No Hyper Inflation -- Hyper Prosperity Instead!

In the 1970's, after a long period of negative real interest rates, the US experienced hyper-inflation. In the past year, our government has inflated its balance sheet while corporations and individuals have worked at paying down debt. The ballooning of the Fed balance sheet has caused many folk to believe a period of hyper inflation is coming. The following chart shows that conditions are not nearly the same as after the 1973-74 recession. Thus we can expect different results.

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Soaring Real Incomes! Why?

Real incomes are leaping off the tops of charts as consumer prices fall. In 1995 it took more than 30 weeks of average pay to buy the average new car. Today, it takes 22 weeks of average pay to buy the average new car. The Producer Price Index just fell by the largest amount in 60 years! The home affordability index hit an all time record level a few months ago (still at very high levels).

Why are real incomes rising so fast? I've said it before and I'll say it again that the law of substitution is far more powerful than is commonly understood.

Tough times cause people to cut unnecessary expenditures. Some of the things they cut become permanent savings. When an expensive item is cut, a less expensive thing is typically added.

"There is an app for that" is the iPhone slogan. There are 65,000 software applications available for the iPhone. There are fewer Google Android apps but the growth rate of Google apps has averaged 50% more per month for the past 6 months! Listen to an iPhone commercial carefully and you will hear that there is a massive amount of substitution taking place all around the world.

The buzz this week has been about the TOM TOM GPS iPhone app. For $100, iPhone owners can acquire a sophisticated turn by turn GPS system that would have cost $3,000 a five or so years ago. But, it is not the substitution of software for hardware that is most significant. The real savings comes in the miles driven due to better directions. The avoidance of wrong turns saves huge amounts of time and money. As the cost of owning a GPS system falls, the number of owners will increase dramatically and the cumulative miles saved will become a huge number. The price of gasoline will be lower than it would be otherwise because so many miles were avoided.

A research report sent out last week details the savings environmental savings achieved by the downloading of a CD versus the physical production and purchase of a CD. The savings is estimated to be 40 to 80% of the cost of the product! Apple has plans to build a new one billion dollar solar farm because the demand for downloads (apps and media) is so large. Every time Apple builds a billion dollar server farm, I believe Google will build at least two.

US mail volume declined by 20 billion pieces year over year; while Google saw a 46% increase in email users! Yahoo, which has 106 million email customers, saw a 22% increase! Clearly a large quantity of electronic delivery is being substituted for a large quantity of physical delivery. When one listens to advertising supported music on Pandora, instead of driving to a store to buy a CD, the savings achieved are perhaps two or three times the price of the CD.

Electronic delivery has become a huge snowball with a lot of hill left. Electronic delivery is scooping up all the snow, leaving our government in the position of trying to roll the US Mail snowball up hill. The bigger the electronic snowball, the fewer the customers to help push the US Mail snowball. In two or three years, US mail delivery will be down to 3 days a week and postage stamps will cost 64 cents each, making all the more customers leave.

What is difficult for many to see is that spending on postage is falling not rising. The move from 44 cent stamps to 64 cent stamps will be a nominal increase of 45%. But if the volume of physical mail falls by 60%, there will be a net decline in spending. A few days ago, a friend suggested that we would be better off paying extra for mail because good postal jobs would be eliminated. If that philosophy had won in the 1700's, women would still be working long hours spinning thread.

Another amazing thing is how much substitution is now taking place "up the line". AOL, ATandT, Comcast, Incredimail and others are losing email customers to Google and Yahoo. AOL is now the fourth largest email provider after falling from 45 million users to 36 million users. AOL is king of dial-up but dial-up is the Stanly Steamer of the car business. The Stanly was the best of more than 100 steam powered cars but the internal combustion engine replaced them all.

Did the largest wholesale price decline in 60 years make it into your consciousness? Do you appreciate how big the Economic Tech Boom is going to be? All the money saved on fuel will go somewhere; much of it will go into spending on new electronic gadgets and services.

Dave Ramsey has a growing cadre of fans. His disciplined saving approach has merit, however, the investment opportunity available today is huge. Put $5,000 into the right investment today and it will be worth $2 million or more in 10 years. Put an extra $5,000 into saving today and it might be worth $10,000 in 10 years.

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!

ROUNDING THE BIG CURVE, WE ARE IN THE TURN

It is fun to own the Q's during this turn. Almost every day, a different stock leads the way to higher prices. Today, Microsoft will lead several of the Q's higher. Wow! Microsoft has finally made the turn! Microsoft dramatically outperformed the market from 1986 until 2000. Microsoft is one of those "almost super rich stocks for me". I came very close to "loading the boat" with it in 1986 and would have made 10's of millions of dollars had I done so. Since 2000, the stock has dramatically underperformed. The turn is here.

After beating the estimates and raising the guidance after the market closed yesterday, the stock is up better than 11% in pre-market trading. Of course, companies like Dell, Intel and HP will be pulled along for a nice ride. The boom, boom, boom of the world economy means that billions of computers will sold during the coming prosperity phase of the business cycle. As we all know, it costs Microsoft virtually nothing to make another copy of VISTA. Billions of copies will be sold. Of course, even more billions of smart phones and games will be sold.


TURN, TURN, TURN

This morning on CNBC, John Snow repeated one of the great false beliefs of the TV pundits. Those, with the mind set that a recession is surely near, find it easy to suggest that the consumer is about to stop spending because he is no longer able to use his home as an "ATM Machine". We have been hearing this garbage for three years or more and it has not happened yet. It will not happen because it never was the case. You cannot stop doing something if you never started doing it in the first place. Even at the peak of the home refinancing binge, only 9% of home borrowing went to make other purchases, such as SUV, and most of these purchases would have been made anyway. The home was wisely used to lower the cost of financing but in only a relatively few cases was it used to expand financing beyond the buyers capacity to repay.

The sub prime story also continues to be used to suggest things that are simply not true. Of those who bought homes with no money down, 85% of them will keep making the payments and they will have been converted from renters to owners. Of the other 15%, the opportunity to own has not turned into the blessing that it could have been but a renter who temporarily "owns a home" with no money invested will lose no equity when he loses his deed. When politicians cry about the poor people who are losing their homes, they imply that consumers are losing billions in equity to greedy and evil hedge fun managers. What really happened was that these aggressive investors borrowed money at very cheap rates of interest to benefit by lending these funds to poor credit risk buyers. The aggressive investors made out like bandits during the good times. If you borrow $95,000 at 1% interest and lend $100,000 at 4.5% (including your $5,000 equity) your annual net interest income is $3,550 or 71% return on equity. Those who are losing their $5,000 equity right now have in most cases had several years of $3,550 net earnings on that same $5,000.

