TO GOVERNMENT FUNDING

My statement that the government has more than enough revenue has been challenged. I stand by my belief while offering only a few statements in support of my position. When Art Laffer defends the Laffer curve, he evokes the memory of the 14th century Muslim Philosopher, Ibn Khadun, who wrote "at the beginning of the dynasty, taxation yields a small revenue from small assessments, at the end of the dynasty, taxation yields a small revenue from large assessments." I look at it this way, if your goal is to end prosperity then tax it to death. People are willing to pay very high taxes to "insure the common good" but today there is little that the government can offer to do inefficiently that private enterprise cannot do more efficiently.

The current situation is that government revenues are better than 18.5% of GNP which is higher than average. This has been accomplished with lower tax rates. If the US were to lower corporate rates, as so many other countries have done, jobs and investment in the USA would grow. Citizens need to remember that politicians must "fix problems" in order to collect campaign contributions. We must also appreciate that the politicians are "too smart to fix all the problems." Indeed, to really do well financially, they must create problems that will need to be fixed later. A king for a day could fix the AMT, immigration reform, healthcare reform and energy reform. Democracy has proven to offer longer term stability precisely because we must "muddle through", reach broad consensus and fix our problems slowly. In the process, we must always remember that whenever possible, problems should be fixed by private enterprise solutions. The healthcare system should not be a system of lobby fighting lobbies and more lobbies. A good system would be one in which the patient and the doctor decides what care is worthwhile.

I have not verified the following but it sounds like truth. A Canadian claims that the current waiting list for a human to have a hip replacement is three years long. He says that the waiting time for a dog, not covered under the government system is one week.

THANKS FOR THE REMINDER

I left out traffic congestion as one of the externalities of one person per car. Again, I do not agree that car owners should be forced out of their cars and into multi-passenger vehicles. If the tax on fuel is set to include the real total costs, individual decisions will work together as a market to find the best solutions.

BUY, BUY, BUY!

HISTORY SAYS BUY, BUY, BUY

The following is yet another snippet of history to show that now is a good time to BUY, BUY, BUY.

A decline or near decline in the price of the average house is a rare phenomenon. Right now, it is interesting to notice that the cost of new construction, including a lot in a good location continues to rise, even while folks belly ache about a fall in the value of homes. One of the tenets of economics is that "clearing prices" are reached. Yes, the supply of unsold homes on the market is large, especially when looked at in terms of months needed to clear the inventory at the current sales pace. The problem with this popular measure (especially popular with those making the bear case) is the "double leverage" involved. Other numbers show that building permits and starts have fallen dramatically. On the demand side, the numbers show that mortgage applications are already on the rise. In just the past two or three weeks, the bears have said again and again that mortgages are not available.

I am trying to make two points here: 1) that the housing "debacle" is not as bad as it is perceived to be, and 2) the housing debacle has not killed the bull market in stocks.


The following are the 5 times during my life that housing prices were flat or negative over a full year and the increase in the S&P 500 over the next year.

September 1982 44%
November 1990 33%
July 1992 15%
February 1993 8%
April 1995 39%

ON AVERAGE, LARGE CAP STOCKS INCREASED 27.8% IN VALUE IN THE YEAR AFTER HOUSING PRICES WERE FLAT. WOW!

I like the last entry the best because April of 1995 was right at our previous mid cycle turn. The most recent pattern is in my opinion the one that will be most closely followed in this cycle.

STRONG DOLLAR RESULTS

The financial news media is always in search of the next headline. The recent one has been the fall in the US Dollar. Here again, I like the pattern set in April of 1995, when the dollar bottomed just as the pundits were saying that housing was killing the economy.

There are logical reasons why the bottom in the housing market coincides with the bottom in the dollar. Canadians are currently in a state of euphoria over the value of the Loonie. For the first time in 31 years, Canadians can trade a Loonie for a dollar and get back change. For a number of years, Americans could trade a US Dollar for a Loonie and get a quarter or more in change. This is big news for Myrtle Beach and many other coastal communities. When I was a kid, Myrtle Beach had Canadian Day Parades. These celebrations were held during the early spring, when it was still too cold for Americans to consider Myrtle Beach as a vacation destination. Florida resorts are also celebrating the return of the Loons!

The Euro Dollar has also appreciated substantially. The European can trade for a dollar and get more than 40 cents change. Just a few years ago, Americans could trade for a Euro Dollar and get about 20 cents change.

In April of 1995, the winds of change were blowing as they are now. Many a European and Canadian will make out very well by purchasing a US home now. The European might use one million Euros to buy a $1.4 million luxury home in the states. The price of this home will appreciate substantially as soon as the market clears. Even if it were to only hold its value, the return would be 40% to the European if he held the home until the US Dollar and the Euro Dollar reach parity again. While there is no guarantee that parity will ever be reached again, the history of the move after the mid cycle correction of 1994 says that it will.

OIL PRICE TO RISE IN EUROPE!

Should the US dollar strengthen, the price of oil in terms of Euro Dollars will soar. The law of substitution, which is already going 90 miles per hour in 3rd gear, will hit overdrive. No one knows where new supply smashes into new demand but it is clear that that there is going to be a collision between millions of small cars and scores of super large oil refineries. In Port Arthur, Texas, Shell and Saudi Arabia will more than double output about a year after the first of the Vietnamese super refineries comes on line.

Just in recent weeks, wholesale traders in the US have been reluctant to hold inventories of oil as the amount of natural gas in storage is near record levels, gas producers are being forced to slow down or shut down production and the price of natural gas is down to 47% of the price of oil in BTU terms. Of course, natural gas storage capacity is not enough to supply all our winter time needs with natural gas but a mild winter could see a steady decline in the price of heating oil. Any facility set up to burn gas or oil will go with the less expensive gas until supplies are diminished.

GLOBAL WARMING IN THE NEWS

Ken Fisher notes that when the financial press cannot find negative economic statistics to whine about, they write about global warming or Paris Hilton. Ken avoids making this a political point but in truth it is. The steady push in most media outlets is anti-Bush, anti-business, anti-war and pro-government "solutions". Of course, the exceptions to the rule, such as talk radio outlets and Fox News, prove the rule. Pretty soon, the stock markets should benefit from a change in sentiment. A "Feel Good Factor" is going to emerge. We have moved into the prosperity phase of the business cycle. During this phase, real wages and incomes of the average citizen will rise to the point that the constantly negative "news" will not sell well. As Andy Warhol taught us many years ago, the "news" is a reflection of the feelings of the people. During a time when the "bad news" does not sell, "good news" will be more prominent. Of course, the market top will come after the public has received a steady diet of "good news".

