Christmas in Mpls

Back at the ranch...


After service at St. Johns

Opening presents

...and more presents

McChaCha Slide

Funny new commercial from McDs...

Increased data costs to financial websites

In May 2006 NYSE Arca filed a rule change with the SEC to charge per user fees for sites like Yahoo and Google to publish delayed stock price data. The NetCoalition intervened and the SEC agreed to put a stay on the rule change, after a committee in the SEC had approved the change. Supposedly NYSE and Nasdaq proposed in Jan 07 a more reasonable flat fee (WSJ article indicates $100k/month for NYSE) for real-time data feeds.

(for perspective on text below, Yahoo Finance has 15M monthly UU, 14% of total UU in Oct 07. Google Finance was 1.2M, 1% of their total UU. These nunmbers are US only, based on Nielsen)

An excerpt of the SEC's response to the NetCoalition is below. The SEC is still considering this. Given the revised rates from NYSE, it seems reasonable to expect that there will be fees imposed, and that they will likely be flat rate and reasonable.

The proposals made to Internet companies by the now for-profit exchanges have been exorbitant. They have ranged from $75 per unique visitor per month for Nasdaq data to $15 to $30, or $10 or $9 per unique visitor, per month for NYSEArca data to the $1 per unique visitor per month for the NYSE non-professional rate. At $75 per month for the roughly 49 million Americans visiting financial web sites, fees would theoretically run more than $3.6 billion per month, or $44.1 billion annually. (These numbers are, of course, in addition to the hundreds of millions of dollars already collected annually from the broker-dealer community). If all Internet users of financial pages sought NYSEArca data at the $9 rate, that would still run $441 million a month, $5.3 billion annually. Even the "bargain basement price" of $1 per month for NYSE non-professional data would still render the not-so-Spartan sum of $49 million per month, or $588 million per year. Any and all sums would be, of course, in addition to the actual transaction charges that would be levied on retail investors if they opt to engage in a transaction.

Relatively few of our members' customers are going to purchase market data at $75 per month. It is unclear how many would buy NYSEArca data at $9 per month, but clearly even at $1 per month - where one might expect more user participation - the Commission staff is authorizing a transfer from retail investors to a for-profit monopoly of hundreds of millions of dollars annually, with literally zero showing of any cost basis.

By not submitting any information to provide a factual justification for its proposed fees, NYSEArca prevents the Commission from considering, for example, whether charging Internet companies for access to real-time market data based on the number of users - or "eyeballs" - that visit the site can be justified against the mandate that fees be "fair and reasonable." Given the fact that the ECNs were providing real-time market data to Internet companies at no cost, it seems reasonable that a "flat rate" for access to market data is more appropriate than a "per user" structure that puts the availability of real-time market data out of reach for the vast majority of Internet users.

A more recent article from WSJ via Reuters:

NYSE plans test of real-time Web quotes - WSJ

NEW YORK, Jan 12 (Reuters) - The New York Stock Exchange plans a pilot
program later this year that could bring real-time stock quotes to Internet
users, The Wall Street Journal reported on Friday. The NYSE Group Inc. (NYX.N: )
unit is expected to file a proposal with the U.S. Securities and Exchange
Commission on Friday, the Journal reported.

If the SEC approves the plan, the NYSE will allow Web sites to publish
trade prices with nearly no delay in return for payments of $100,000 a month,
the Journal reported. The test program could be available as early as March,
depending on the SEC's response, the paper said.

Google Inc. (GOOG.O: ) and business news television station CNBC have
said they would offer data for free to their users, the paper said. The NYSE
also has had discussions with other Internet service providers such as Yahoo,
the Journal added. Google is a member of a group called NetCoalition, which has
complained about a lack of real-time stock data offered through services owned
by the NYSE Group and Nasdaq Stock Market Inc. (NDAQ.O: )

看见阎登洪

Pictures from visit to see 阎登洪.


With Jim and Kermit




With Terp


In front of 94th Aero Squadron near College Park

it is at moments after i have dreamed (e.e. cummings)

I found this on a random blog through stumbleupon. It works for me (stumbleupon and the poem).


it is at moments after i have dreamed
of the rare entertainment of your eyes,
when (being fool to fancy) i have deemed

with your peculiar mouth my heart made wise;
at moments when the glassy darkness holds

the genuine apparition of your smile
(it was through tears always)and silence moulds
such strangeness as was mine a little while;

moments when my once more illustrious arms
are filled with fascination, when my breast
wears the intolerant brightness of your charms:

one pierced moment whiter than the rest

turning from the tremendous lie of sleep
i watch the roses of the day grow deep.