The bottom line is that this story is being used to put fear into the hearts of investors when it is time to be an aggressive investor.

SO FAR, I HAVE BEEN PARTIALLY WRONG ABOUT OIL

The price of gasoline has come down as I suggested it would but the raw commodity has not yet rolled over. Who would have guessed that after 8 to 10 increases in interest rates and after 8 to 10 increases in reserve requirements, that China would continue to grow so fast? The good folks at GAVEKAL research wrote a good book titled "THE END IS NOT NEAR" but who really believed those guys? The GNP of China has once again grown by better than 11%. Where is the clearing price? Of course, if I could predict the precise answer to that question, given that no one else can, I would be a multi-billionaire. We really should think of China like a great growth stock. The current price of shares is very high but there is still great potential for growth. Still, given my belief that the US dollar is about to climb and that within 4 or 5 years high returns will be found in fewer and fewer of the biggest companies around, I am not excited about investments in China right now.

A major oil supply company executive says that there are plentiful supplies of oil. In the liquid market, he can buy all he wants and then some. He says financial speculators are jumping on all news of potential international conflict and bidding up the price. He points out that the skirmishes between Turkey and Kurdistan are not even close to where the oil flows.

We are now at such an extreme level that the break will be like the bursting of a damn. The speculators will not be able to get off the long side fast enough. It is my belief that a deal with Iran is brewing. Once a deal is made, about $30 per barrel in risk premium will fall out of the price.

Keep in mind, the turn in Microsoft is a part of the same process of the turn in oil. The substitution effect includes enormous spending on electronics as a way to reduce dependence on oil. The USA and many other countries have dramatically reduced our use of oil over many years. China is investing heavily to reduce its dependence. Some of these investments will take years to complete but many others are already producing results. Indeed, China is in the process of building 30 nuclear power plants which will replace oil in many a manufacturing process. In the USA, oil usage declined .7% during a year of dramatic export growth. Pundits who say there is no evidence of reduced demand are not looking at the total picture.

The good news is that the world has been hit by the blows of higher oil and taken the punch well. One key ingredient has been the success of economic science. The central bankers have not dried up all the money to stop inflation and thus thrown the world into recession. Instead, money has been available and it has been used to "go around" the "oil problem". Billions of dollars are being spent on billions of projects from coating windows with film to sun powered algae farms.

Those who use high gasoline prices as an example in their constant complaints about inflation do not want to acknowledge that the cost of manufactured goods continues to come down. When China buys oil at ever higher prices but produces end products for less than their prior prices, the net result is not inflation.

CHINA MUST SLOW DOWN

Sooner or later, growth in China must slow. The combination of the rising Yuan with higher interest rates and higher reserve requirements will ultimately do the job. A slow down in growth from 11% to 6% would be a huge event. The China stock markets could be hit very hard by such an event. Always remember that the price of shares is set by the value of the future earnings discounted to present value. If growth slows, future earnings slows and prices fall.

BUY USA, BUY USA, BUY USA GO MICROSOFT GO!

RESPONSE TO RESPONSES

Many thanks to those who respond to my emails. It is humbling to know that you took the time to read my words.

INFLATION:

I have used the example of newspapers and magazines to show that some prices are falling from something to zero; I could have used long distance phone calls, transferring money or maps instead. I personally read many articles from many magazines online without buying a subscription to those magazines. I use a map that plots where I am, calculates the distance and time to my destination and talks me through the turns. Using today's technology, the distribution costs of these services is almost zero. Therefore, the publisher can offer the services in exchange for goodwill or for advertising space.

At least one reader believes inflation is a lot worse than I. This reader still subscribes to his local paper and he notes that his cost of food has soared. One issue this raises is that we each have our own personal inflation rate; the national numbers are the average for all consumers. The consumer who is an early adopter may have inflated his costs when he waited in line all day to buy one of the first iPhones. He paid a high price in time and money. Another consumer can buy today for a substantially lower price. In very short order, the first iPhones are going to be relatively obsolete. They access the internet at a very slow speed relative to what is already available on other networks and extremely slow relative to networks that will be built over the next several years. The price of the next great innovation may be sold at a much higher price but that will not be an inflated price. The fact is that the price of new inventions start high and typically fall and fall some more. The first Xerox machines were leased because few businesses had $100,000 to spend.



Food is important to all of us. Very poor people spend the great majority of their income on food. The sharp run up in the price of food in recent months has caused many very poor people to go hungry. In America, the percentage of incomes spent on food has fallen for as long as charts can be found. I recall a chart from a year or so ago that compared spending on recreation to spending on food. The chart made a big X. The average American spends less than 6% of his income on food. He spends many times as much on recreation. Broad measures of inflation capture the price of all ski lift tickets purchased and the price of all hamburgers purchased.

The typical reaction to the preceding statement is to say, "Oh, so those who can afford a ski lift ticket are the ones who are not seeing inflation." In fact, for the great majority of people, this is exactly wrong. It has been the cost of services, most often purchased by the wealthy, that have gone up the most in price. The inflation rate for a college education, for a heart operation or indeed for a ski lift ticket, have all climbed many times more than the price of a hamburger. One of the wags at GAVEKAL Research quips that "it has never been so expensive to be rich."

Biased people can "mine the numbers" to always show that inflation is better or worse than it really is. We all know that one can prove anything with statistics. The all time best and most consistently correct inflation forecast has been supplied by the bond market. The FOMC likes to look at the implied 5 year and 10 year inflation estimates derived from the spreads on 5 year and 10 year TIPS bonds versus standard 5 and 10 year bonds. Old timers like to rely more on the structure of the treasury market. In other words the willingness of investors to buy 5 year treasuries paying 4.6% says a lot about the markets inflation expectations. Don Hayes uses the 10 year treasury rate chart, to plot inflation a few months into the future. The stats are that this method gives off an r square close to 90! In case you have not noticed, the ten year bond has stayed in a tight range for several years and is currently closer to the bottom of that range than to the top. The inflation risk in today's market is very moderate.

SLOW DOWN OR ECONOMIC RECESSION?

