“The great upheavals which precede changes of civilization, such as the fall of the Roman… … Empire and the foundation of the Arabian Empire, seem at first sight determined more especially by politically transformations, foreign invasion, or the overthrow of dynasties. But a more attentive study of these events shows that behind their apparent causes the real cause is generally seen to be a profound modification in the ideas of the peoples. The true historical upheavals are not those which astonish us by their grandeur and violence. The only important changes whence the renewal of civilizations results, affect ideas, conceptions and beliefs. The memorable events of history are the visible effects of the invisible changes of human thought. The reason these great events are so rare is that there is nothing so stable in a race as the inherited groundwork of its thoughts.

“The present epoch is one of these critical moments in which the thought of mankind is undergoing a process of transformation.

“Two fundamental factors are at the base of this transformation. The first is the destruction of those religious, political, and social beliefs in which all the elements of our civilization are rooted. The second is the creation of entirely new conditions of existence and thought as the result of modern scientific and industrial discoveries.

“The ideas of the past, although half destroyed, being still very powerful, and the ideas which are to being still very powerful, and the ideas which are to replace them being still in process of formation, the modern age represents a period of transition and anarchy.”
Gustave Le Bon The Psychology of Crowds (1895)

The opening words of Gustave Le Bon's famous study of crowd psychology were written more than a century ago, but they speak to the challenges facing investors today. Many of the assumptions on which investment decisions have traditionally been based are being tested in ways they have never been tested before. During HCM's three-week trip through Europe and Israel, the Federal Reserve raised interest rates by another 25 basis points and indicated more hikes are to come, home-grown terrorists attacked London's transit system, and oil prices generally remained above $60 dollars per barrel. What did the financial markets do? Corporate bond and stock prices rallied! This is not the reaction one would have expected from the markets. This aberrant behavior of financial markets suggests that Le Bon's observation about his own time may apply equally to our own: “the modern age represents a period of transition and anarchy.” Certainly the large number of hedge fund managers struggling to produce positive returns in the current environment could agree with that assessment.

How has the world changed? One plausible set of answers is provided in the 75th Annual Report of the Bank for International Settlements (BIS) that was published on June 27, 2005. In this report, the BIS spoke of three “welcome structural shifts in the global economy.” First, it pointed to “the liberalization of the economies of many emerging markets [that] has unleashed competitive forces that have led to major changes in the industrial world.” Second, it identified “a similar pattern of liberalization in financial markets, which has both made them more efficient and given them global reach.” Third, “monetary authorities almost worldwide have focused increasingly on bringing inflation down to low levels and keeping prices stable thereafter.” The report goes on to say that “[w]hat is not so clear is whether the interaction of these structural forces has had, or might still have, some unwelcome side effects as well. At the least, such massive changes must raise questions about the dynamics of modern economies, and uncertainties as to the proper conduct of policies looking forward.”1

Conventional wisdom suggests that financial markets should be acting in a particular way. Interest rates should be rising based on fears that high oil prices will lead to higher inflation. Stock prices should be suffering from fears that terrorists will disrupt the global economy. Yet none of these things have happened. The fact that markets are not reacting to news as they have in the past suggests that the structural changes that have taken place over the past two decades are having important effects that must now be factored into investors' thinking. Almost a year ago, HCM wrote about how conventional thinking comes to change.
“In 1962, Thomas Kuhn wrote a groundbreaking book about scientific discovery that describes the process whereby established scientific beliefs are ultimately discarded when they no longer provide satisfactory explanations for physical facts. He called such established beliefs 'paradigms.' '[P]aradigms provide scientists not only with a map but also with some of the directions essential for map-making. In learning a paradigm the scientist acquires theory, methods and standards together, usually in an inextricable manner. Therefore, when paradigms change, there are usually significant shifts in the criteria determining the legitimacy both of problems and of proposed solutions.' (109) Paradigms come under pressure when they can no longer answer the questions posed.”2
Paradigms are the roadmaps scientists use to explain the physical world. They are analogous to the kind of thinking that economists and market pundits use to try to explain the course of the financial markets. When that thinking no longer provides satisfactory explanations, it is time to look for new explanations, think outside of the box, look at the box from a different angle, or tinker with the shape of the box.