My "good news" for you today is that the process of building a market top is just getting started. Keep a close watch and you will notice a very gradual shift in the news. Also keep in mind that the kinds of advertising that you will see will also change. You will see lots of ads for companies like Boeing that are making all the planes they can make. Of course, the right time to buy shares in this company was several years ago. It will not go down in price for many years to come but its upward price momentum has already peaked. It takes a long time for the "big boys" to distribute their holdings to the public. Of course, the media outlets that sell these large corporate ads will be the outlets that survive. Do you think it coincidence that positive "news" articles and corporate ads will accompany one another, or soon before or after?

Yes, be a skeptic but be a wealthy skeptic. A fun market is headed our way.

POLITICS IMPORTANT

No one knows the ultimate outcome of the current fight for budget and campaign dollars. Funds are flowing in all directions. Powerful "special" interests are playing hard ball. In this crazy but necessary game of horse trading, many in power are willing to vote to spend billions annually for years to come on all sorts of wasteful schemes, provided they "win" the goodies they want for themselves. Senator Grassley, a Republican from Iowa, is one of the current key power players. I do not believe Grassley is for a $35 Billion add on to a disruptive health care plan, but he is willing to vote for it to establish a strong bargaining chip. Almost everyone in the House and Senate would agree that health care reform is needed but none of them would honestly say that the $35 billion dollar would be their personal first step.

Again, I have good news. So far, Congress has been unable to pass much of anything. This is good news for America and good news for the markets. As we have seen time and again, lots of bad legislation passes when one party is in control. Bush will veto the worst of the spending. Unfortunately, to get a dose of his own sugar, he will swallow some bitter medicine. Still, all in all, the compromises reached will not harm the economy badly. As a general rule, the economy will do very well for as long as the government stays out of the way.

BUY, BUY, BUY the fight will be over in a few weeks and members of congress will go home to take credit their "wins". That is one of the good things about a good compromise, all can claim to have won. These wins will become part of the "FELL GOOD" cycle discussed above. When corporations, the news media and the congress combines to tell the "good story", it will be natural for the masses to "FEEL GOOD". BUY, BUY, BUY!

UP and UP and Up

CAL earnings forecasts keep going up and up and up. The increases are only pennies at a time but the pennies are adding up in the face of record oil prices. The forward PE is now at 6.38%. What would this number be if a savings of $2 per share were to materialize?

OTHER BLACK SWANS ARE SWIMMING IN THE AREA

The key point of the "black swan concept" is that a surprise can happen at any time from most any direction. The thing is that one can often see the potential for spotting a black swan in areas where the great majority see no possibility. So far, no one has been able to reasonably explain the "air attack" of Syria by Israel on September 6. Did Israel drop a bomb on nuclear supplies bond for Iran, explosive supplies bond for Iraq or was it just a reconnaissance plane that mysteriously dropped extra fuel tanks on the Turkey -Syria border?


In any event, rumblings continue about a potential deal in regard to Palestine and Israel. Don't hold your breath but don't be shocked if this is the "surprise" that ignites the next big move in the market. The odds of a particular event may be very small but the accumulated odds for one of many possible events is great. How many times have you heard someone say that such and such could not happen again in a million years?

My favorite once in a life time story is my golf story. I had a clear shot at the green except for one problem, a very small dogwood tree was directly in my way. It was at least 30 feet away and my partners told me to aim for the tree because I couldn't hit it in a million tries. My ball hit the tree dead center looped upward and landing exactly in the spot I had just hit it from. After a good laugh my partners said that that the shot was truly one in a million. They said to aim for the tree again. Yes, I did. I hit the tree the second time in a row. You had to be there to know how unlikely the shot was. I honestly believe that I could go to the spot and try a million times to hit that small sapling again and never succeed.

BIG SURPRISE!

Even after the cut in the Fed Funds Rate, the psychology of the market place is still one of disbelief. Yes, there were huge inflows of funds to mutual funds but a large amount of this money flowed into "old news stocks." Money is flowing into international, energy, basic materials, gold and other inflation plays. WHY? Because people are doing what the "big boys" suggest. Goldman Sachs just announce an earnings jump of 70%! They make most of their money trading against the crowd. They are saying that oil is headed much higher. Believe them at your own peril.

JUST THE FACTS

The facts are that the CPI was up 2% year over year and down .1% in August. At the same time, the real, inflation adjusted earnings of the public, were up 4.4% year over year. Over my 57 years of life, there have seldom been better numbers. Even the price of gas has not gone up for close to two years. During the same time, the price of a very useful electronic map has fallen by thousands of percent.

BUY, BUY, BUY, BUY, BUY, BUY, BUY

HOLD YOUR NOSE, I SMELL A STINKING COMPROMISE AND A VERY BIG BULL

Congress has failed to pass 12 of the 13 budget bills. The deadline of October 1st is also the date the debt ceiling runs out. Is there going to be a replay of the 1995 government shutdown? I don't think so. A very smelly compromise or two may be in the works.

One bill likely to pass will be the "Airline Passenger Bill of Rights and FAA Satellite Air Traffic Control and Airline Flight Path Correction Bill." No, Congress will come up with a shorter name but to "get the votes" the bill will include provisions to soothe the wounds of the unhappy. This bill will regulate payments and benefits granted to those who are stuck on the tarmac for hours on end. Of course, once the airlines get a bill passed to fund a new high tech satellite navigation system, the problem of being stuck on the tarmac will miraculously be solved. CAL has already spent at least $50,000,000 building a new hub in Cleveland to relieve the congestion at Newark. There is no question that the big carriers have been paying more than a fair share of the cost of FAA services. After the bill has passed, smaller planes will save a lot of money by avoiding taking a prime landing spot from one of the big carriers. Smaller airports will be utilized more by these smaller planes.


The airline industry and the traveling public will all be big winners when a compromise is reached. Among the losers will be the owners of homes that are in the direct flight path to the major airports. Part of the huge cost savings will be more direct flight paths near these airports. The savings will be in terms of money and time. Many a flight will cut 20 minutes off its landing time. Connecting flights will see improved scheduling. The cost of the system will be upwards of $50 billion but it will be well worth it. A compromise should be reached very soon.

ALTERNATIVE MINIMUM TAX

Senator Grassley of Iowa is trying to steer Congress toward the elimination of the AMT along with making the 15% rate on capital gains taxes permanent. Grassley argues that Congress does not need to offset or score the loss of revenue from the AMT tax because the government has never expected or budgeted this income. Of course, Charlie Rangle and the rest of the Democrats are pushing other ideas. The idea that the democrats will fight the hardest for is the closing of the "loop holes" in regard to "carried interest." They know they have a "winner" in regard to attacking the taxes paid by hedge fund managers. The fact that a change in the law will not cause even a twitch in the tax revenue collected gauge does not matter. Many a business will have to be restructured to avoid the extra tax but, again, the amount of new taxes collected will be minuscule. Indeed, the normal, reasonable and rational decision of many an investor will be to avoid realizing the gain on investments once the tax rates go up. The free flow of capital is one of the things that makes the US economy dynamic and prosperous. The passage of extra taxes also includes a hidden "tax surcharge."