Many a coincidental indicator shows that the world economy is slowing down. Weak economies are most often accompanied by declines in inflation rates. As I noted yesterday, even the decline in interest rates that occurs during slow downs or recessions is by definition a lowering of inflation rates. The USA holds the trump card! Many pundits have "talked-up" their international portfolios. The common theme has been that the world economies have been stronger than the US economy and the stock markets have out performed. The key words in the prior sentence are "have been". Smart investors do not invest in what has been but in what is likely to be. What is likely is that the economy that has the strongest currency is actually "set-up" to suffer the worst during the slow down.

2000 EXAMPLE

In the year 2000, the US dollar was very strong. In 2000 and 2001 the USA was the only major country to suffer through a recession. Yes, 9/11 influenced the US economy but the economic down turn was well before September of 2001. Right now, numbers are starting to flow showing a slow down in Europe. The weak US dollar is a wonderful blessing in these circumstances. US businesses can easily compete with others because the exchange rates with many other nations gives us a strong boost. The great news is that the slow down will lower short interest rates more. We might easily see another 50 basis point cut by the FOMC before year end and with new great prospects for strong growth in the USA we could see the dollar climb out the roof. The big money is made by buying near a currency bottom, just like buying a stock near the bottom.

WHICH STOCKS?

This morning I read a story about a German oil drilling company that has hit another oil gusher in Libya. The company, RWE, has moved from $19 to $88 over the past 5 years. Late last year, it briefly traded above $90 per share. The price had settled back down to about $80 before the gusher was hit. I hope you can how the fact that the price is lower now than it was last year is a signal. The time to buy this stock was 5 years ago. The exact best time to sell the stock was last year when it was trading above $90. The momentum is gone. Those who moved from energy to technology when this stock was at $90 have done well.

The total investment process required to "catch up to the new price of oil" still has many years to play-out. We know many things about the way this process will be completed. For example, we know that Shell and the Saudi will spend $7 billion to more than double the capacity of the Port Arthur, Texas refinery and we know that Kuwait has increased its budget on its new refinery to over $14 billion. We expect that the Port Arthur upgrade to be completed in 2010 and we expect the Kuwait refinery to start-up in 2012. Others refineries will start-up before and after each of the above. While it takes a lot of faith to spend $14 billion on a refinery that will not start until after scores of others have been completed, it does not require faith that the price of oil will stay above $50 per barrel.

The existing Port Arthur refinery has paid for itself many times over at much lower after inflation adjusted prices. It was started way back in the Spindle Top days. It has refined billions of gallons of oil and it is being expanded so that it can refine even billions more over the next many, many years. The investment is being made because the investors expect to make better than a 15% gross return on their investment. They can do that even including a forecast of oil falling back below $50 per barrel. Long term investors can certainly buy oil drilling stocks, hold for decades and make solid returns. However, with the crowd pushing oil stocks hard, you should expect to see these stocks under-perform the market for the next 5 to 10 years. Innovative companies, the ones that are generally finding ways to do things while using only small amounts of energy will do well. Transportation companies that consume large quantities of fuel will also do well.

BANKRUPTCY AT AMERICAN AIRLINES?

After I wrote that AMR faces tough union negotiations in the weeks and months ahead, one reader mentioned that a pilot friend believes AMR is about to be forced into bankruptcy. I strongly disagree. AMR made it though a very difficult time, after 9/11 without filing bankruptcy. Since that time, the company has dramatically reduced its costs and dramatically improved its balance sheet. It has even survived the spike in fuel prices and it will earn at least 65 cents per share this quarter after paying an average of $2.11 per gallon of jet fuel. A few pennies decline in the price of fuel, not due to a recession but due to growing supplies and demand destruction, would boost earnings by perhaps dollars per share.

The big argument being made by the pilots union is that they gave up 30 percent of their pay when it was necessary to save the company from bankruptcy and they now expect to get this pay back. There are at least a couple of big ugly flies in the soup! After AMR pilots "volunteered" to cut their pay, other pilots at other carriers gave up an even higher percentage of pay. In several cases, such as DAL and NWA, the negotiations to reduce costs were held while the companies were in bankruptcy. In the case of CAL, the total give-backs of all union employees were more than a billion dollars per year. The other big fly is that even after the give backs, the AMR pilots are very well paid. So, what you have is a situation where the pilots want 30% raises that cannot be supported by the current market.

It so happens that just this morning the GM -- UAW deal was completed. Thirty years ago, it would have been incredulous to suggest that one day GM workers would give up their company paid health benefits or to accept a contract with no annual cost of living increases. American consumers can rejoice. We have been paying an average of $1,500 in healthcare benefits each time we have bought and American car. Many who can not afford health insurance have paid for it for others.

It is a totally new, global, world in which we live. AMR pilots face the same problem as the GM workers. The fastest growing airlines, which are not based in the USA, expect to dramatically increase their flights to and from the USA. Without doing the searching to prove the point, I am confident in saying that the senior pilots in China do not earn $170,000 per year for 30 hours of work per week. $5,500 per hour plus benefits is not a bad gig but only a very small percentage of the worlds pilots get that rate. Ironically, if the public were willing to trust highly reliable electronic systems, which are much more dependable than the average pilot, the pilots would be not needed at all. Ouch! Believe it or not, in the not too distant future, the competition for travel will include 100% auto pilot crafts. Of course, the politicians would have to stand aside for this to happen and when it does happen it will start with small planes at remote locations.

THE NEAR FUTURE

The new satellite based air traffic control system will be a blessing. It will cost a lot of money but the investment will cut the operating cost of the carriers while, most importantly, reducing the time in the air for tens of thousands of flights daily. Millions of people will save hours daily after the plan is fully implemented. As usual, when the government is the provider of a service, politics get involved and one result is a huge amount of waste. It is only common sense for a 10 passenger jet to have a financial incentive to give up a prime landing spot at a major airport for the benefit of a 300 passenger jet. Giving up this slot should be based on the micro-economics of the situation. In other words, the price of the landing spot should be determined by the market, so that some operators would voluntarily choose smaller airports. Only the individuals involved can determine how important it is to land at the major airport. The government imposed system is the equivalent of Soviet Union system of deciding how many pairs of blue jeans the country should make.

THE IMPORTANT POINT FOR INVESTORS

Investors need to avoid taking one small data point and drawing harmful general conclusions. The core facts are that airlines are operating at record capacity and making money at the start of the prosperity phase of the business cycle. The solid growth in the revenues of these highly levered companies is leading to spectacular growth in earnings. Here in the middle of the mid cycle correction, it was "big news", a couple of days ago, when AMR announced that revenues for the quarter would grow at only 3 to 4%! When a business with very high operating leverage grows revenues by 3%, profits might rise 20%!