- e.e. cummings

How music prefs predict personality...

...or is it the other way around. Anyway, results from a music psychology test at outofservice.com, a collection of psychology self-tests. The music test on there, from a researcher named Jason Rentfrow at the University of Cambridge. Supposedly 90,000 people have taken tests on that site. My results are here. The hope is that this plays into online personalization in a Pandora-esque way.

Salmon Roe

My beautiful triathlete wife registering for the Fat Salmon 1.1 mile swim in Lake Washington. Note birthmark on arm.

The end of the cheap credit ride...

Interesting Seattle PI article below. Growth rate profile matches the rate of housing starts (graph from RBC Sep 19, 2007 report from Gerard Cassidy)



Note peak in 2005. It also matches the peak of subprime and alt-a loan home sales.




SeattlePI:Seattle home values hottest in U.S.
Click here for article

Wednesday, September 26, 2007Last updated 7:27 a.m. PT
By AUBREY COHENP-I REPORTER

Seattle-area home appreciation has been the hottest in the nation for 11 months in a row, despite steadily slowing for the past year and a half, according to data released Tuesday.
July's price for a typical home in King, Pierce and Snohomish counties was up 6.9 percent from July 2006 and 0.2 percent from June 2007, according to the S&P/Case-Shiller Home Price Indices, which do not give actual prices.

The August median home price was $439,000 in Seattle and $415,000 in King County, according to the Northwest Multiple Listing Service. Both medians figured in condominiums and single-family homes.

While July's annual increase was the smallest for the Seattle area in nearly four years, it was still the largest in July among the 20 metropolitan areas the indices track, just five of which posted an increase.

The story is a bit different for month-to-month appreciation, with nine other areas posting increases and all but one of those exceeding Seattle's percentage change. The 20-city composite index declined 0.4 percent from June and 3.9 percent from July 2006.

"The decline in home prices clearly continued into the summer months," Robert Shiller, chief economist at MacroMarkets LLC, said in a news release accompanying the report.
Detroit was simultaneously worst among the 20 cities for annual price change, with a 9.7 percent decline from July 2006 to July 2007, and first for monthly change, with a 1.3 percent jump from June to July.

Tampa, Fla., had the second-highest annual decline, at 8.8 percent, while Charlotte, N.C., was second to Seattle for increases, at 6 percent. Miami posted the biggest monthly decline, with prices down 1.7 percent, followed by Tampa and New York, which were both down 1 percent.
The drop in the 20-city index was the largest ever for that measure, which goes back to 2000, while the 4.5 percent decline in S&P's 10-city index was the largest for it since July 1991.
S&P Index Committee Chairman David Blitzer said prices might level off nationally by the end of the year.

"Maybe the first stage is steep declines, and we're just about done with those," he said. "The second stage is not much gain, not much loss. The rest of the economy has to catch up to home prices."

Shiller, an economist at Yale University, told lawmakers in a statement last week that the loss of a boom mentality among consumers posed a "significant risk" of a recession within the next year.

Unlike monthly sales statistics, the Standard & Poor's indices try to track the price of typical houses in a market by applying a formula to repeat sales of homes.

They screen sales for distortions, such as foreclosures or sales between family members, and weigh them for such factors as remodeling, neglect and the time between sales.

The Seattle area saw 33 months of double-digit annual appreciation, peaking at 18.5 percent in November and December 2005.

test

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Dirty king coal

Click here for article.

May 31st 2007
From The Economist print edition

Scrubbing carbon from coal-fired power stations is possible but pricey

THERE are two remarkable things about Sleipner T, a gas rig in the middle of the North Sea owned by Norway's state-owned oil company, Statoil. One is the working conditions. Technicians get around NKr600,000 ($100,000) a year, private rooms with televisions and ensuite bathrooms, and work two weeks out of every six. That is what you get when social democracy meets oil wealth.

The other unusual thing about Sleipner T is that the CO2 which has to be extracted before the gas can be sold does not contribute to global warming. Instead of being pumped into the atmosphere it is reinjected into the ground, 1,000 metres below the seabed. That is what you get when an innovative company meets a carbon tax.

Statoil started capturing and storing its carbon dioxide in 1997, five years after Norway introduced a carbon tax. Nobody paid much attention then, but these days Statoil gets a regular stream of visitors because carbon capture and storage (CCS), also known as carbon sequestration, is widely seen as a possible quick fix for global warming.