Senator Grassley needs 60 votes to get a bill through the Senate. The Democrats need the 60 votes to get a bill to the President but it needs 67 to over ride a veto. Congress currently "enjoys" a favorable rating of 27% of the citizens and the disapproval of 64%! I don't recall lower numbers. Do the Democrats really have the stomach for closing down the government? When the Republicans tried in 1995, they caught too much heat to handle.

BIG BULL MARKET!

Twenty five long years ago, when I was an investment broker with Merrill Lynch, an event happened two times that has not happened again until the day before yesterday. The up to down volume on the New York Stock Exchange was greater than 25 to 1. Such an event, according to The Sentiment Trader, has happened only seven times. In addition to the two times in August of 1982, it happened in 1950, 1951, 1957, and 1978. In most cases, the market jumped, then stumbled around for a week or two and then jumped again. In all seven cases the market was up strongly within three months and the average increase of the average big stock was 9.4%. If you appreciate how "heavy" is the S&P 500 or the Dow Jones Averages, they you appreciate that serious money was made during these historic moves.

The up to down volume this past Tuesday was better than 30 to 1!

One possible scenario is that the market will struggle for the next couple of weeks and then have another huge up day when Congress passes a reasonable compromise. Of course, when Congress lumps 12 massive appropriation bills into one grand package, all sorts of extra billion dollar earmarks get funded. Yes, I can already smell the stink of the compromises coming but the process of "muddling though" is as good as government gets. Government is a necessary evil, generally the less the better.

GOOGLE ADVERTISING REVENUES TO SOAR!

Google continues to charge ahead with innovative "solutions." The coming advertisement revenues from "rich media sources" is going to make the revenues from the current text ads look very small. Google is ready to patch together its innovative "gadget" ads with its current operations and with the DoubleClick system as soon as the closing of the purchase is complete.

Mobile ads are also ready to explode. INTC, TXN and others are making dramatic strides in reducing the battery power needed to operate sophisticated hand held, wireless computers. Those children born this year are going to live in a very different world than the one that you and I know.

STRONG DOLLAR AHEAD!

After falling hard for 4 years, the value of the US Dollar is about to turn. As a general rule, the turn will mean that the performance of international investments will weaken and the performance of US investments will improve. Part of the reason that China has been growing at unprecedented rates has to do with the value of the US dollar. As the dollar and the yuan (which is pegged to the dollar) have fallen, the price of Chinese goods sold in Europe has fallen. The ECB is still in need of an increase in Euroland short term rates to slow the European economies. Job losses are going to be very large in Euroland unless they can reverse the growing advantage of the Chinese manufacturers. ECB rates are at 4% and the US Fed Funds rate was just reduced to 4.75%. Under the circumstances, one cannot expect the dollar to climb until the market is confident that either the spread is going to switch from a -.75% to a plus something.

Yes, I am saying the opposite of what the TV pundits repeat at least a few dozen times each day but history and common sense are on my side. The price of oil and gold is being pushed by fear of an "Iranian Event", by the falling dollar and by the belief that lower short term rates will stimulate the economy and thus the consumption of oil. Since 1978, Iran has been isolated from the rest of the world. Over the past couple of years, hundreds of deals have been made that will bring Iran out of isolation. The current situation is much like the negotiations to buy a business. Outsiders can often discover that negotiations for a takeover are in progress but only the insiders can make an highly accurate, educated guess as to weather the final deal can be closed. It would be a silly move for insiders to openly state their educated guess. If one suggests that a deal is close only to see it fall through, then the party has embarrassed himself with no potential gain. If sabers are rattled putting the prospects of a deal into great doubt, then a successful conclusion provides relief to all parties.

Iran has fastidiously maintained its right to develop the peaceful use of nuclear power. I believe Iran will develop said nuclear power after a deal is made that will reduce the threat to the rest of the world. Obviously, almost everyone would prefer that all nuclear weapons were destroyed. It has never been a comfort to know that Russia or India or Pakistan or others have the capacity to start a nuclear war. The deterrence of self destruction just does not seem very powerful when dealing with people who are willing to commit suicide to insure a trip to heaven. Still, I suspect that the final deal will give Iran the "supervised" right to develop nuclear energy.

Our French Friends have added a bit of pressure. I smell a compromise in the works but it has been more than a year since I first caught a slight scent in the air. Only time will tell but the combination of a few deals in Congress and a couple of deals in Iraq and Iran could make for a huge stock market rally before the November elections.

DO NOT TAKE THE RISK OF BEING OUT OF THIS MARKET! A SMALL SPARK COULD CAUSE A MARKET EXPLOSION!

LOVE IT, LOVE IT, LOVE IT

The rest of the world followed the USA lead over night; markets around the world soared! The part I love the most is that at least half the talk is about the boom in oil and gold. A lot of money is pouring into the "tired end" of the market while the "jump" in the "other end" is just getting under way. Part of the reason is that many investors falsely believe that inflation is about to soar.

Yesterday a reader sent an article that suggested investors should hide out in bonds until the "worst" is over. My SELL, SELL, SELL on bonds is looking pretty good right now; bonds have fallen while stocks have soared. Economics professor, James Hamilton, issued a follow up study yesterday that suggests that the whole curve shifts down when the Fed Funds Rate is cut. Oops! Not this time! My belief is that even the good professor tends to get the cart before the horse. In the past, central bankers waited too long to cut short rates; the economy has often reached "free fall" before the start of the rate cuts. The first move in rates is never enough to float a falling lead hot air balloon, it is only enough to slow the fall. After the second cut or two, it is only common sense for long rates to go up, stimulating an economy is positive for future real growth and for future inflation.


The great news is that inflation continues to be very well behaved. The massive purchases of raw materials in Asia continues to be converted into lower priced goods around the world. The dramatic fall in the US dollar continues to "put the wood" to the seat of the pants of all the other industrialized nations. Exports from the USA and from China (which pegs its currency to the US Dollar) are soaring. You won't read this hardly any where else but, Bush has made some great chess moves in recent months. He has sacrificed a pawn or two in order to set up the democrats. If you were a democrat senator right now, what bill would you propose and expect to get signed into law?

The big push by democrats to "bring the troops home now" has failed in its purpose while pushing the democratic presidential candidates to take left wing positions that will not help them in the general election. The American people want to be safe from terror. Bringing the troops home in the middle of the war is not the winning position. The latest attempt to disrupt the war, forcing the troops to spend a lot of "down time" is unraveling.