What will be the story a year from now? Will the unions still be fighting for a 30% raise that is not going to happen? Are these employees frustrated? Certainly! Do they really expect to make 30% more than their friends at other carriers? Most do not.

BAD NEWS IS GOOD NEWS

The "news" this morning was "bad." Orders of durable goods declined. Duh! Housing starts are way down so there are not as many furnaces or hot water heaters being purchased. The down tick is the "bad news" needed to push interest rates lower and inflation down more. Yes, this is circular logic but that is why they call it a business cycle.

Just remember that interest rates and commodity prices tend to move together. Right on cue, oil supplies recovered a bit this morning and oil prices slipped. The process is slow but sure.

HANG IN, HOLD ON, BUY ALL YOU CAN!

Thanks again for the feedback.

WHAT HAPPENED TO THE AIRLINES YESTERDAY?

Yesterday, I received a fair question. What happened to the airlines? One fellow was kind enough to note that his Google and Garmin are at record highs but he is in the hole on more than half of his airline shares. I took a look and his QLD has done quite well also but then I have to admit that I have been aggressive on CAL, aggressive for good long term reasons.

The casual observer thinks that airline shares were down hard because of a modest tweaking of guidance at AMR. AMR reports that non fuel costs will be slightly higher this quarter and that revenue growth will be slightly slower. Sure enough, some analysts cut AMR's estimates from as much as $1.04 per share to $.66 per share. This was a bit much, especially considering that the company corrected the figures a bit later in the day to say that cost per mile would come in at $11.98 versus the $12.06 that the analysts were using. Even so, the cost figures were up and the spread between AMR's cost and the costs at CAL, NWA and DAL has grown.


WHAT IS THE REAL DEAL?

It has become clear that Congress is going to practice a game of "rope-a-dope", also called Chinese Water Torture. As we all know, it is difficult for congress to complete a budget on time. The US fiscal year begins on October 1 and none of the 12 budget bills have been passed. There is little budget discipline to be seen anywhere in the process. For example, the Senate is just about through hammering out the defense appropriations bill and it is loaded with about 300 amendments that do not relate to defense in any real way.

The old "Christmas Tree" game is being played. In this game, one member agrees to support the goodies wanted by another member and another and another until they can cobble together a voting block and attach what has traditionally been called "pork" or "pork barrel spending" to bills that "must" pass. Today Congress calls pork barrel spending "ear marks". Politicians from both sides of the aisle work very hard at "winning these goodies" for their home states or districts. Get a large enough group together and a real government boondoggle will be passed.

A good example of a boondoggle is the corn ethanol subsidies. By agreeing to build 200 small refineries in 200 different counties across the country, enough votes were added to the farm belt votes and to the "environment-at-all-costs crowd" to pass the very wasteful ethanol fuel program.

The way the "rope-a-dope" strategy is going to work is that Congress will drag out the budget process until the November 16 adjournment date and perhaps even into a "recall" session in December. Congress will send Bush bills for him to veto. Then they will send him a continuation bill. Even the continuation bill will not be "clean". If the government gets closed down for a day or night, they will act again but try to blame Bush for the closure. All the while, horse trading will continue; a vote for this will be traded for a vote against that. Of course, subsidized "health care for the children" and attempts to cut off funding for the troops will be trotted out again and again.

In case you are too young to remember, "rope-a-dope" was the strategy used in a famous boxing match 30 or so years ago. The one fighter covered up and allowed the other to hit at his arms and gloves. The blows were largely reflected by arms and gloves and eventually the hitter wore himself out. Congress is going to try to wear Bush out. Bush will have to veto spending deals that include "goodies" for all the districts before the budget is finally passed. The Democrats hope that they can gradually offer the right combination of "goodies" so that they can peel away enough votes to over turn a Bush veto.

The "heath care for poor children bill" has lots of supporters even though it extends Medicaid to families making $85,000 per year and even though it adds to the mess of Medicare and Medicaid. The strategy of the Democrats is like a sacrifice pawn move in chess - by loading the health care system up with inefficiencies it is believed that the whole system can be scrapped in exchange for a comprehensive government plan.

Hillary's latest plan is far better than the one she attempted to pass more than 10 years ago but it is still a "take-from-some-to-give-to-others government confiscation". In her plan, those who are young and those who take care of themselves are forced to over pay in order to subsidize those who are slothful.

The analogy is constantly drawn to the area of auto insurance. It is said that just like all drivers are required to carry auto insurance, we must all be forced to buy a certain kind of health insurance. I agree that a lot of folks drive up the cost of medical care by not carrying insurance and then going to the "free" emergency rooms to get very expensive care for non-emergencies.

However, the analogy to auto insurance only works to a point. Individuals can choose to carry only liability auto insurance and even then only a base level is required by law. More importantly, those who drive carefully pay much less than those who are repeatedly caught speeding or violating other traffic laws. In the Hillary plan, the young guy who eats properly and exercises pays far more than his fair price while obesity is subsidized.

HOW DOES THIS DRIP, DRIP, DRIP CONGRESS EFFECT THE AIRLINE BUSINESS?

Both the house and the senate passed bills to fund an important upgrade to the air traffic control system. Of course, as usual, the Democrat majority passed a bill that would increase taxes and one that would continue to force the major airlines to pay for an extra large share of the system. Like the subsidized heath care for the obese, they would give the corporate jet fleets a major break; small jets now pay only 3% of the cost of running air traffic control systems but they consume 16% of the services provided. In one way this is no big deal but when day after day thousands of passengers are delayed, routinely by 30 minutes or more and sometimes by several hours or even days, as a result of waiting on small jets to clear, the problem is real. As always, when the government sets the price, great harm is done to some while others are given great gifts. The Soviet Union fell apart for the very reason that central planning is wasteful; markets are the most efficient means to set price.

Charging set rates for FAA services is similar to what has happened in NC to the highway system. In the old days, all the gasoline tax dollars were used to build roads. In order to have great roads, NC citizens went along with one of the highest gasoline tax rates in the country. Many years ago, Governor Hunt, who had preschool education as a priority, started finding ways to take money from the highway trust fund. The annual "withdrawal" is now around $175 million per year. Not a huge amount in terms of state government but enough to service the debt to build about $3.5 billion worth of roads.

