Al Gore

If you click on the title of this post, you will be taken to the website of Generation Investment Management. The Chairman of the firm is Al Gore.

Generation's investment philosophy incorporates sustainability issues into their investment process. I think that is admirable, as long as their investors are happy with their returns. However, I wonder how many people know that Al Gore is hyping global warming to the benefit of the companies in which Generation invests? Doesn't that sound like at least a little bit of a conflict of interest?

If I buy a stock and then post here wonderful things about it that I can't prove, without disclosing my ownership, I would find myself in a world of trouble with the SEC. Generation owns alternative energy companies that would benefit from any legislation that limits carbon based fuels and Al Gore travels around the world drumming up support for just this type of legislation. Hmmmm....

A Yen for a Correction

Why did the stock market sell off over 400 points yesterday? The standard explanation was the sharp correction of Chinese stocks which was caused (allegedly) by fears that the Chinese government would take measures to reduce speculation by locals on their exchange. Why would selling on the local Chinese market cause a worldwide selloff in stocks? The Chinese stock markets have a combined capitalization of about $350 billion. A couple of well heeled US private equity funds could LBO the whole thing. And the Chinese have about $2 trillion in savings so even a 10% plunge in prices shouldn't have that much of an effect on the Chinese economy. The selloff in world stocks was only partially related to the Chinese stock market fall.

The real culprit was the Japanese Yen. Huh? I haven't seen any news story yet that even mentions the move in the Yen yesterday, but that was the real cause of the selloff. Let me explain. Hedge funds have for many years executed a trading strategy called the carry trade. The funds borrow yen at a low interest rate (rates in Japan were just raised to 0.5%) and convert the yen to another currency where they can get a higher yield. Borrowing at a low rate and investing at a high rate means the trade has what is called positive carry. In other words, the yield on the investment more than offsets the interest cost from the loan. Once upon a time, the carry trade was primarily a bond trade. Borrow at 1% in Yen and buy Treasury notes with a yield of 5%. If the exchange rate stays the same, the fund makes the 4% difference. Leverage this up and you can generate high returns with seemingly low risk. The problem is that the exchange rate never stays the same. Over the last several years though as more and more funds have engaged in the trade, the very act of doing the trade caused the yen to fall which actually increases the profits of the funds who got in early.

Now funds have wandered away from the bond market with the carry trade. If you can make 4% buying Treasury notes, why not take the borrowed money and invest in the S&P 500 and make more? If you borrowed in yen last summer and put the money in US stocks you would be sitting on some big profits. These yen loans are now financing trades all over the world. Brazilian bonds, Turkish bonds, US stocks, Russian stocks and bonds, etc.

Here's the problem with the carry trade. If the yen starts to rise, the funds start to lose money as the cost of buying back the yen to repay the loan rises. And that is what happened yesterday. As the yen started to rise, the hedge funds took action to limit their losses. To do that they needed to buy yen which caused the yen to rise further which caused other funds to buy yen, pushing the yen higher which caused...you get the picture. To pay back the yen loans, the funds then needed to liquidate the investments they had bought with the loans. That would be the aforementioned bonds and stocks. And we get a 400 point loss in the Dow.

So here's the question. Did the funds start buying yen because they wanted to reduce their risk after the Chinese stock market fell? Or were the funds buying yen because they feared that other funds would buy yen to reduce their risk? It's a circular argument for which there is no answer, but one thing is certain. If the yen rises - for any reason - the pain will be felt a long way from Tokyo. I have talked for many years about the excess liquidity in the world financial system. The source for much of this liquidity is Japan and if it dries up the consequences for asset prices will be severe. I wonder if US politicians who believe a stronger yen would help the US economy by making our exports more competitive have any idea what the consequences would be if their desires came true? I suspect not.

I wrote our latest tactical update last Saturday and got it out to clients on Monday. The main theme was the need to reduce our equity exposure:

This past week felt like a turning point in the markets. I find it hard to explain why a seemingly uninteresting week with no major economic news felt so important, but I have learned, after many years of investing, to trust my instincts. And my instincts tell me that something changed this week....I have advocated an overweight position in stocks since our first tactical update in August, but the time has come to make a change. During most of this rally the average investor has remained skeptical. When I wrote that first tactical update back in August, the surveys showed more bears than bulls. As the market has risen, the number of bulls has increased steadily; as the market has rallied, more and more investors have jumped on the bandwagon. This week for the first time, bulls represented more than 50% of the survey participants. And that alone warrants at least a minor change. I am reducing our overweight position in stocks. I am still recommending an overweight but reducing our exposure to a more comfortable level.