When HCM went back to look at what it had written on this subject before, we were amazed to see that it started with two quotes: one from Professor Kuhn's groundbreaking book, The Structure of Scientific Revolutions, and the second from the BIS's 74th Annual Report. (Sometimes it's better to be lucky than smart.) The quotation from BIS bears repeating here: “[t]he analytical assumptions that have underpinned policy formulation…to date merit rigorous re-examination. With the structure of the economic and financial world having changed so quickly and dramatically, and perhaps with future change still to come, it could well be dangerous for policymakers to simply assume that their old answers will remain the right answers.”3 This quotation brings to mind a couple of thoughts.

First, what would constitute such a policy error in today's world? In HCM's opinion, it would involve the Federal Reserve basing policy on the last war, i.e., fighting inflation, and stopping the current interest rate hikes based on the view that inflation is no longer a risk. In HCM's view, this would be a terrible error because it would leave interest rates too low and at levels that would continue to fuel excesses in the housing markets and credit markets that will eventually lead to dislocations. As noted in the BIS's 75th Annual Report, “[t]oday, real policy rates remain around zero in spite of last year's record global growth and emerging signs of tightening capacity constraints.”4

Second, traditional ways of looking at the relationship between economic factors such as inflation and interest rates and the overnight interest rate set by the Federal Reserve and Treasury rates should be re-examined in light of the structural changes that have occurred in the global economy. Accordingly, HCM is recalibrating its investment strategies in lights of these changes and the fact that markets are no longer acting in the manner they have in the past. While we still believe that the Federal Reserve will continue to raise the overnight rate at each of the remaining Open Market Committee Meetings in 2005, we do not expect market rates to respond immediately. Market forces – a surplus of liquidity, global deflationary forces, and sluggish economic growth in many regions – will lead market rates to lag and the Treasury curve to flatten further.

What HCM thinks will happen over the next 12-18 months is that (i) higher quality corporate bond spreads will remain tight and (ii) higher quality corporate credit will outperform lower quality credit. Conversely, lower quality credits will be the first to feel the effects of low inflation and sluggish economy. This means that lower quality credits (rated single-B or lower) should see their spreads widen on both an absolute and relative basis.

Investors should never forget that lower quality credits are really equities-in-disguise and as such should not be valued or priced based on spread. Because they are priced based on spread, however, they are mispriced (i.e. overpriced) and will eventually succumb to the risks inherent in equity instruments offering bond returns. Today, the average price of a high yield bond (based on the Merrill Lynch High Yield Index) is a mere 343 basis points above Treasuries, which is a paltry return for a security that over time is likely to experience a significant number of defaults (which will vary from 40% for single-Bs to 80% for triple-Cs). We happen to be in a very low default environment today, but this too shall change as these bonds mature. After all, weaker credits are competing in a globalized economy with few barriers to entry and strong deflationary forces suppressing their revenues but not reducing the value of their debts. The market – for some inexplicable reason – is still willing to fund dividend deals to financial sponsors of weak credits. At some point, these inconsistent trends will collide.

The Case for Lower Rates

Van Hoisington and Lacy Hunt have been successfully beating the drums for lower rates for a couple of years and deserve a great deal of credit for thinking. In their recent quarterly letter, cited by HCM's friend John Mauldin in his most recent Outside the Box (July 18, 2005), they made some very interesting observations that bolster the low inflation argument. Citing a Harvard economist, Richard Freeman, they pointed out that the global workforce has doubled since the fall of the Iron and Bamboo Curtains as the result of the addition of workers from China, India and the Soviet Union. As a result, Freeman has calculated that the capital/labor ratio has been lowered to 55-60% of what it would have been without these changes, resulting in lower returns to labor and higher returns to capital. Freeman concludes that “A decline in the global capital/labor ratio shifts the balance of power in markets toward capital as more workers compete for working with that capital.” Freeman calculates that it will take thirty years before the global economy will return to the capital ratio that existed when the Iron Curtain collapsed, which suggests that a prolonged period of low inflation lies ahead.