Over the years, NC roads have suffered and the current governor is pushing to build toll roads. Of course one idea behind toll roads is that of a user fee. Another idea is that politicians tend to want to raise revenues (taxes) and they can because the government knows how to spend money better than the market place.

COLLECTIVE WISDOM IS GREAT, WHEN APPLIED CORRECTLY

The old saw that a camel is a horse designed by a committee contains truth about collective wisdom; folly follies when "group think" wins. On the other hand, the wisdom of the crowd has been proven time and time again in markets all around the world. Markets are not perfect but they are far more perfect than are "group think" asset allocations.

The following is an example to show the wisdom of the crowd. If a large number of people are asked a question about which they know little they will tend to offer an average answer that is better than the one derived at by a committee. Specifically, if 10 to 1000 city folk at the fair are asked to guess the weight of an large animal, it does not matter if it is an elephant or a jersey cow, the average guess will be very close to the right answer. The more people that guess, on average, the closer the average guess to the actual weight. However, ask a group of 10, 20, 30, or more to get together to choose one best guess and the wisdom of the crowd goes away. The dominate members of the group pull the group toward their guess rather than toward an average estimate.

THE BOTTOM LINE

Congress has passed continuation funding for the current air traffic control system. Three months worth! The huge sums of money spent lobbying Congress for the past several months is simply not enough! Give the passengers sitting on the tarmac three more months to soften them up! In the mean time, AMR and its unions will have their own little slug fest. AMR is the only major line to have made it through 9/11 without filing bankruptcy. The AMR pilots took big cuts in pay to "save the airline". After bankruptcy, DAL, NWA and even UAUA have lower cost structures in place. The pilots are in the unenviable position of asking for their wages back even though they are already earning more than most other pilots. They are asking for wage increases of more than 30%. I doubt they will get more than 10 or 12% but the fight is on. The lowering of guidance by AMR yesterday was probably related to the negotiations ahead. This is one of those times when the airlines are accounting for every expense they can find.

CAL just put an extra $50,000,000 into its pension plan. As I recall, the accounting on pension deposits is a complicated mess but all in all I suspect that CAL was able to lower its current earnings by some portion of this addition and the prior ones made.

LOOK AT THE CASH

The cash hordes being built by the major carriers tells my story. Until sentiment turns and the "feel good factor" boosts these stock prices, the "accounting game" can hide a lot of stuff but the billions in unrestricted cash says a lot. One might guess that these cash hordes will be used to fend off a hostile takeover but we all know that financing the purchase of a company is much easier if the company to be acquired holds lots of cash. One might argue that the cash will be used to buy new planes but in reality planes are usually leased or acquired with long term financing.

A couple of weeks back, Alaska Air announced a share buy back. It seems that the wisdom of the stock buy back might finally be spreading to the airline business. The pay negotiated at AMR will effect all the other carriers but once a deal is done, a share buy back announcement by any major carrier could be the catalysts to sentiment change. CAL is currently selling at around 7 times trailing earnings and 5.7 times forward earnings; boost these numbers to the market average and you get a jump in share price from $30 to $80 lickity split.

Of course, the change in sentiment is not the whole story. A buy back of shares will increase the earnings per share. The normal roll over that will take place in the oil market over the next few years will also result in higher earnings per share.

NEW CAPACITY

CAL has quickly added a lot of flights to its new hub. Many of these flights are on "feeder sized" planes. The big jets will still be used to leave the hub for profitable long haul flights.

If you do not appreciate just how much growth there is in international business, take a look at the recent action by Google. Google will partner to put a new communications cable beneath the Pacific Ocean. Google will gain access at cost rather than the current extra high Pacific rates. These rates have been pushed up because demand is great relative to available space. A fellow on one of the business shows said it well last night. He notes that just because the world has been blessed to be able to bring a few hundred million Chinese out of poverty over the past 20 years it does not mean that we should forget about the 2 billion others. He says the globalization story is still in the early stages. There is no doubt that air traffic is growing most rapidly within the borders of China and India but US International Carriers will get a fair share of the traffic that spills out to the rest of the world.

PATIENCE, PATIENCE, PATIENCE

Being of virtue is tough. Patience was never my strong suit. However, in regard to market moves, I have had to learn to wait, wait, wait, wait, wait and wait some more. The current situation takes my memory all the way back to the summers of 1982 and 1974. In each case, waiting for the market to make its big move was like waiting for paint to dry. The 1974 time was more exciting than the summer of 1982 but not in a good way. In 1982, most of the shares I purchased just sat there. They did not keep going down much but it seemed that the start of the "big bull" would never come.

This time we have had a number of fits and starts. For example, it was late July of 2006 when value lost its momentum to growth and when small lost its momentum to large. Even so, value stocks and small stocks keep making surges. Our QLD has made us happy but the last dip was large and the recent very strong run has just now put us back close to a new high. An upside break out from here would probably run-up another 15% pretty quick but who can time the market? We are left with the charge to be patient. Congress will eventually get its work done and the odds are good that no major new taxes will be passed. The drain to the markets will not be great enough to kill this bull.

BAD NEWS IS GOOD NEWS!

One thing that will help you be patient is to recognize that right now, bad economic news is actually good news! With T-Bills trading at 3.75%, it seems that the FOMC will need to cut the Fed Funds Rate by another 50 basis points pretty soon. Big Ben and company many feel the need for cover. Bad economic news would do the trick. If personal spending slows or if there is an increase in unemployment claims, the FOMC may have all the ammunition it needs to give the patient another high powered electrical jolt.

INFLATION PHOOEY!

One of the funny things is how short sighted prognosticators can jump to the long term view at just the wrong time. We all understand that those who want to be negative can always find a reason to do so. In the case of lower interest rates, the negative always jump on the risk of higher future inflation. While it is true that if interest rates are too low for too long, the economy is likely to overheat and there is likely to be inflation, but that process does not happen in days, weeks or even months. The immediate effect of lower interest rates IS LOWER INFLATION!

The decline in the cost of money from 5.25% to 3.75% is a tremendous price reduction. For many a business, it is like a 28% cut in the cost of raw materials. TV pundits seem to love to talk about the decline in home prices and inflation in the same breath. Again, those who are looking for "bad numbers" can find them or they can make them up. When the price of gasoline was rising, inflation was terrible. Now, with the price of gasoline back down to $2.62, it is the price of oil that is the problem.