I was able to get some selling done prior to yesterday's big selloff, but frankly I wasn't able to do everything I planned. Timing is everything in this business and while I'm proud of the call to sell some stocks, I can't help but think that I waited a little too long. One thing for sure; no client should have been surprised by the selloff. We have been talking about the likelihood of a correction since early in the year. In fact, we've been hoping for some kind of correction so we can put some money to work, but this was a little too much too soon. Oh well; you take what the market gives you.

The market will probably try to make some kind of rebound over the next couple of weeks. I doubt it will make new highs though and a retest of the low yesterday would be routine. I will probably be looking to do some selling on the rebound and save my ammunition for the next downdraft. That's the plan anyway. Let's hope my timing is a little better this time.

Iraqis Learn Nothing

The current Iraqi government is hard at work trying to emulate all those other states who have nationalized their oil industry. Too bad. As indicated below, the Iranians and Venezuelans haven't had a lot of luck with that central planning thing. Nevertheless, the Iraqis seem headed down the same sad path:

In its current form, the legislation envisions the re-creation of an Iraqi state oil company, and it gives broad latitude to officials from the country's various regions to encourage foreign investment and development.

Here's an oil worker's union official:

"History will not forgive those who play recklessly with our wealth," he said. "We consider the new law unbalanced and incoherent with the hopes of those who work in the oil industry. It has been drafted in a great rush in harsh circumstances."

What exactly does he mean by "our wealth"?

The rhetoric echoes the sentiment of many everyday Iraqi citizens. The nationalization of the Iraqi oil industry in the 1970s under Saddam Hussein remains a point of pride for many Iraqis, and opposition still runs deep to any hint of foreign interference.

Why not form a company and distribute shares to every Iraqi citizen? If the oil truly belongs to the Iraqi people, why does the government get to decide how the wealth is distributed? Why does the government get to decide if foreign companies can do business in Iraq? Distributing shares could also go a long way toward solving the political problems. If every Iraqi owned shares in the company, there would not need to be a method for distributing oil revenues among the provinces. The violence in Iraq is about money and power, but primarily money from the oil sector. That needs to be removed as an obstacle to peace. The best way to do that is by distributing the wealth in the only truly fair way - private ownership for every Iraqi citizen.

Venezuela and Iran

Venezuela and Iran are providing a real world economics lesson to their citizens. Both these countries are command economies run by decree from on high rather than responding to market signals. And the results are just what economics predicts.

From the Miami Herald

CARACAS, Venezuela -- Meat cuts vanished from Venezuelan supermarkets this week, leaving only unsavory bits like chicken feet, while costly artificial sweeteners have increasingly replaced sugar, and many staples sell far above government-fixed prices.

President Hugo Chavez's administration blames the food supply problems on unscrupulous speculators, but industry officials say government price controls that strangle profits are responsible. Authorities on Wednesday raided a warehouse in Caracas and seized seven tons of sugar hoarded by vendors unwilling to market the inventory at the official price.

Hugo Chavez seems to believe that the laws of economics do not apply to him and his backwater of a country. But price controls always have the same effect - shortages. Chavez imposed price controls in an attempt to control inflation that is now officially pushing 17%. Unofficially, it is most likely a lot higher than that. That is an example of treating the symptom rather than the disease. The disease is excess money (bolivar) creation which when combined with controls to prevent capital flight causes people to react to protect their meager savings. If you can't convert bolivars to dollars (or some other currency) and your bolivars are worth less every day, the only thing to do is spend the money. And that feeds the inflation. With price controls pricing many goods at less than production cost, producers are unwilling to produce to fulfill the rising demand created by the capital controls. Thus shortages appear. Call it socialism or communism or whatever you want, but this is economic idiocy writ large.

Iran is also experiencing some shortages these days. Not suprisingly, the cause is the same. Iranians, sitting on top of some of the largest oil reserves in the world, have a shortage of fuel. There are two simple reasons for this. First, the actions of the mullahs over the last 28 years means that most multinational oil firms don't or can't do business in Iran. That wouldn't be a great problem if the Iranian economy were allowed to operate in a more market oriented fashion. But the need to maintain political control means the government must maintain economic control as well.