On the energy front, the "big oil" man, Bush, has forced the environmentalist to admit that ethanol is not the answer. Bush caved into the democratic game of "paying off corn farmers." By doing so, he helped start the back lash to wasteful subsidies for bio-fuels. Many folk on both sides of the isle have started to understand that it would consume far too many food resources to replace even a small portion of our energy needs. Even the carbon sequestering schemes are starting to be seen as just more government boondoggle. The fact of the matter is that the most effective scheme for sequestering carbon is managed forest growth. New growth sequesters carbon much faster than old growth. China is now moving hard in the direction the USA headed over 100 years ago. The USA has reforested millions of hectares. The fear of environmental activist, those who want to leave the forest alone even if it means the occasional fire burns a few billion acres, has impeded the process but common sense prevails over the long haul.

The wealthy are always attacked by the left but, of course, wealth allows the "right thing" to be done. The poorest of the poor continue to use up the forest. Countries like Bangladesh are down to 7% forest coverage. A country like China, which moved rapidly from the poorest of the poor to a developing nation, can now afford to join the USA in its reforestation program. Of course, much more could have been done in the USA. The USA continues to pay farmers not to grow crops on land that could be growing trees. Like I have said before, an acre of forest sequesters more carbon annually than what can be saved through the growth of ethanol in 50 years. As usual, people (particularly democrat people) tend to try to do for nature what nature will do for itself. It is hard to do better than God!

With the price of oil at all time highs, as a democrat senator, would you fight for carbon taxes when the science continues to show that many of the schemes to cut carbon dioxide are proving to be inefficient boondoggles? Would you push for tax increases in the middle of a housing recession and credit crunch?

The tide is turning. Senator Obama just proposed a tax cut for the middle class. No doubt, he would pay for it by eliminating slapping shackles on the rest of the economy but at least it is a mention by a democrat that taxes need to be kept low. One of the economic things least understood by the democrats is corporate taxation. The bulk of the taxes paid by corporations are passed directly through to consumers. The big company is easy for democrats to attack but the attacks hurt the "little people" the most. Today, corporate taxes in the USA are high relative to the rest of the world. The same politicians who complain about jobs being lost to competitors overseas are willing to make the situation worse. Countries in Western Europe, Eastern Europe, Asia, Africa and South America have lowered corporate taxes. The manufacturing boom in Eastern Europe, for example, is not an accident. Tax policies do matter and the general principal holds that individuals make better decisions than the government in regard to how to spend the peoples money. There is waste all around; waste committed by individuals, governments and businesses. Schumpter won the "battle" with Galbraith long ago. Even totalitarian regimes do well when they allow the people economic freedom; the Chinese do not have a bill of rights but they are buying homes and buying and selling goods.

WHERE DO WE GO FROM HERE?

Ben Bernanke has demonstrated his understanding that the price of oil will ultimately take care of itself. The economic train does not need to be slowed to a crawl in order to halt inflation. Inflation is always a problem in the balance of goods and money, but given the opportunity the market will find substitution goods if the money is available. The big oil energy projects are still under construction but price does cure price. Much of the current run up is a continuation of speculation. It has always been true that market tops are much harder to see than market bottoms. The topping process is one where momentum is lost and where relative declines occur long before there are actual nominal declines. From 2005 to 2006, the price of oil clearly went up. From the peak in 2006 to the peak in 2007 there has been no real increase. The momentum is gone even though the dollar has fallen to record lows. The dollar is about to turn and go up for the next 5 years or so. All the while, new energy supplies will come on line. Let me put it this way, who would have ever guessed that Russia would sign contracts to supply China and Korea with electricity?

The invisible hand of Adam Smith has been at work and it will continue to work its magic. Is it not just wonderful how the slack in the housing market comes just as construction of refineries, power plants and industrial facilities is gathering steam? Is it not neat that the build out of WiMax net works will occur just as Intel and many others are ready to supply the world with incredibly cheap chips that will dramatically change the way we communicate?

Once again, the price of a computer chip, this time made incredibly small by nano-technology, will drop by thousands of percent. Those who focus on oil to say that inflation is terrible have simply not considered the growth in computer chip sales relative to oil sales. Over the past 30 years, the people of the USA have used less and less oil per person. Sure the nominal price has gone up but the total increase in dollars spent on oil lost its momentum long ago. At the same time, the number of silicon chips purchased has gone up many thousands if not millions of times. The price of these chips has fallen and fallen and fallen some more and are ready to fall once again.

Huge quantities of chips will be sold in coming years. All the ways these chips will be used to boost productivity are not known and not knowable. One known and easy example is the huge savings from avoiding the wrong turn. When GPS is everywhere, a few trillion wrong turns will be avoided each year. Yes, GPS will serve as a substitute for trillions of gallons of fuel.

BUY CONSUMER CYCLICALS, BUY TECHNOLOGY, BUY TRADITIONAL BANKS, BUY INDUSTRIALS, BUY TRANSPORTATION!

MAKE MONEY ALONG WITH THE REST OF THE WORLD!

SELL LONG BONDS, AVOID GOLD, SELL COMMODITIES, AVOID OIL STOCKS, AVOID MATERIALS, AVOID UTILITIES.

SELL, SELL, SELL!

Greenspan talks from both sides of his mouth but he is probably right about long term interest rates. LONG BONDS SHOULD BE SOLD!

Some of you own long term bonds hidden inside of various mutual funds. Some of these funds automatically buy more bonds the older you get. SELL, SELL, SELL.


Look at in terms of the US Dollar versus the Euro. Back in 2000, a great time to sell stocks and to buy bonds, the US Dollar would buy the same as $1.17 Euros. Today, a dollar will buy the same as $.72 Euros. It is not time to take a vacation in Europe! The relative costs has gone up better than 60%! Of course, with the value added and carbon taxes added, it costs about 23% more to travel to Europe than it first appears. If you want to conserve wealth and energy, stay home.

I do not believe the pattern we are about to follow is like prior times when inflation was out of control and long rates went up and up and up. On the other hand, it is not wise to own long bonds while thousands of billion dollar industrial projects are underway around the world. The demand for money is real. Some of these projects are close to the time when they will reverse their current effects. For example, the cracking unit was just installed on the first of the new super refineries in Vietnam. For the next 18 months, a lot of resources will be devoted to finishing the construction. Then, when it cranks up early in 2009, it will supply two thirds of all the fuel used in the whole country. When the second unit is finished, a couple of more years out, Vietnam will be a finished oil product exporter.

Investors must always keep in mind that inflation is a result of too much money relative to the amount of goods available. In the 1970's, it was assumed that the "oil shock" had to cause inflation. As we have just experienced over the past 5 years, oil can go up and up and up without causing the overall inflation rate to go crazy. For years, the demand for oil has increased dramatically in Asia but the prices of the products flowing from Asia has gone down. Have you noticed the price of a GPS mapping device lately? Pretty soon, owning an electronic map will be affordable by almost every one in the entire world. Now don't tell me how awful the inflation rate is. The iPhone has dropped 25% in price only a few months after its introduction.