The facts of life today include that each and every day a large number of people stop paying for certain magazines and newspapers. These folks have found that the Internet provides all the news they need. The marginal cost of this Internet news source is ZERO! The price of the newspaper falls from 50 cents to ZERO! The law of substitution lives and breathes. The bottom line is that publishing a newspaper online is far more economic that physically printing a newspaper. My old boss, the President of Legg Mason Wood Walker was fond of saying, "In the long run, economics wins!"

GRANDMA and GRANDKIDS

Put all of Grandma's CD's into just a few big stocks such as GE, MSFT and WB and she will do well. She will no longer be on a fixed income as her profits will grow over time.

Be sure that the grandkids own Google in what I call an ABC portfolio. My only grand child owns APPL, BIOGEN, CAL, Dell, Etrade, Google and Sprint. We plan for her to own the rest of the alphabet before too long. We pay no mutual fund fees and no commissions except for the initial purchase. The educational value for her to own small quantities of so many companies is worth more than the millions she will eventually earn. We live in freedom! We are blessed beyond measure! Praise the Lord!

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.

NORTHERN ROCK BANK LOOKS BUSTED

The run on Northern Rock Bank in England continues and is making "news". At the same time, former FOMC Chair, Greenspan, is blasting Bush while apparently trying to talk the market down as much as he can. He talks about inflation on the one hand and deflation on the other. He seems to have forgotten his part in this whole cycle. It is a matter of record that he took the Fed Funds Rate down to 1% in June of 2003, well after the stock market had turned up and after home mortgage lending was already hot. Big money is made when the market swings wildly. Most investors should stay in the market 95% of the time and avoid "playing the other man's game". To some extent it at least appears that the FOMC is running a crap table and the "big boy bankers" have the house odds in their favor.

While I believe in supply side economics, I cannot throw out classical and Keynesian truths. The control of money by the FOMC does play a major roll in the sharp fluctuations of the business cycle.


The good news is that in about two months, this will all be behind us. Unless "Big Ben" executes a water torture drip, the turn should be relatively fast. The wild card is still Congress. It remains to be seen just how hard the congress will push for tax and spend social programs while trying to cut off the support to the troops. Chances are that a continuing resolution will be passed at the end of September. Over the next few weeks, trillions of dollars of spending will be pushed into a hectic schedule of horse trading. Dr. Ken Wertz at Chapel Hill was fond of the muddling trough budget process. He, unlike most of us, enjoyed watching the sausage being made. Boy, do we need to reduce the wasteful spending. To not pass the 13 budget bills and then roll all of government into a massive last minute lump that no one knows all that has been stuck in and pulled out at the last minute is no way to run a railroad.

The savers at Northern Rock will not lose money but most are taking the precaution of withdrawing from one bank and redepositing with another down the street. Our fractional banking system works and the evidence shows that the level of skill of the central bankers keeps improving. I do not believe there will be a recession. I am counting on the central bankers to provide liquidity as is necessary to avoid a "real credit crunch". So far, as has been demonstrated by stock markets that are down only 5% or so from the top, this "turn" is being handled well.

The next few weeks will probably be volatile weeks in the market. You should avoid trying to jump in and out on the bounces because one of them is going to soar. The short term swings will look small when viewed in hindsight a couple of years from now. Get on this bucking bronco and hold on because a fun ride is under way!

NOT THIS WAY BUT THAT WAY

Ben Bernanke, the leader of the US Central Bank, suddenly finds himself running in the opposite direction of his team mate, Jean-Claude Trichet, leader of the European Central Bank. Perhaps the blame is Bernanke's for getting to the 5.25% level too quickly or perhaps it is Trichet's for taking forever to get to the 4% level, but the large spread is pounding on the currency markets. Three months ago, the ECB had made it clear that short rates would be increased last month above 4%. When the sub prime mess hit, the ECB held rates at 4% only to spew out hawkish statements since that time. In other words, the ECB is ready to raise its interest rates.

This is a good thing as the dollar has fallen to all time lows against the EURO. TV pundits often talk upside down about the strength of the dollar. A discussion about the relative strength of a currency can be and often is just as complicated as you want to make it. The pundits tend to focus on the attraction created by high relative interest rates. This focus fails to accept that currencies are much like stocks in that the price is based on potential real growth. A country that keeps its tax burden low and that constantly works to improve its productivity will enjoy a rising currency. With 4% rates, Euroland businesses currently have a cost advantage over US businesses. US businesses must currently fight off base rates of 5.25% which is a significant burden over and above the 4% rate. As a result, the US economy is weaker than much of Euroland.

What if Trichet were to follow though on his talk and raise rates to 4.25% and what if the FOMC gradually lowered to 4%? Can you see what a relative boost that would be for US businesses and consumers?

China just reported the highest inflation rates in 10 years. The Yuan is closely pegged to the US dollar. When the dollar falls, the Yuan falls relative to other currencies. As a result, the cost of imported goods goes up. Now that the turn is upon us, the dollar will appreciate, the Yuan will appreciate, inflation rates will fall in the US and in China and the second half boom will be under way.


WHEN, WHEN, WHEN?

The $64,000 question is when? Unfortunately, the exact timing is never clear. Will it take two cuts by the FOMC or two increases by the ECB to turn the tide?

STAGE 1 AND STAGE 2

In stage one of a perfect cycle, bonds soar in value while stocks and commodities suffer. The real price of industrial commodities peaked several months ago, so even though oil and gold are hitting new highs, I believe we are well into stage one. In stage two, stocks climb on board with bonds. After all, the way stocks are priced is to capitalize earnings at the discount rate that is available in the bond market. The lower the current yield of bonds, the more attractive stocks become.

Since August 16, stocks have been in a hurky jurky uptrend. Bonds have soared in value. A cut in the Fed Funds Rate and an increase in the ECB rate should both serve to support the dollar (I know, John Brown and many other TV pundits disagree, but the evidence is clear). Strength in the dollar will cause low inflation rates to fall out of bed. By the time all of this happens, the selected stocks will be off and running.

DO THE MID CYCLE TURN STRETCH AND DEPOSIT ALL THE EXTRA CASH YOU CAN SPARE. BIG MONEY WILL BE MADE OVER THE NEXT THREE YEARS!

ROCKS IN THE ROAD, SO WHAT?!

When I wrote that Big Ben is about ready to fire the starters pistol, a reader asked how I can believe the "race is ready to start" when there are so many problems. He mentioned the union negotiations, the failure of congress to pass the budget and of course, the housing "collapse".

My reply is: What is new about financial stress at market turns?


Indeed, one of the most positive indicators I have that the market is ready to turn is the fact that there is financial stress.