Second, the Iranian government subsidizes the price of gasoline. A subsidy has a similar effect to price controls. If you maintain the price lower than the market, demand will create shortages. It also creates smugglers:

From the Wall Street Journal

But an even bigger problem is the consumers themselves. That's because subsidies make energy practically free in Iran, discouraging any serious energy conservation. Gasoline, for example, costs about 40 cents a gallon at the pump. That's encouraged an explosion of use, as Iranians add new cars while continuing to use fuel-guzzling old models. It has also encouraged a brisk smuggling trade as Iranians buy millions of gallons of fuel at the subsidized price and truck them into neighboring Pakistan, Turkey, Afghanistan and Iraq for sale at market rates.

It is also interesting to note that oil production in Iran today is only about two thirds what it was when the mullahs took over. And they have to import gasoline to meet the demand they've created by subsidizing the price. They claim they need nuclear power to provide for future energy needs. What they need is an Amazon account so they can purchase a few copies of The Road to Serfdom or maybe Wealth of Nations.

They've Got Us by the...Assets

Recently a good friend voiced a slightly altered version of the above phrase during a discussion of the Chinese government preference for US dollars. No she didn’t use the plural form of a word defined by Webster’s as “a round object that is hit or thrown or kicked in games”. She’s not that kind of girl. She was referring to the Chinese accumulation of US Treasury and Agency debt, but it now appears that the Chinese government is looking to diversify beyond the fixed income asset class. The Chinese government is rumored to be forming an investment fund, called the National Foreign Exchange Investment Company, to invest in other asset classes. The fund will be used for mergers and acquisitions of overseas businesses, energy assets, and equities.

With holdings of $1 trillion in reserves, it seems logical that the Chinese will look to invest some of the $200 billion the fund is expected to be seeded with initially to buy the stock of US companies. Why sell dollars and drive down the value of the fixed income allocation? That might seem like good news for investors in US stocks, but it should also send a bit of a chill down the spine of every stockholder. What exactly are the Chinese up to? Are they just looking to diversify as any prudent investor would or are they after something else? Since I’m writing this, it should be obvious that I believe they have another agenda.

I don’t know if the Chinese government has a long term plan to dominate the world like some James Bond villain, but their mercantilist impulses have consequences for the US economy and sovereignty. The number of grandstanding, populist politicians demanding that the Chinese revalue their currency up against the dollar grows by the day. These economic ewoks believe our trade deficit with China will magically disappear if only the Chinese will allow the Yuan to appreciate. And everyone knows that the trade balance is the vital sign that signals economic health…right? Well, not exactly.

Since 1976, the US has run a trade deficit every single year. The only times we have seen an improvement in the trade balance is during recession. So if eliminating the trade deficit is the path to economic nirvana, we just need a really good recession and our problems will be over. And a recession, or worse, is exactly what we would get if the politicians have their way. Senators Schumer (D, NY) and Graham (R, SC) (economic idiocy is apparently the only area of true bipartisan agreement) have previously introduced a bill that would levy tariffs of 27.5% on Chinese goods unless the Chinese take steps to “correct” the undervalued Yuan. Somehow these two intellectual giants have determined the exact amount by which the Yuan is undervalued.

I find it highly unlikely that the Chinese would just accept such a high tariff barrier and they don’t have to. As my friend said, they have us by the….Treasuries. Enact tariffs and the likely Chinese response would be a fire sale of US dollar denominated bonds. And there are a lot of excess dollars in the world. Furthermore, the rise in the price of Chinese goods would not be a good thing for the US economy. In case Senators Schumer and Graham haven’t noticed, those flat screen TVs the Chinese manufacture get sold in places like Best Buy and Circuit City. What do the honorable gentlemen have against the pimply faced gadget geeks that work the aisles of Best Buy? What about US companies manufacturing in China? Do the politicians really believe that if we raise the Yuan, that these US companies will relocate all their manufacturing back to the good old USA? I’ve got news for them; a 27.5% increase in wages in China will not be nearly enough to equalize things from the perspective of a manufacturer.