The more important point made by Hoisington and Hunt is that global economic forces are overwhelming what occurs in the United States economy. “The lesson here seems to be that first, our $12 trillion GDP economy can be significantly influenced by the $44 trillion world economy, and second, long term forces – or secular trends – can, in fact, overwhelm the normal U.S. cyclical economic developments.” This is one reason why inflation in the U.S. has remained so muted in an era of record low interest rates; global deflationary forces have counterbalanced the effects of low U.S. interest rates to keep prices low. Where low U.S. interest rates have had an obvious impact is in local U.S. housing markets. As HCM has argued before, there are good reasons for the Federal Reserve to continue to raise the overnight rate to 4.0%. Inflation, however, is not one of those reasons. As stated in the 75th Annual Report of the Bank of International Settlements (p. 4) (published on June 27, 2005): “a wide body of empirical evidence indicates that inflation upticks have recently become much less persistent, that exchange rate pass-through to domestic prices has fallen considerably, and that inflation expectations are now much better anchored at low levels than in the past.” As this is being written, Federal Reserve Chairman Greenspan is telling Congress that the Federal Reserve must continue to raise interest rates. HCM hopes that the Chairman is a man of his word. If the central bank insists on waiting for inflation to return to continue to raise rates, it may be waiting a long time, and in the meantime it would allow serious imbalances to continue to grow.

This slow-growth argument may seem at odds with the headlines. After all, while HCM was away, the stock market rallied above 10,600, oil rallied above $60, and spread products (bonds and loans) saw their spreads tighten. And we almost forgot to mention that the Federal Reserve hiked interest rates for the 9th consecutive time and gave no indication it would stop. U.S. first quarter GDP growth was revised upward to 3.8% from the initially reported 3.5%, and the government announced that the projected budget deficit for this fiscal year would be almost $100 billion less than initially estimated due to higher tax receipts than anticipated (the new projected deficit will be equivalent to approximately 2.5% of GDP). Imagine where we might be if the U.S. Congress were to stop spending money like a bunch of drunken sailors! Imagine what great shape we'd be in if Congress were abolished altogether! All in all, there has been more than sufficient fuel for the bulls to chew on while those of us who worry about the quality and composition of economic growth continue to look to the future with concern. The markets, however, do not have the luxury of looking that far ahead. Portfolio managers, whether they are running mutual funds or hedge funds, are struggling to produce positive returns in the current environment as it becomes increasingly apparent that pension and other legacy gaps are only increasing in size. But again, that is too far beyond the current quarter's performance measure to worry about. Desperate for current returns, portfolio managers are being driven to do all kinds of dumb things to churn out weak single digit returns.

Auto Bonds

One of those dumb things may be to pile back into the bonds of the dying automobile industry. One of the reasons that overall bond spreads have tightened dramatically over the last month is that the sell-off in auto sector bonds has reversed. The bonds of General Motors Corp., which had led to significant losses in April and May in the aftermath of rating agency downgrades of both GM and Ford Motor Company, have rallied back on good June U.S. sales (resulting from the extension of employee discounts to customers – if you can't sell cars profitably, at least you can try to make it up on volume, right?). GM's 8.375% bonds due in 2033, which reached a record low of 72 in June, rallied back to as high as 88.25 in mid-July to yield 9.6% (a spread of 610 basis points over Treasuries, more than 200 basis points narrower than its widest level).5 To place this in context, these bonds traded as high as 102 in early February of this year. Mind you, this is still a very high yield for a corporate bond in today's environment and 267 basis points wider than the average spread of the Merrill Lynch High Yield Index, which was trading at a stingy 343 basis points above Treasuries in mid-July.