As I have said many times, the ideal environment for stocks includes a low inflation rate. When does the inflation rate fall? During times of economic stress.

We must remember that one man's pain is another man's gain. The slow down in the housing market is largely the result of the 17 increases in the Fed Funds Rate starting in June of 2004. The increases were brought on by the strong world wide economy. If one area of the economy is super strong, another area needs to be weak in order to avoid over heating and high inflation rates.

INFLATION RATES ARE FALLING AND ARE PROJECTED TO FALL SOME MORE!

China just hit a 10 year inflation peak; inflation in the rest of the world has started rolling over. Please remember that listening to the talking heads in regard to inflation is only confusing. You have people on the TV such as Barry Ritholz who has been whining about inflation for several years. When gas prices were going up, he had a point, but after two years of flat or moderating gas prices, he still yaks about how the FOMC is between a rock and a hard place. The best inflation forecast is available in the blink of an eye. All one has to do is observe the 10 year treasury bond rate. The rate on the treasury bond is always a combination of projected real economic growth and inflation. Don Hayes moves the bond plot forward 2 months and gets an inflation forecast that has an r square of 88! Did you notice the huge drop in 10 year rates over the past several weeks? INFLATION RATES ARE READY TO FALL SOME MORE!

My friend Lamar, who was a broker at Merrill Lynch in the early 1980's, will remember our old 1.9 indicator. We plotted the t-bill over the dividend rate of the S&P. In the summer of 1982, in October of 1984 and in September of 1990 this indicator gave a BUY signal, just as it did two weeks ago. Again, this is nothing but a fall in short term interest rates.

Fed Funds have been trading day after day well below the target rate of 5.25%. In other words, the FOMC has been keeping enough reserves in the banking system to hold rates well below their own published target. The rate has bounced around the 4.7%. The FOMC has already cut rates but is waiting for the "appropriate" time to make the announcement.

YES, I DID SAY...

I said that stocks would take off after commodity prices have moved down the "third hump". I also said that the stock market discounts or moves 6 to 12 months ahead of the economy. Each cycle is a little different. In 1996, the CPI adjusted CRB index peaked in February of 1996, the big gains were made by those who "got in" to the new market leaders even before the peak. The CPI adjusted CRB peaked in January of 2007. The NASDAQ 100 is already busting out. The DOW JONES is making headlines by jumping up and down by 200 points or more but all the while the NASDAQ is performing well. Yes, it jumps up and down but it jumps three steps and only retreats a couple.

ROCKS IN THE ROAD

The auto unions and the congress are holding out as long as they can. They would love to see a big turn in the economy. The unions want auto sales to take off. The car companies have produced enough "extra" such that they might even enjoy reducing inventories during a strike. The congress wants to spend a lot of money. To spend the money they need to raise a lot of taxes. They would love for the economy to be strong. Unfortunately for them, the economic weakness will continue until well after the budget needs to be passed. The idea of raising taxes, while the economy is in the tank, cuts against the wisdom of all the major economic theories. Keynes nor Friedman would have advocated raising taxes during a "slowdown".

Because the stock market leads the economy by 6 to 12 months, there are always "rocks in the road" before it takes off. Sure, the battle between Bush and the Democratic Congressional Leaders will likely drag on for several more weeks. By law, the 13 budget bills are to be passed and signed by October 1 but continuing resolutions are not uncommon. Bush is likely to veto some spending and the congress is not likely to "close the government down". The state of the housing market is going to encourage Democrats to advocate all the more spending. They will want quasi government agencies such as Fannie Mae to "bail out" the mortgage market. The argument will be made that this will be done to protect the poor homeowner, who never had equity to start with, but the effect would be to bail out the lenders who stretched to make an extra buck.

Bush has asked for reformation of FHA. The odds are that some of the reforms he wants will be passed along with a few additions that he will not like. My guess is that by mid October compromise budgets will be passed. The actual speed will depend on the perceived advantage or disadvantage in regard to the coming elections. With many primaries just around the corner, the candidates will want to be back on the campaign road as soon as they can.

WILL THEY CUT AND IF SO BY HOW MUCH?

Keeping the market guessing serves a purpose. The longer the FOMC can keep the question in doubt, the more inflation they can squeeze out of the sponge. As noted, their strategy has worked. TIP spreads and regular 10 year bond rates show that inflation is dead. China will be the last to feel the slowdown but some big economic waves are already headed across the ocean. The weakness of the Yen and of the dollar are each having the expected effects. Industrial machine orders in Japan just jumped by 17%! The super efficient Japanese are ready to go head to head with the Chinese who have low cost labor as their comparative advantage.

I continue to believe that the odds of a recession are less than 50/50 even though the highly accurate TradeSports betting site now has the odds at around 55%.

YES, RATES WILL MAKE A DIFFERENCE

It has been fun to listen to various pundits suggest that it is "too late" for lower rates to make a difference. OH COME ON! Have the pundits forgotten the law of supply and demand? If the price of money is cut, the demand for it will go up. A cut in one of the cost of doing business will mean there will be more business done. It is true that the effect of lower rates is a process for the economy the effect will be much more immediate for the stock market. EACH CYCLE IS A LITTLE DIFFERENT. WE DO NOT KNOW IF THIS ONE WILL JUMP EARLY OR LATE. THE BEST STRATEGY IS TO JUMP ON THIS BUCKING BRONCO AND HOLD ON FOR DEAR LIFE. ADD ALL THE FUNDS YOU CAN BECAUSE ONCE THE STAMPEDE STARTS THE TEMPTATION WILL BE TO WAIT FOR A "PULL BACK" TO JUMP. IT IS SIMPLY HARD TO GET ON A MOVING TRAIN. GET ON NOW AND SIT FOR A WHILE! YOU MAY BE SCARED BUT NOT TRYING TO JUMP ON BOARD AFTER THE TRAIN IS MOVING IS EVEN MORE SCARY. 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!

The Credit Squeeze of 1966: BUY BUY BUY

THE MID CYCLE CREDIT SQUEEZE!

US Real estate went up and up some more for most of the years after WWII up until 1966. Then, suddenly, the market, in cooperation with central bankers and politicians engineered a credit squeeze. I remember this well because my mother was a real estate agent at the time. The banks and savings and loans had money to lend, they were financially solvent but, due to arcane laws about interest rates (Banks could not legally pay more than 7.5% on a certificate of deposit), it made no sense for them to make mortgage loans. Suddenly, it did not matter how good your credit was, no one could get a home loan. Review the economic history of that year and you can see the chilling effect this development had on the economy. Still, there was no recession, only a mid cycle rotation.