And let’s just suppose that the Chinese are magnanimous and actually do revalue the Yuan. Would it have the effect that Schumer and Graham assume? I don’t think so. The Chinese are primarily assemblers of products and thus import the parts for the products they assemble. They also must import raw materials such as oil. So if the Yuan is revalued up, what would be the effect? Probably not much. Their input costs would go down thus increasing their profit margins and allowing them to absorb most of the presumed rise in price for the final goods sold here in the US. The economic effect would likely be negligible and the trade deficit would be little better than it is now. And the Chinese would have a stronger currency with which to buy US equities and other assets. I’m really having trouble finding a positive here.

So what are the Chinese doing? While we are distracted with Iraq and North Korea, they are waging a kind of stealth economic war against us. Our politicians are doing exactly what the Chinese want them to do. By demanding a rise in the Yuan, US politicians will provide the Chinese with additional purchasing power to gain the assets they need to further their leverage over the US economy. Add say $500 billion in equities to their Treasury holdings and they will have a measure of control over our economy with which everyone should be uncomfortable. If they decide to move on Taiwan, we’ll have a choice of economic suicide or letting the Chinese have their “renegade” province back. I suspect the American public will choose flat screen TVs over defending Taiwan.

The good news is that we don’t have to let this happen. We are in this situation because of our own policy mistakes, not because of the Chinese. The primary cause of the situation is a monetary policy that attempts to control $US money supply without acknowledging the existence of or the need to control asset inflation. Globalization has the effect of holding down US consumer inflation by importing cheap manufactured goods from, ironically, countries like China which have much lower wage costs. The Fed, seeing no consumer inflation, assumes that they have control over the global supply of dollars. The asset inflation that we see all around us is ignored. Greenspan spoke of the conundrum of low long term interest rates and Bernanke talks of a global savings glut. What they apparently won’t acknowledge is that the cause can be found by looking in the mirror. There is no global savings glut; there is a global US Dollar glut.

Lousy monetary policy has been exacerbated in recent years by equally lousy fiscal policy. Inflation affects politicians too. The excess supply of dollars allows us to spend billions in Iraq even while politicians compete to see who can try to stuff the budget with the most egregious pork barrel project. Tax receipts rise as capital gains are realized from the asset inflation and spending rises even faster. I guess the politicians believe that if the Chinese are willing to loan us the money, they should find a way to spend it.

The answer to ending the Chinese influence on our economy will not be found in simple policy prescriptions like currency devaluation and import tariffs. The solution is found in a monetary policy that anchors the dollar to a true price indicator (that includes asset prices) and a fiscal policy that supports growth while controlling government spending. Until that happens, the Chinese will continue to further their grip on our….assets.

Coming Next: In my next essay, I’ll discuss the asset inflation that is the result of the excessive money creation of the Central Banks of the world.

Changes to the Fed Statement

The FOMC left rates unchanged for a fifth straight meeting but said the economy is "somewhat firmer".

Changes: "...Substantial cooling in the housing market" at the last meeting became "some tentative signs of stabilization."

Language from the last meeting about inflation moderating due to "reduced impetus from energy prices, contained inflation expectations, and the cumulative effects of monetary policy actions"...was removed. I would think that means they believe that inflation has moderated already. One could take that as hawkish in that they aren't looking for any more moderation of inflation.

Everything else is the same as the last statement.

It seems that they have a more positive view of the economy and are still more worried about inflation than growth. We still think the Fed is on hold for at least the first half of the year and maybe for much longer.

Fed Statement

The Federal Open Market Committee decided today to keep its target for the federal funds rate at 5-1/4 percent.

Recent indicators have suggested somewhat firmer economic growth, and some tentative signs of stabilization have appeared in the housing market. Overall, the economy seems likely to expand at a moderate pace over coming quarters.

Readings on core inflation have improved modestly in recent months, and inflation pressures seem likely to moderate over time. However, the high level of resource utilization has the potential to sustain inflation pressures.

The Committee judges that some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Susan S. Bies; Thomas M. Hoenig; Donald L. Kohn; Randall S. Kroszner; Cathy E. Minehan; Frederic S. Mishkin; Michael H. Moskow; William Poole; and Kevin M. Warsh.

Goldilocks in the House

The advance report on GDP for the 4th quarter 2006 was reported at +3.5%, better than the 3% expected by economists:

Real gross domestic product -- the output of goods and services produced by labor and property located in the United States -- increased at an annual rate of 3.5 percent in the fourth quarter of 2006, according to advance estimates released by the Bureau of Economic Analysis. In the third quarter, real GDP increased 2.0 percent.