So, long bond rates are not going to go out the roof, as implied by Greenspan. However, there will be pressure on interest rates while the infrastructure is built to "catch up to the demand". My friend and former colleague at Merrill Lynch made a forecast in the early 1980's. He said that the business cycle was going to be tamed. I believe Ben Bernanke will not take the Fed Funds rates up and down the ladder as was done by Greenspan. Shortly after Greenspan was made Chairman of the FOMC, he took short rates up sharply and the crash of 1987 hit. The Dow Jones Average went down and down some more, then on October 19, it went down 23% in one day. The little 10% dip we had last month was not enough to cry over.

The problem in the short run is that the market may be initially disappointed with tomorrow's rate cut. It took a number of years after the 1995 rate cuts for the dollar to recover against the Euro. The ECB is still holding rates at 4% so Ben will not likely match that rate any time soon. We also have Congress to worry about. The leaders of congress want so badly to install a carbon tax system that will raise the level of lobbying to new all time levels. Already, billions have been spent trying to influence the outcome. Of course, those companies that have room to reduce carbon emissions would love to be subsidized for providing the service. Just like corn farmers, who would turn down the payments from the "government of the people."

As usual, good intentions have hurt us all with unintended consequences. Had the environmentalists not fought the management of the forest and had the government not paid land owners to not grow crops, many more acres of forest would exist and the world would be a cooler place. The democrats in congress have a "mandate" from the misinformed to raise taxes in order to "improve" health care and the environment and to end the war in Iraq. Bush has the upper hand except in regard to the expiration of the tax cuts passed in 2001 and 2003. Economically, raising taxes and spending inefficiently will keep the US from achieving its potential. Our country is so strong that we can take a tax hit and keep on ticking. As we are moving into the prosperity phase of the business cycle, we can afford a lot. Still, we should not waste what we have.

The ECB is under great pressure to "normalize" their interest rates, which is another way of saying that they need to bring them in line with US rates. The export growth from the US is adding to our total GDP but Euroland will suffer a huge trade deficit if they do not adjust. As is evidenced by the bank collapse this past weekend, Euroland is also suffering from the sub prime mess.

Until the adjustments are made, the dollar will fall, oil in US dollar terms will go up and gold in dollar terms will go up. Even so, inflation rates are falling so it is possible for the ECB to hold rates and for the US rates to fall more than I expect they will. Like I have said, I believe the swings are going to be less violent than in the past. Therefore, I expect Ben to make a cut but for the ECB to increase rates. Growth will slow for a quarter or two, as the consumer who has listened to the news has been frightened. Those who pay little attention to the news are as happy as can be. Their paychecks are rising, they are buying stuff they could never afford before and enjoying the good life. Their retirement accounts have risen in value year after year for 5 years in a row and the value of their homes has doubled in a relatively short period of time.

BUY, BUY, BUY, STOCKS, STOCKS, STOCKS

SELL, SELL, SELL, BONDS, BONDS, BONDS.

SHARE BUY BACKS AND GROWTH!

For the first time I can remember in a long while, an airline announced a share buy back today. Alaska Air will buy back $100 million worth of stock and will use cash on hand to make the purchase. A lot of pundits rail against share buy backs. One thought is that companies should pay dividends instead. The counter argument is that the effect for the company is the same but the buy backs give the share owners the option of collecting taxable income now or deferring the gains to a later time. The frustration about buy backs is in regard to employee stock options. Company managements are tempted to "spend" stock options like drunken sailors. As we all know, a few company CEOs now make millions of dollars per year off of company issued stock options.

Another major positive thing about company buy backs is that they show the wisdom of "holding back on capital spending". The age old problem that has created the boom and bust of the business cycle has been excessive expansion during the "good times". If the individual companies in an industry are disciplined enough to avoid cut-throat expansions, all the companies earn higher profits and the "bust phase" is muted.

The airline industry has been showing much restraint in recent years. The biggest carriers, including UAUA, AMR, DAL and NWA have all reduced capacity. Old fuel guzzling planes have been sold to fuel rich countries such as Russia.

CAL has gotten into this act and recently sold 5 planes to Russia and has reportedly been negotiating the sale of at least 10 more. CAL was the first domestic carrier to order the new, fuel efficient 787. It has also lead the way in taking other steps to reduce fuel consumption, such as installing winglets on the tips of their fleet. These winglets are similar to the air foils installed on trucks some years ago to reduce wind drag. CAL has bucked the growth trend to some extent. It has reduced its US presence but it has been expanding rapidly in the international market. The strategy of adding direct flights from US hubs to international locations has provided CAL with niche flights with no direct competition. Many a passenger would rather fly direct rather than land in a hub to connect for the second leg. The cost to CAL is lower and yet margins are higher.

With the New York area saturated with as much traffic as it can stand, CAL has added another major hub at Cincinnati, OH. The city agreed to pay $16,000,000 of the cost to upgrade facilities. CAL will grow this hub by 40% over the next several years. With new plane deliveries to begin next year and with steady world wide demand growth, CAL will add several more direct international flights. The second CAL direct flight to India will commence in October and the company is lobbying hard to start another direct flight to China.

CASH, CASH AND MORE CASH

Because CAL's earnings have been sheltered by depreciating assets and by Net Loss Carry Forwards, the company has been collecting cash, cash and more cash. To "dispose" of some of the extra cash, the company has made extra large contributions to its employee pension plan. The company just announced yet another $50,000,000 deposit. The good news for the company is that if it gets into a pinch, it will be able to stop making contributions because it is well ahead of the level of contributions required by law. Even so, the company has announce that it expects to end the quarter with over $3 billion of unrestricted cash.

With $9 billion of new planes on order, $3 billion does not seem like a lot of money but airlines often lease planes with little or no money down. It is entirely possible that Alaska Airlines has started a new trend; the share buy back may be the first of many to be announced in the industry.

Merger Mania

Time and again, merging two carriers has proven to be a difficult and unproductive task. Midwest Air was recently successful in fending off its determined suitors. NWA will own a minority stake but Midwest will remain an independent carrier. The merger of US Airways and US West is still a work in progress. Each of these carriers know how to "do things right"; it takes a lot of effort to over come the cultural biases built up over the years. Airline mergers are tough. Still, many believe consolidation is needed; perhaps not. By buying back shares with excess cash, all carriers might enjoy higher profit margins, stronger balance sheets and niche markets. It is pointless to continuously do battle to try to take over another carriers prime market. CAL is one of the carriers that defends its hubs at all cost. No matter how low a discount carrier goes, CAL is willing to match prices and still offer bonus amenities such as bonus frequent flier miles through out its extensive net work. In addition, frequent fliers can visit CAL lounges and those of its partners.