This points to a continuing anomaly in the corporate bond market that HCM has commented on before. Specifically, it does not seem sensible to HCM that GM should pose a 77% greater risk of default than the average high yield bond. Yet isn't that what current spread levels are telling us? Accordingly, just as HCM has previously pointed out that the spread gap between GM and the average high yield bond would narrow, we would expect the spread narrowing process to continue over time since it remains far too wide in view of the relative risks of GM and the average single-B corporate credit. That is not to say that GM is not a risky credit, but the risk involved in owning single-B credits, which involve a significant degree of equity risk of loss, is very high and severely underpriced in today's market.

Speculation Reigns

For the moment, however, the markets continue to see the world through short-term rosecolored glasses. Terrorism, like massive economic imbalances, tsunamis, and other acts of God (we are only a month into the hurricane season and have already seen three landfalls, which does not give those of us in Florida the warm and fuzzies), trouble the financial markets not at all. Interestingly, however, while the markets are thriving, market practitioners are struggling through one of the most difficult periods in recent memory. The much-publicized difficulties experienced by several large hedge funds have highlighted the fact that the hedge fund space has become overpopulated. But this is part of a larger phenomenon, namely that financial markets have become saturated with money and speculation. But a few hedge fund meltdowns will do little to quench the thirst for decent returns, particularly among institutions whose legacy costs continue to outpace their investment earnings.

The real question from HCM's standpoint is whether many of the hedge fund strategies that have attracted so much money over the past few years really made sense or were legitimate investment activities in the first place. By legitimate, we mean serving a function other than speculation, the spinning of money from money. It has been an open secret, for example, that many hedge funds are simply glorified momentum investors (a fancy name for day traders). It has also been widely known that the convertible arbitrage sector, which is for the first time experiencing meaningful losses, has been dominated by a limited number of large investors who could effectively control the pricing of convertible bonds as long as the underlying credits remained solvent.

HCM is speaking again of the entire paired trading strategy phenomenon, which is nothing other than financial speculation that in many cases provides financing to companies that either don't deserve it (i.e. are not credit-worthy) or at least don't deserve it at the rates the market is offering. These strategies are responsible in part for low bond yields and tight bond spreads that send investors chasing higher returns in a low return world. The only way to get those returns is to use leverage to increase risk, yet the rewards being offered are stingier than ever.

The global search for yield has become an exercise in what Thoreau would have called “circle-sailing,” and what others would correctly describe as investors chasing their own tails. The problem is that like the dog who finally catches his own tail, bites down on it and yelps in pain, investors who are able to invest in strategies offering higher returns often end up regretting the risks in which they have sunk their teeth. Because the cruel logic of investing in today's financial markets means that there is more money chasing the same prize but only a limited amount of prize money to be awarded. The global economy is really a zero sum game. The central banks can go on creating money from nothing, but they can't do so forever (despite what they tell you on CNBC). In HCM's opinion, we are nowhere near the kind of comeuppance that will lead to catastrophic market losses. But we are also nowhere near the kind of economic equilibrium that would bode well for sustained, healthy economic growth. The game can continue for awhile but it can't continue indefinitely.

The World Is For Sale

Fresh from our travels, HCM can attest that everything is for sale. From 50% discounts in Jerusalem as shopkeepers attempt to recover from the collapse of tourism resulting from the intifada (a special case to be sure), to sharp markdowns by London's high street merchants, to the 50% or more markdowns in Paris's tony shops, the retail world is marking down prices at a desperate pace. European consumer economies are clearly suffering from a slowdown. Nonetheless, the ECB refuses to lower interest rates in view of high oil prices and a burgeoning money supply. Perhaps the only thing in greater supply than money in Europe is retail goods. At the same time, the price of real estate in places like London and Paris, as well as in Venice and Capri, is going through the roof. This highlights the difference between financial assets, which continue to thrive in an era of cheap money, and consumer and manufactured goods, which continue to experience deflationary pressures.

The London Bombings

Perhaps the most obvious sign of market optimism was the shrugging off of the first set of suicide bombings to occur in a major Western democracy. We are speaking, of course, of the July 7th London bombings, which we learned about while touring the Golan Heights (we will not speculate on the significance of that). Having returned to London about a week after the attacks, we can report that the city has bounced back. The streets are teeming with tourists and the buses and underground are filled with commuters. This is a fitting tribute to those who were killed or injured in the attacks; the murderers (why we dignify them with the name of terrorists is beyond us) clearly failed to make any point beyond their exhibition of nihilism.