The 2% growth in the 3rd quarter had convinced most that the economy would continue to slow forcing the Fed to cut rates. We argued in our last two Tactical Updates that the economy was unlikely to fall into recession:

Betting against the US economy has been a poor bet over the last 30 years and we are generally optimists about the US and world economy....We think a more likely outcome is that the economy re-accelerates and interest rates rise sometime next year.

In addition to good news about growth, the inflation numbers reported along with the GDP report were exceptionally good as well:

The price index for gross domestic purchases, which measures prices paid by U.S. residents, increased 0.1 percent in the fourth quarter, compared with an increase of 2.2 percent in the third. Excluding food and energy prices, the price index for gross domestic purchases increased 2.3 percent in the fourth quarter, compared with 2.2 percent in the third.

We also predicted this in a previous Tactical Update:

A slowdown to a more sustainable pace would actually be quite welcome as it would ease the pressure we’ve seen on natural resources (commodities) and tend to reduce inflation.

Obviously, most of the moderation in prices in the fourth quarter was due to falling energy prices as the ex food and energy numbers were in line with the previous quarter.

Another theme we have stressed is the deflationary effects of globalization and that can be seen in this report as well. Import prices fell 8.5% in the fourth quarter which probably contributed to an overall drop in imports of 3.2%. Exports were up 10%. So much for all that worrying about the trade deficit.

The big drag on the economy continues to be housing as real residential investment fell 19.2%. This was partially offset by an increase in non residential structures of 2.8%. Another drag was inventories which only increased $35.3 billion in the quarter vs $50 billion plus in the last two quarters. This may mean an added inventory build in the first quarter that will add to growth.

Overall, it seems that the Goldilocks economy is back. We continue to believe that the Fed is on indefinite hold. We see no reason to expect a rate cut or hike in the near future. We'll get a little more info this afternoon when we parse the Fed statement. We also expect growth and corporate profits to continue to surprise on the upside.

U2

There have been a number of articles recently about the business dealings of Bono and U2. All the articles essentially call the band hypocritical for structuring their business affairs to minimize taxes:

Bono's own dealings haven't always followed the altruistic ideals he espouses, says Richard Murphy, a Downham Market, U.K.- based adviser to the Tax Justice Network, an international lobbying group.

Minimizing Taxes

Murphy points to the band's decision to move its music publishing company to the Netherlands from Ireland in June 2006 in order to minimize taxes. The move came six months before Ireland ended an exemption on musicians' royalty income, which is generally untaxed in the Netherlands.

``This is somebody who's exceptionally rich taking the opportunity to shift his tax burden to somebody else, but then asking governments around the world to spend that tax take in the way that he would like,'' Murphy says.

U2's move to the Netherlands is wrong, says Dick Molenaar, senior partner at All Arts Tax Advisers, a Rotterdam-based tax consulting firm for artists and musicians. ``Everybody needs to pay his fair share of taxation to the government, and therefore we have roads and education and everything,'' he says.

I saw the band on their latest tour and admire Bono for his pragmatic activism. I don't think there is any conflict between what he does for the various causes he represents and how he structures his businesses. One can be a good capitalist and also be a good person concerned about the state of the world. I'd rather see him keep his hard earned money and be involved than for him to pay more taxes and be less involved.

AEI Market Outlook

John Makin at the American Enterprise Institute has a new article about the outlook for the market in 2007:

As we enter 2007, many market commentators describe themselves as "cautious" concerning the stock market. They should not be. The major determinants of stock prices are expected profits and interest rates. Both factors are currently supportive of higher stock prices. Profits are expected to rise by about 10 percent during 2007, while interest rates should remain stable and may even fall, providing further support for stock prices.

Makin's outlook is more optimistic than ours but this article makes a good case for stocks:

Based on historical norms since 1985, the current yield on ten-year government notes (about 4.75 percent) and the projected earnings of the companies in the S&P 500 stock index over the next year suggest that the present level of that index--about 1,420--equals only about 80 percent of its "fair value." In other words, if we take our bearings from expected earnings and interest rates, if the stocks in the S&P 500 were currently valued as they have been on average over the past twenty years, the index would be at 1,775 instead of 1,420.

I'm more concerned about rates and it appears the market is as well. Expectations for a rate cut this year have essentially been removed from the market and that is the source of the recent hesitation in the market. However, I expect earnings to be better than expected as growth seems to be accelerating again and that could indeed push the market closer to fair value.