It took a few years for the "big boys" to learn how to compete with the low cost carriers. Now a days, the big boys fund small companies which can go toe to toe with the discounters. A company like Republic gets the fuel buying power of CAL, discounted costs to buy planes and yet it hires lower cost employees to operate the lines. The company signs contracts to fill the feeder flights that land just in time for connections to the major hub flights. As a result of this well planned and executed competitive strategy, companies like LUV are left to admit that they cannot grow at the same rate as they have in the past and they continue to offer employee buyouts.

TIE UPS, LINK UPS, NETWORKS

Companies like LUV need the same type of "link ups" that have been made by CAL. CAL has over 250 "partnerships" with other carriers. Russians can buy one ticket all the way from the depths of Siberia through Moscow, New York (Liberty New Jersey), and to whatever final destination in the US they might choose. The various carriers share the revenues. CAL has the most sophisticated ticketing system. The most recent change permits customers to go online to make changes from one flight to the next. Depending on the circumstance, there may be an extra charge for making the change. Customers can even select seats online.

1995 ALL OVER AGAIN

In 1995, the dollar was hitting all time record lows against other currencies. The airlines were having a tough time. Indeed the entire US economy was under pressure from a Fed Funds Rate that had been pushed to high levels. Then the FOMC cut rates. The dollar turned and climbed for the next 5 years. The airlines saw dramatic traffic growth while their fuel costs fell.

The recent free fall of the dollar combined with hints that Iran will be embargoed have sent oil prices out the roof at the same time that supplies are more than adequate to meet our needs. We are in the "shoulder season" when less and less gasoline is demanded and when refineries must make the switch to produce double the amount of heating fuel and half the amount of gasoline. The reason refineries are not buying as much raw fuel right now is because they perceive that pending slower economic growth is going to reduce demand for oil. China, which has seen its industrial production soar partly due to the rapid fall in the dollar, is about to begin a steady slow down. Substitution effects are starting to take hold. New supplies are coming on line. OPEC did not increase production out of the kindness of their hearts. Saudi Arabia spent $6 billion over the past 4 years developing a new field. Having spent the money, it made sense to sell the oil.

Ironically, both of the leading Democratic candidates for the Presidency have supported liquid coal fuel for most of their careers. John Edwards has tried to use the issue to gain support. He says that CTL technology should not be used because liquid coal throws off more hydrocarbons than does other fuels. I am starting to have fun observing the gyrations of the environmentalists. They have come to realize that bio-fuels are not nearly as environmentally friendly as they first believed and they have come to realize that sugar cane grown in Brazil is a much better source of fuel than is corn, rape seed, palm oil, soy or other northern hemisphere crops. Their actions to support bio-fuels has lead to the destruction of ever more hectares of rain forest. Clear cutting in Brazil is producing bamboo and sugar cane plantations which indeed do absorb about twice as much carbon as do rain forest but this is not "worth the price".

Eventually, CTL technology will be improved to the point that liquid coal will become a growth industry. Probably not in this cycle because the price per barrel is about to fall and because the Democratic Congress has put fear in the hearts of anyone who would consider such production. Should the Democrats pass one of their tax and spend schemes (both a carbon tax and a cap and trade system are "tax one to give to another programs", congressmen can raise lots of campaign contributions by being for or against either one of these systems), the added cost of the tax could sink otherwise profitable ventures. Ironically the drive to reach energy independence is being held back by those who express the desire to achieve this goal.

I am not fond of tax increases, but if we want to tax "pollution externalities" a straight forward carbon tax would be the best solution to the energy problem. Under this method, the fuels that pollute the most would pay the highest tax and the market would quickly figure out which fuel works the best.

Windmills, which are very resource expensive (requiring tons of concrete and steel per unit of production) might make a little more sense if they were deemed to be a low source of pollution. Of course, the problem is that some agency would have to rate them as a pollution source and the citizens of North Carolina have declared that we do not want windmills sticking up from our mountain tops. Location, location, location would be a key determinant of a windmill's pollution rating. You can see that a carbon tax would put a lot of power in the hands of some agency but again, this would be better than seeing billions spent to lobby congress.

If the tax on CTL were fixed in the law the lobbying would not surface except before the next expiration date of the "fix". In any event, the USA has enough coal to supply our energy needs for 200 years. We also have enough natural gas off our coast to supply our needs for the next 200 years. We also have enough shale oil in Colorado, Wyoming and Utah to supply our needs for the next 200 years. Canada has enough tar sand oil to supply our needs for the next 200 years. There is no shortage of energy. There is an unwillingness of Congress to legislate!

The purpose of reviewing the energy situation is to provide support for my market stance. Those who understand that the price of oil will not go up and up and up can have faith in the idea that the price of airline stocks will go up and up and up. The turn is near!

BUY, BUY, BUY!

GOLD IS A "SPECIAL" COMMODITY

The CRB is composed of energy, agricultural and industrial commodities. The price of precious metals is a whole 'nother story. The recent "flight" to quality saw the price of treasury securities jump and the price of gold jump. Any "flight to quality" is a "fear response" to an event or events. The "meltdown" of the sub prime paper market had people around the world running for safe havens. Even the price of gold is getting lower and lower in inflation adjusted terms. Those who bought gold more than a year ago at $700 cannot sell it now at a real, after inflation adjustment, profit. Seven hundred dollars in a good money market account for a year is now better than $730.

Gold is special but it pays no dividend; it earns no interest; it is what it is, but never more or never less. Yes, gold is an industrial metal, but we use substitutes whenever we can. As an industrial metal, gold is used up but most of the gold in the world is held as a "safe" store of value. Holding gold is very much like insurance. There is a significant cost to owning an insurance policy but we do it to reduce the extremes of our personal risk-reward. In other words, I cannot fault anyone for keeping a few thousand dollars in gold, provided they understand this is an emergency reserve and that there is a steady long term loss of value. The after inflation value of gold drops at about the same speed as the value of a printed dollar. It makes no sense to keep a lot of cash or gold hidden in a mattress.


ABUNDANT SUPPLIES

The false reasoning that I constantly see is the idea that "we are running out of resources". The idea was common for centuries because lots of people were always at risk of running out of food. The supply of gold available is more than we will ever need. Just as the supply of oil available is much more than we will ever need.

Over the next 10 years, more industrial metals will be used in the production of electronic gadgets than ever before. The boom in gadgets is nowhere near the end. However, each of these gadgets is more powerful and smaller than the gadgets they replace while using less resources per gadget. The real "win" is that these gadgets often replace the need to spend many times more resources.

A lot of gold will be used in the production of electronic connectors over the next 10 years but one gaudy gold chain is enough to produce 10's of thousands if not 100's of thousands of connectors. There is still more gold in the ground than all that we have ever dug. Indeed, there is more gold on the ocean floor than we have ever used. There is a cost to go get it and depending on the next invention, the relative value of gold to titanium might change dramatically. However, in the long run, the relative value of gold goes lower and lower and lower to our standards of living. In the old days, a fellow who owned a bar of gold was a very wealthy man. Today, millions of people live in houses that would make that wealthy man's house look like a chicken coop.