There is clearly something amiss in a world where an 18-year old boy/man is prepared to kill himself in order to blow up a bus. But there is also something clearly wrong with a society that allows preachers of hate to incite such violence with impunity. Britain is waking up to that fact after trying to convince the world that it no longer deserved the moniker of Londonistan. Legislation to permit the immediate expulsion of preachers of hate will come before the Parliament very soon. Despite the legal niceties danced out by civil libertarians, it does not take a genius to distinguish between free speech and speech that incites to violence. Did people really think that the hate-mongers at the Finsbury Park Mosque in London were kidding? Or that they were speaking metaphorically when they called for violent attacks on the West? Having spent a week in Israel, HCM is perhaps more aware than ever that the Bush Doctrine, which is really the doctrine Israel has followed since being forced to fight for its survival from the very moment of its birth in 1948, is the most effective means to prevent the types of attacks that shattered America on 9/11 and London on 7/7. But the fact that it now appears that the London bombers were British-born men of Pakistani descent who'd spent their entire lives living in a democracy points to the fact that deeper measures are necessary. We can attack the terrorists where they live outside of Western democracies, but we have yet to figure out how to penetrate and change the modes of thought that are perpetrated upon impressionable young men in communities suffering from high unemployment and social alienation. Tony Blair has correctly spoken of the need to enlist Moslem leadership in the process of attacking the problem of terrorist nihilism at its core. Ultimately, there is really no other way to address the problem.

In the meantime, we will continue to live with heightened security measures that seem to elevate form over substance. To HCM, the most frightening aspect of the London bombings was the fact that they were treated as something to be expected. That is not an unreasonable view for a country that has tolerated for far too long what has gone on in the Finsbury Park Mosque and other supposed places of worship over the last decade. But hopefully such toleration will no longer be considered the price of living in a free society now that it has been so obviously abused. London and the rest of the West will likely become a little less free in the hope of becoming a little more safe.

But we should all remember that when bombs explode in London, we are all Londoners, just as we are all Israelis when they go off in Netanya, and we are all Iraqis when they explode in Bagdhad. Until we understand that, and act on that understanding, the bombs will keep exploding, and innocent people will keep dying.

Information presented in this newsletter was obtained from sources believed to be reliable but accuracy and completeness and opinions based on this information are not guaranteed. Under no circumstances is this an offer to sell or a solicitation to buy securities mentioned herein. Harch Capital Management, Inc. and/or its employees, including the author, may have an interest in the companies mentioned. All data and information and opinions expressed are subject to change without notice.

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1 The Bank of International Settlements, 75th Annual Report, June 27, 2005, Basel, Switzerland, p. 7.
2 The HCM Market Letter, August 15, 2004, pp. 1-2.
3 The Bank for International Settlements, 74th Annual Report, June 28, 2004.
4 The Bank of International Settlements, 75th Annual Report, June 27, 2005, p. 8.
5 The bonds did drop back after this was written to the 85-86 area (hardly a disastrous sell-off by high yield bond market standards) after GM announced a worse-than-expected $286 million loss for the second quarter as losses from the North American car and truck business overwhelmed profits from selling cars outside North America and profits from GMAC's automobile and home loan business. This is the first time GM has lost money for three consecutive quarters since a 10-quarter stretch from 1990-1992, a period when its legacy costs were much lower than they are today. To place the company's business in perspective, worldwide auto operations lost $948 million in the second quarter while GMAC's finance operations earned $816 million. The company has earned more money from its finance operations than automobile business since 2002, and there is little to suggest that this will change in the near future.

Conclusion

I trust you enjoyed this edition of Outside the Box and I should note that my firm and affiliates do not do any business with Harch Capital.

Your watching the world events unfold analyst,

John F. Mauldin
johnmauldin@investorsinsight.com
www.frontlinethoughts.com