Madeleine Albright - Hedge Fund Manager?

Jan. 18 (Bloomberg) -- Madeleine Albright, the former U.S. secretary of state, raised $329 million to invest in emerging markets, joining the ranks of former dignitaries who have entered the lucrative world of private fund management.

Think there might be a bubble in the hedge fund world? There's a lot of ex political types in the hedge fund world now, but this has to be a sign of the apocalypse or something. This is a woman who toasted Kim Jong Il and negotiated with Milosevic.The Dutch think she's got some political insight:

``We see a lot of potential in emerging markets for economic growth,'' Jelle Beenen, a portfolio manager at PGGM, said in an interview. ``The reason that investing there is always a problem is there are issues like fraud and political instability, so that's why there's value in political-risk management and the involvement of Secretary Albright is a valuable one.''

But apparently that political insight isn't expected to produce very much:

PGGM expects Albright Capital to deliver a 10 percent return over the ``long term'', Beenen said.

I don't know about you, but if I put my money in emerging markets and deal with all the political risks, such as Hugo Chavez confiscating my investments, I want a hell of a lot more than 10%.

Bernanke Speaks

Fed Chairman Bernanke gave his biannual testimony to the Senate today. You can read his prepared statement, if you can keep your eyes open, via the title link above. The topic is entitlement spending on baby boomers and the effects on the budget, which aren't pretty. Everyone should know by now that major changes to Social Security and Medicare are necessary if we are to avoid a European level of government spending. Government expenditures are now about 20% of GDP in the US vs roughly twice that in Europe. The results, high unemployment and low growth, are plain to see.

In the question and answer period, Bernanke made clear that increasing the retirement age is probably the most likely solution to the entitlement spending problem:

He also encouraged policy makers to find ways "to make the labor market as accommodating as possible to older people who wish to continue working."

In answer to another question he put forth the notion, as Greenspan did many times, that CPI understates inflation:

"We do think...that standard CPI does overstate true inflation -- if we could measure true inflation -- by some amount between one-half and one percentage point," Mr. Bernanke said.

I wonder if Bernanke has actually been in a store recently to buy anything. If he has, he knows the absurdity of this statement. Notice too that he acknowledges that the Fed can't even measure true inflation, which should make one wonder how they are supposed to control something they can't even measure.

Tactical Update

Click on the title link to view our latest tactical update. Here's an excerpt:

Interest rates are another area of concern to us. We think the big surprise this year may be that contrary to popular thinking, rates are finally set to rise. The public and most of Wall Street is still expecting the Fed to cut rates, probably multiple times, this year. That may happen (although we don’t think so), but we think there are reasons to be concerned about long term rates regardless of Fed activity. One of the major buyers of long term Treasuries over the last several years, in addition to the Chinese, are the oil states which have reinvested the windfall from higher oil prices into the Treasury market. If oil prices continue to fall these states will have less buying power and the reduction in marginal demand could have a detrimental effect on Treasury prices.

Funnily enough the Wall Street Journal has an article about this today:

With crude prices retreating, oil producers will have less wealth to spread around the world. That should mean lower energy prices and lower inflation, but not necessarily a drop in long-term interest rates.

Click here to read the rest of the article.

Inverted Yield Curve

The link above is to a story in the WSJ about the inversion of the yield curve and the likelihood of a recession.

The bond market is having relationship issues that are getting harder to ignore.

Normally, yields on long-term government bonds are higher than yields on short-term ones. Investors demand a bigger return for the risk that comes with holding an investment that takes longer to repay.

The relationship has been upside-down since July, however, with yields on short-term U.S. Treasury bills exceeding those on long-term Treasury notes. Late Friday, the yield on the three-month Treasury bill stood at 5.05%, well above the 4.648% yield on the 10-year note.

This unusual state of affairs -- known as an inverted yield curve -- has gone on longer than many economists expected and has some wondering whether the bond market is signaling that the economy itself could turn upside down.

Even non-Wall Street types are starting to notice. Charlotte Observer sports columnist Rick Bonnell likens an inverted yield curve to a basketball player whose shooting percentage is lower at the free-throw line than from the field. It's uncommon and nerve-wracking.