It is the abundance, cheapness and dirtiness of coal that makes CCS so appealing. Coal produces 50% of America's electricity, 70% of India's and 80% of China's. It is widely distributed around the globe, which enhances its attractions at a time of concern about energy security. Burning coal is the cheapest way of generating electricity. And coal produces around 40% of the CO2 emissions from energy use.

High gas prices have meant that coal has been enjoying a revival in recent years. In America some 150 new coal-fired power stations are on the drawing board. In China, two 500MW coal-fired power plants are starting up every week, and each year the country's coal-fired power-generating capacity increases by the equivalent of the entire British grid. So anything that offers the prospect of cleaning it up is attracting a great deal of interest.

Standard pulverised-coal (PC) generation can be made a bit cleaner by burning the fuel at higher temperatures. “Ultrasupercritical” generation can cut CO2 emissions by a fifth. But if demand goes on increasing, that is not enough. Hence the interest in CCS.

CCS is being done in three places—at Sleipner; at In Salah in Algeria, where the CO2 removed from gas produced by a joint venture between BP, Statoil and Sonatrach, Algeria's state-owned energy company, is stored in the desert; and at the Weyburn oil field in Saskatchewan, Canada, where the CO2 produced by a coal gasification plant in North Dakota is piped across the border and used to increase the pressure in a partly depleted oil field. This process, known as enhanced oil recovery (EOR), is in use in 70 oil fields around the world, but at Weyburn, unusually, some of the CO2 remains underground.

Most of the operations involved in CCS are familiar. First, the CO2 must be separated from other gases. At Sleipner, for instance, the CO2 content of the gas that emerges from the oil field is 9%. That has to be reduced to 2%, which is done by passing the gas through amines (nitrogen-based chemicals). Second, the CO2 is moved along in pipelines. That is commonly done in EOR, as is the third stage—injecting it into the ground.

The fourth stage is the least familiar. When CO2 is being used for EOR, it returns to the surface (except at Weyburn). For sequestration, however, the CO2 must be stored underground, probably in depleted oil and gas fields or in porous briny rock. Statoil has been doing this for a decade at Sleipner, and there is no sign of the stuff bubbling up again. Scientists say that within decades or centuries it will dissolve, and within centuries or millennia it will react with elements in the rock and form new minerals. But this part of the process needs more study.

The challenge is to put all those technologies together and deploy them at a reasonable cost, and on a scale that can make some impact on emissions. That will take some doing. If 60% of the 1.5 billion tonnes of CO2 that America produces every year from coal-fired power stations were liquefied for storage, it would take up the same amount of space as all the oil the country consumes.

Coal-fired power stations are the likeliest candidates for CCS because they are dirty and numerous. But there is a difficulty with PC plants: they spew out a huge volume of flue gas, of which CO2 is only a small part. Separating it from other gases is expensive. The main alternative is to turn coal into gas before using it to generate electricity. The resulting CO2 and hydrogen are then separated, the hydrogen used to generate electricity and the CO2 stored. A few such integrated gasification combined-cycle (IGCC) plants have been built.

Every which way
Now that power utilities are beginning to accept that they will have to do something about carbon, the big question is what. GE has bought Chevron's IGCC technology. The cost of generating electricity from it, according to GE's Steve Bolze, is 20-25% more than a PC plant, but Mr Bolze believes that, once the cost of separating carbon is taken into account as well, IGCC may be cheaper.

Philippe Joubert, president of power systems at Alstom, which in March announced a joint venture with American Electric Power, America's biggest coal-fired generator, rejects the idea that IGCC is cheaper, even with CCS. “This is clearly not true. We should know. We are in IGCC as well as PC. It's clearly 10% more expensive. All serious academics realise that it is more expensive.” A study by MIT published in March tends to side with Mr Bolze. Generating electricity from an IGCC plant with carbon capture, it maintains, is 35% more expensive than PC without CCS; but PC with CCS is 60% more expensive than PC without.

Plans for IGCC plants are proliferating. In America, at least, that says more about subsidies than about faith in the technology's future. George Bush announced a $2 billion clean-coal initiative in 2002, and the 2005 Energy Policy Act, notorious for its pork content, included $1.6 billion-worth of subsidies for coal gasification.

According to the International Energy Agency, around 15 power plants with CCS are being planned and another seven CCS projects are on the drawing board. Most make economic sense either because of direct subsidy or because of their particular economic circumstances. Statoil and Shell are planning to sequester CO2 from a Statoil power plant on the Norwegian mainland under Shell's Draugen platform. The investment is justified by Norway's carbon tax, currently about €50 per tonne. BP is planning a petroleum-coke-fuelled power plant in California, where electricity is particularly expensive and the petroleum coke for the power plant comes as a by-product of oil refining; the project is a joint venture with Edison International, an electricity company.