OIL, OIL and More OIL

Today, OPEC will decide to hold production levels or not. Saudi Arabia has an extra 500,000 barrels of supply available. In two more years, a huge project will give Saudi Arabia another 1.2 million extra barrels. With Iran and Venezuela pumping at 100% of capacity, they have little desire to increase quotas. From a fairness point of view, it makes sense for all the OPEC producers to produce at a set percentage of capacity. The current excess capacity of about 3 million barrels per day is largely available from Saudi Arabia. Does it make sense that Saudi Arabia would spend $6 Billion to develop a 500,000 barrel field only to sequester 100% of its production?

In the old days, OPEC routinely increased production quotas in the winter time in order to supply the heating demands of the Northern Hemisphere. However, substitutions have been easy for winter time heating needs relative to summer time transportation needs. It is simply much easier to burn extra coal for heating purposes than it is to somehow convert coal into fuel for automobiles. Even Toyota has struggle when trying to make their hybrid vehicles "more electric and less gasoline". Much work is being done to figure out the best way to "refine coal" into liquid fuel.

The political left continues to beat their drums about "renewable" energy. They are willing to fight the use of more coal at every juncture. It does not matter if coal can burn clean to them. They score no political points for finding a solution to the "energy crisis" but they win big as long as they are able to convince a gullible public that we must develop renewable energy because we are going to "run out" of the good old stuff. Of course, the battle is tangled up with the "environmental cause". We plow 90 million hectares of rich top soil annually to grow pesticide laden corn in order to "save the environment". What a shame and what a waste!

The good news is that the "energy crisis" is on its last cyclical leg. Over the next two to five years, the investments already made and being made in energy production will start to bear fruit, just as the investment in production of more efficient autos and other uses will bear fruit. Keep in mind that the extra money now being spent on gasoline is going to flow into "electronic gadgetry" and the software required to operate these gadgets. This software will include music and videos. The hand held "Dick Tracy" watch is just around the corner. The use of these gadgets will save a lot of gold.

BUY, BUY, BUY!

IN CASE YOU MISSED IT, BUY, BUY, BUY, BUY, BUY, BUY

One of my favorite economists is the guest host on Squawk Box this morning. He is on the money! This morning, he said that a very powerful combination event is about to happen. The President will announce assistance for sub prime borrowers this morning and Ben Bernanke will basically hold firm against inflation. Brian points out that the hedge fund players who have shorted the sub prime loan securities, using 20 to 1 leverage, could take a serious hit when many of these loans are suddenly worth 100 cents on the dollar.

Doing the right thing! It is an understatement to say that George Bush is not a very popular President. Still, Bush is once again "doing the right thing." A number of TV talking heads have said that the sub prime mess was caused by lending money to "people who did not deserve to own a home." My belief is that every American should be given the opportunity to own a home. Before the announcement that Bush will propose new rules that allow sub prime lenders to refinance, I correctly maintained that more than 85% of all those "poor credits" who were allowed to buy a home with no money down would continue to pay their loans. With the additional help, the number will be significantly higher than 85%. Given a poor person a helping hand is not a bad thing.


It is not like anyone is agreeing to pay the mortgage for the homeowner. Many times every day business loans are "restructured." Corporate CFO's have the experience to know that if a company has a short term financial problem that a deal should be struck to redo the terms of outstanding loans. There is often a long term cost or penalty but help is often available.

As Bernanke mentioned the other day, there are many creative ways possible to help those stuck in loans that have onerous terms. If a loan started out as an interest only loan and is about to be reset with a $500 per month principle payment, the terms could be modified to reduce the principle payment. No one would be hurt. The bank does not need $500 per month in principle to make the loan a profitable loan. Sure, if the principle payment becomes a graduated amount, for a few years, the loan would look like a 50 year mortgage but the graduated principle payment could increase a certain percent each year and continue to increase even after the $500 per month principle payment is reached.

Employment and wage growth are strong. A person who has successfully paid an interest only loan for the past three years might easily afford a $100 per month increase in his home payment this year and another $120 per month next year and so forth. The proposals to be made by Bush today will be along these lines. He will use executive authority for the government to guarantee the refinancing of 80,000 of these loans. This is the right thing to do. He will make other proposals, some of which will require the passage of congressional bills.

WOW!

Those who have sold these mortgages short are suddenly being hammered. Short selling anything is risky business. One of the smart moves that was made recently was to eliminate the short sale up tick rule. Yes, once again a smart move has been severely criticized as an idiotic move. The removal of this rule has been blamed for the "extreme volatility" of the recent markets. What a joke!? To begin with, this market has not been "extremely volatile" and second of all the removal of the rule has the effect of reducing volatility not adding to it. This is just one more area where a lot of very smart people have "joined in group think" to get things upside down and backwards. Last night, John Brown repeated the oft repeated mantra that Ben Bernanke is between a rock and a hard place because if he cuts interest rates the dollar will fall. John and those criticizing the removal of the short sale rule are looking at one end of an elephant and concluding that it is a snake. Use the water level in a lake as an analogy, if one only looked at how much water was flowing over the dam, without ever knowing the level of the lake, one might conclude that the lake level is going down on a day when the over flow is very heavy. The truth is that if much water is over flowing the dam, there must have been heavy rains upstream and the lake is probably full to the brim.

Under the old rule, an artificial rule said you cannot sell short unless water is over flowing the dam. You were not permitted an exception because you had checked upstream to know that the "rains are coming".

There are a number of children's board games that demonstrate the point well. In many of these games, players will often attempt to "corner a market." In a "business game" they might consistently bid high on a certain resource in order to be the only one able to sell certain goods. The problem they discover is that they pay so much for the resource that their profit margins are low. The game of Risk is another game where one cannot win by being overly aggressive. The more you attack your neighbors, the weaker you become, leaving an opening for another player to put you out of the game.

In the same way that investors can buy all they want on the way up, they should be able to sell all they want on the way down. Think about it this way; how low can speculators drive the price of a stock? Even if they committed conspiracy and as a group shorted 200% of all the shares outstanding, would they drive the company out of business because the price of the stock was down to a very low price? No, a profitable business in this situation could declare a dividend and the short sellers as a group would owe 200% of the total dividend!

Certainly most investors understand that when they buy a share of stock on the market, they are not investing in the sense of giving the company money. When the shares were originally sold by the company, it got money. If you buy a few shares or sell a few shares it does not effect the balance sheet of the company one iota.

BUY, BUY, BUY

The point of the above paragraphs about short selling is that the pundits have found just one more thing to rant and rave about when they should be pounding the table saying BUY, BUY, BUY! In the old days, recessions were common at the mid cycle juncture. Certainly, the rollover has and will cause a little pain. The GNP numbers posted yesterday tell the story well. For the second quarter, the US economy grew at a real rate of 4%. The rants of those who say inflation is out of control must remember that this 4% has been adjusted downward to account for inflation. The problems in the housing market reduced this number by about 75 basis points. Therefore, if there had not been a problem in housing, the real economy would have grown by 4.75%!