This time around, the credit squeeze will not last as long. It will take time to unwind the carry trades but money will be available at a price. Lenders are still making loans today. Jumbo loans of greater than some $400,000 plus are temporarily hard to find but ask your local credit union and you will find good loans available at good rates. The re-sell market is temporarily dry for the big loans. This time, the bankers could generally could make the loans if they wanted but they are not sure where interest rates will settle once the highly leveraged carry trades are unwound. With a world wide capital spending boom in place, the concern is that business borrowing is going to push rates up. The good news is that inflation rates are low, causing loan rates to stay low.

THE SUN RISES OVER JAPAN!

The Japanese economy has been in a funk since 1989. Interest rates have been so low in Japan that hedge funds have been willing to borrow at low interest rates in Japan and to re-lend in other nations around the globe. The problem is that doing this trade exposes the practitioner to currency risks. If the Yen appreciates in value, the borrower of Yen must payback the appreciated currency value, not the currency that he borrowed. For as long as Japan was "in the funk", the deal paid handsome rewards. Now that the economic mid cycle turn is here, the Yen is "steadily" appreciating, these borrower-lenders must scramble to collect their funds as quickly as possible so they can buy the Yen before it goes even higher. To some extent, this is at least a temporarily self fullfilling action as the demand for Yen puts all the more lenders into a temporary bind. On the other hand, some of the central bankers of the world that were injecting emergency funds just a few days ago are now regularly withdrawing excess liquidity; the big ripples in the pond are getting smaller day by day. Another big stone could ripple the waters again but the worst is over.

It is ironic that Greenspan has been blamed for keeping the fed funds rate too low at 1% for too long. The truth of the matter is that it was Japan that suffered deflation for the past couple of decades and it was Japan that offered the world cheap cheap cheap money. For many years, the central bankers of Japan could hardly lend Yen at zero interest. They said take the money please!, pay us back when you wish and there will be no interest added to the principle. As the currency was declining in value, the deal could only be made when foreign, profitable projects could be funded with this money.

NO MORE FREE MONEY!

The world economic recovery is real. The world's economy in the past year grew as fast as it ever has in history. Japan, which is still much more dependent on manufacturing than is the USA, was hit harder than others by the competition from China, India, et. al. Now that the mid cycle correction is well under way, Japan will enjoy the late cycle capital goods spending boom that is underway. For example, Japan will build a number of the 40 nuclear power plants planned in China. Much of the the excess currency reserves built up in China over the past 20 years will be spent on items such as 787 DreamLiners and nuclear power plants. In the mean time, there are still a few hundred million Chinese who are willing to work for more than food. The growth in China continues. The speculation in the China market has sucked up money from around the globe. The mid cycle correction will be over by the time there is much of a slow down in China.

OTHER NEWS

While the sub prime mess gets more than its share of the ink, the other news around the world is interesting. (The sub prime story is the news media's way of talking about the unwinding of the carry trade. Saying the world is coming to an end as a result of a "crash" in the residential real estate market demands a bigger audience than saying that speculators can no longer borrow in Japan to lend elsewhere).

One item of note is the move by some airlines to sell or spin off their frequent flyer programs. Canadian Air completed its spin off last year and others are at least taking a look. It has been said that UAUA was offered $7.5 Billion for its program. Flyers on UAUA would still earn frequent flyer miles but they would be managed by an independent company. A major difference in some of these programs is that all flights become available for frequent flyer rewards. The points needed to fly at peak demand time might be higher but, since an average of 17 percent of these points are never redeemed, it makes sense for an independent system. Points can be used for all sorts of purchases, everything from upgrades to consumer goods.

PRESSURE ON IRAN, IRAQ AND USA

The pressure to make a deal is still on Iran, Iraq and the USA. The time is drawing near for a number of deals to be struck. President Bush is applying new pressure on Iran. The administration is about to declare the Iranian Revolutionary Guard to be an organization that supports terrorist. This is a significant action as the Revolutionary Guard is an industrial-military complex. It is a "machine". It takes in a lot of money from many sources and uses these funds to support terrorist in Lebanon, Afghanistan, "Palestine", Iraq, etc. By proclaiming the status, the USA can disrupt the commercial activities that are used to support this organization.

The Iraqi prime minister is under great pressure and he is pressuring others. Iraq needs to increase oil production as this is the primary source of revenues for the government. Most of the Iraqi interest groups understand that the country needs to settle its differences in regard to the sharing of oil revenues so economic progress can be made. Once it is clear that the central government is a long lasting entity, the rational for cooperating through the government will increase. I still have faith; establishing a free government is no small challenge, one that takes time to build.

RECESSION PROBABILITY

The most recent sub prime mess will contribute to slower growth in the US economy. However, with exports growing at 11.2% and with a capital building and spending boom in progress by American businesses and with year over year profits rising at better than 14%!, I see no recession in sight. I say this, knowing that we have had a slightly inverted yield curve for about a year and that growth in the monetary base is at recession levels.

WOW! Car sales down, housing sales down, hedge funds and mortgage brokers going belly up and NO RECESSION! I believe there is about a 20% chance that we will actually see a recession. Who knows how scared the public has gotten as a result of the "bad news". For most US citizens, the Yak, Yak, Yak about sub prime is of little importance. The unemployment rate is near record lows and, while this is an incidental indicator, leading edge numbers still show great strength in the economy.

WOW! If profits are up 14% and with the business spending boom continuing and with competing treasury securities selling for higher and higher prices, STOCKS SURE DO LOOK ATTRACTIVELY PRICED!

Oil futures keep trading up each time a storm is named but the OPEC oil sellers continue to report that selling oil is becoming like pushing on a string. For the past 5 years, anyone who had oil did not need to hang out a sign. Buyers would find the sellers. Now buyers are getting choosy. They are not running their high cost refineries and are buying fuel that is easy to refine. Why "cook" heavy grades of junk at high temperature if the sweet stuff is available. On the other hand, one refinery after another with access to cheap Canadian tar sand oil is expanding or converting production.

Hurricanes usually miss most of the production assets. As each one misses, you can expect the price to retreat. The unwinding of the carry trade will reduce the money available for all sorts of speculations. With Ben and company holding real short rates up, I expect the commodity complex to see some pain in the coming months. Commodities down; technology stocks up!

BUY BUY BUY!

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