That last paragraph is the interesting one. If sportswriters in Charlotte are talking about the inverted yield curve, then it's importance must have slipped a bit. Frankly, I don't want my sportswriters to even know what a yield curve is much less that it happens to be inverted. I've been watching Shaq shoot free throws in Miami for the last two years and while it is painful, it doesn't make me think of yield curves.

I don't anticipate a recession this year. A slowdown in growth is already evident and I think that is as far as it will go. That is, of course, subject to revision.

BCA Sector Analysis

We subscribe to the Bank Credit Analyst as one of our independent research sources. BCA has been doing independent economic and investment research since 1949 and has a sterling reputation. They have just recently published their US Equity Strategy Cyclical Indicator Update.

The update overweights Technology, Healthcare and Energy.

Within technology, because they are looking for stronger captial spending relative to consumer spending, they emphasize Data Processing, Software, Computer Storage, and Communications Equipment. We will be reviewing these sectors for potential investment.

They are particularly enamored of healthcare and within that group, health care equipment. We already have an overweight in healthcare through Pharma, Biotech and general healthcare. We will be reviewing the healthcare equipment sector for potential investment.

BCA is also recommending an overweight in energy which we don't find particularly convincing. We will review the sector for possible upgrade, but for now we don't believe this sector is deserving of special attention.

Bond Guru still Bullish on Bonds

Well, I am shocked, shocked I say. Bill Gross, manager of the largest pool of fixed income assets outside of Asian Central Banks, thinks interest rates are headed lower. In other words, the largest manager of bond funds thinks you should buy bonds:

We at PIMCO look for a Fed Funds rate of 4¼% by December of 2007 with 5 and 10 year yields hovering at levels perhaps 25 basis points higher. While that by no means would be reflective of past bond bull markets in terms of magnitude, that is not to imply that 12/31/07 would mark its last gasp.

I happen to like and respect Bill Gross and his arguments in this commentary are pretty convincing. However, Bill Gross is also a bond manager in a 25 year bull market in bonds. I don't know if he's right or wrong about rates this year - I suspect not- but he'd be a fool to predict anything else.

AMT Repeal

A bill was introduced yesterday in the Senate to repeal the Alternative Minimum Tax. Of course if the Democrats get their way on paygo budgeting it will mean rasing taxes or cutting spending somewhere else to make the bill "revenue neutral". Guess which one is more likely....

Lou Dobbs basing the CS Monitor

FAIRFAX, VA. – Dear Mr. Dobbs, Congratulations on having a large new bloc of voters bear your name! Politicians ignore the "Lou Dobbs Democrats" at their peril.
Every night on CNN you claim to speak for these people. They are America's middle class: decent folks who work hard and play by the rules but who, you insist, are abused by the powerful elite. Free trade is one of the policies allegedly supported by the elite and for which you reserve special vitriol. You thunder that imports destroy American jobs, reduce wages, and make the economy perilously "unbalanced."

But you are mistaken.

The article is written by Don Boudreaux, a free market economist at George Mason University, who also blogs at Cafe Hayek.

I am an unapologetic free trader who believes, as does Mr. Boudreaux, that a trade deficit is not a bad thing. How is it bad for Asians to supply Americans with cheap manufactured goods? Tariffs will only raise the price of those goods and hurt the poorest of Americans. How is it bad to allow Asians to pull themselves out of poverty through the free exchange of goods across borders? Free trade is a win/win situation that benefits buyers and sellers. Lou Dobbs is either a first class xenophobe who has little understanding of economics or he's a populist pumping up his ratings by playing to the fears of the economically illiterate.

Maybe this is why oil prices have been falling?

A source close to Pajamas Media has learned that Iran’s Supreme Leader, Ayatollah Ali Khamenei, has apparently succumbed to the cancer that hospitalized him last month, as exclusively reported by Pajamas Media, at age 67. He has been Iran’s most powerful figure since replacing Ayatollah Khomeini in the role of Supreme Leader in 1989.

Not exactly a mainstream source, but if true major changes could be coming in Iran.

Standing O for Ethics Reform

WASHINGTON (CNN) -- On the same day that the 110th Democratic-led Congress convenes with a plan to immediately pass lobbyist and ethics reforms, the Congressional Black Caucus Thursday gave a standing ovation to Rep. William Jefferson, the Louisiana Democrat who faces an FBI probe into bribery allegations.

Jefferson is the Louisiana Rep. that kept $100,000 in cool cash in his freezer. I guess ethics reform is for the other party.