Yes, the growth in the economy will be reduced by the recent "freezing-up" in the credit markets. Will there be a recession? It's not likely. Besides, a mild recession would not be a big deal. Recessions are announced after the fact and the stock market typically jumps up big time right in the middle of a recession. What happens during a recession is that the price of money goes down enough to increase the profit margins of companies. What has happened the past two months? The price of money has come down!

BIG BEN IS KEEPING HIS CALM WHILE PUNDITS ARE YELLING FIRE!

Smooth, smooth, smooth! The water in the big lake is smooth. Pundits have focused on a 250 point drop in the Dow on one day and a 250 point jump the next day and screamed VOLATILITY! This correction got to about 10% before reversing quickly. It is now less than 5%. In 1987, the correction was 23% in one day! Big Ben is proving his metal quickly.

Sure, those who believe $100 oil is just around the corner are screaming that Ben should lower rates. Those who have profited by prior wild swings in the market are ready for Ben to capitulate. Ben is about to disappoint these players. Under the current circumstances, Ben will probably lower rates a little. However, he is not going to stop fighting inflation. His move to lower the discount rate without lowering the Fed Funds rate was a master stroke. It was filled with common sense but it was a master stroke because it went against the grain of conventional wisdom. Many said that it was only a confidence building move but in reality it had teeth. A few days later, when all the big and strong banks took down chunks of money, the pundits said again this was just a confidence building move but it was much more than that. Slowly the numbers will be revealed. The banks that were in trouble did not go to the discount window directly but got "pass through" - loans from the money center banks. Liquidity was restored where needed without causing a run on the banks that needed the help. Had a regional bank jumped at the discount window, they would have been shooting themselves in the foot. They would have seen millions of dollars of withdrawals from their frightened depositors. The system is sound; fear in the eyes of pundits is going away and Ben will not need to lower short rates much. Smooth sailing ahead!

BIG PROFITS

Early this morning, one of the Asian airlines announced profit growth of better than 25%!

What is a mid cycle turn? Before the turn, there is generally enough capacity to produce all the goods needed throughout the world. Sales are much stronger than they were during the previous recession but demand is generally satisfied without building new plants. By the time of the turn, the gradual growth of the population and the additional growth in standards of living means that production capacity is short. By the time of the turn, there is a need for more and more and more major capital projects. You have to have the plants plus the energy to run them. This is the reason that China has no less than 40 nuclear power plants on the drawing boards.

Capital projects consume huge quantities of resources. For example, Saudi Arabia and Kuwait each have a number of development projects on the drawing board. Indeed, they each have a single project that will cost over $9 billion dollars to develop. Specifically, the development of the Khurais field in Saudi Arabia is expected to increase total production from Saudi Arabia by 1.2 million barrels per day. This is an increase of about 10% by the worlds biggest producer. Several thousand workers will be required to build-out this field but once it's built only a few hundred will be required to operate it.

Business construction already requires more capital and more workers than were required by the housing market when it was at its peak a couple of years ago. Look at it this way, each one of these $9 billion projects are the equivalent of building cities of 45,000 $200,000 homes. I can't remember the average cost of the nuclear plants in China. I recall that the latest designs are smaller. $5 billion each is probably in the ball park for a total of $200 billion. The electricity from these plants will support many times the number of production facilities. We are talking about trillions of dollars of construction over the next several years.

It is only natural for the demand for money for major capital projects to squeeze out home construction. When the average Joe finds that money is available to buy a house, he goes for it. When money gets tight, he stays where he is. On the other hand, when a company is selling all the products it can make, it does not let the cost of money get in the way of expanding. When the "prosperity" phase of the business cycle is here, the FOMC has to hold tight. It has to lean against the wind. It has to keep short term interest rates up so that a bidding war does not develop. If five companies selling the same products are all selling out of goods, the one that can complete the next plant the quickest is the one that will reap the benefits of having goods for sale that are in short supply. Ben's job at this point is to focus on inflation even though the housing market is weak.

The constant argument that the consumer is the engine of the economy is a good argument for a different time. The new locomotive is the business locomotive. The consumer will come along for the ride. We simply should not worry so much about the consumer during these times. Most Americans spend the income they receive. This is the reason that payroll deduction works to build a retirement nest egg, even though, the person who will make regular deposits to a stock account will grow much more wealthy. The person who routinely saves to an an aggressive investment account is a rare individual.

Of the people I help, only a few of them make regular additions to their accounts. Most wait until the account has moved up strong and then they add chunks of money. It is too much to expect them to lean against the wind as they should and add chunks of money while the market is down. Therefore, regular monthly deposits are a rare blessing. Big irregular deposits make my job very difficult but I accept the challenge freely. The main point is that during the "prosperity phase" jobs will remain plentiful and wages will increase. Consumers will not be as apt to refinance their homes but they will have steady income and they will spend it. The year over year growth in personal income is currently running at about 300 million dollars!

Yesterday, I said that Big Ben is about to shoot the starters pistol. He is, but the actions to be announced by President Bush will address the "sub prime crisis" more specifically than a Fed Funds rate cut can do. Cutting the Fed Funds to solve the sub prime crisis is a bit like going deer hunting with bird shot. As a result of "help" in the mortgage market, the need for Ben to cut will be much reduced. This may cause great disappointment by those screaming FIRE but holding firm against the wind is the right thing to do. I expect a minor cut of 25 basis points at the September 18 meeting and not much more later in the year. More importantly, the second half of the business cycle is underway without a severe crunch at the "turn".

Consumers who are paying 50 cents less per gallon of gas are buying electronic toys. New toys are on the way. The new toys are typically connected to one another. Kids are playing games with other kids from around the world on their cell phones. Business people are able to "get things done" quicker than ever before. The build out of this new system is not even half way done.

The energy/electricity investments must always come first and indeed they are in the works. I do not believe there has ever been as much energy/electricity under development. The poorest of the poor are starting to feel the effects; oil projects in Africa are starting to enrich millions of people. The newest OPEC member, Angola, will add about 200,000 barrels of production per day this year. The good news is that this is just the start. It takes time to develop an oil field but there are hundreds under development.

Production from China has been held back by the scarcity of electricity. This scarcity is in the process of being filled. The 15% growth rate of China is unsustainable because the law of large numbers will be in the way but billions of dollars of new production will continue to hold the lid on inflation as long as Big Ben will keep one foot on the brakes.

You will know that the world has hit hit 4th gear when products begin to hit the market that take advantage of super highway broadband wireless networks. These networks will allow more to be done at lower costs.

BUY, BUY, BUY! LIFE IS GOOD!