One big company that is making a sizeable punt on CCS is Vattenfall, which is building a 30MW plant in Germany. “I'm totally convinced”, says Lars Josefsson, Vattenfall's chief executive, “that the issue of carbon sequestration will change the way we do business in the long term. I believe the companies that realise that soonest will be the winners.”

If CCS is to take off, the rules on CO2 storage need sorting out. The 1996 London protocol on dumping waste at sea was amended earlier this year to allow CCS at sea. But rules on land need attending to, for promoters of CCS worry that it will become as contentious as nuclear waste.

And, as always, there is the problem of cost. At present, academics reckon that it would take a carbon price of around $30 to make sequestration economic—below the peak that the ETS hit briefly in 2006, and way above the $10 safety valve in the only carbon bill in Washington, DC, to mention a figure. But the cost may come down, because that is generally what happens as technologies are commercialised.

Despite the tricky economics, the sheer abundance of coal is an argument for pursuing CCS. And if it can be made to work, it has a certain poetic circularity: the carbon extracted from the earth as fossil fuel shall return unto the earth whence it came.

The energy situation

Investment

From Jun 2 Economist leader: In 2003, the most recent year for which figures are available, America's power-generation business, arguably the world's biggest single polluter, spent a rather smaller proportion of its revenues on R&D than did America's pet-food business. But that's beginning to change, as our survey this week makes clear.

Global investment in renewable power-generation, biofuels and low-carbon technologies rose from $28 billion in 2004 to $71 billion in 2006, according to New Energy Finance, a research company.

Costs
As the likes of General Electric and BP put money into cleaner technologies, costs will fall. The price of a watt of solar photovoltaic capacity dropped from around $20 in the 1970s to $2.70 in 2004 (though a silicon shortage, caused by rocketing demand as a result of madly generous German subsidies, has pushed it up since). The price of wind power has fallen from $2 per kilowatt hour in the 1970s to 5-8 cents now, compared with 2-4 cents for coal-fired power. More investment will bring prices down further; and, as the gap shrinks, so the costs of switching from dirty energy to the clean sort will fall.

Risks
Yet business's new enthusiasm for clean energy is a fragile green shoot in a dark landscape. Much could happen to crush it. A sustained fall in the oil price, for instance, would undermine investment in costlier, cleaner technologies. But the bigger risk is political. Businesses are investing in alternatives to fossil fuels because they assume that carbon emissions will be constrained in the future. If governments do not act to curb emissions, those investments will eventually wither.

Carbon Tax
The best way for governments to encourage investment in cleaner energy is to make the polluter pay by putting a price on CO2 emissions. According to the Intergovernmental Panel on Climate Change, the body set up under the auspices of the United Nations to establish a consensus on global warming, a price of somewhere between $20 and $50 per tonne of CO2 by 2020-30 should start to stabilise CO2 concentrations at around 550 parts per million (widely reckoned to be a safeish level) by the end of this century. A $50 price tag would raise petrol prices in America by around 15% and electricity prices by around 35%—hardly draconian when set alongside recent fluctuations. The IPCC reckons that stabilising at 550ppm would knock around 0.1% off global economic growth annually.

A carbon price can be established either through a tax or through a cap-and-trade system, such as the one Europe adopted after signing up to Kyoto. A carbon tax would be preferable, because companies would then be able to build a fixed price into their investment plans; but businesspeople and politicians are both strangely averse to the word “tax”. A cap-and-trade system can be made to work, but the price has to settle at a level that affects commercial decisions. Europe's hasn't: the price has been too volatile, and, for much of its existence, too low, to shift investment patterns much.

Europe has tightened its system up, and the carbon price has risen to a level which could start to make a difference. But Europe, by itself, will not save the planet. It is America that matters, not just because it is the world's biggest polluter, but also because without its participation, the biggest polluters of the future—China and India—will not do anything.

Current investment projects

My hypothesis is that performance can be improved above that of index funds (i.e., broadly diversified funds) because broad diversification in an indiscriminant fashion captures the good, the average, the mediocre, and the bad. And as the screens from return on tangible capital and earnings yield show, there is a long average-mediocre-bad tail. If we can take steps to slice off that tail (e.g., Magic Formula filter) that can go a long way to improve performance. Of course, then there's the problem of diversifying within the remaining companies.

In Bill Miller's apologetic shareholder letter, he mentions that the main reason Value Trust underperformed the indices was that the tail has flattened: where before there were three opportunities, two of which had $12 selling for $10 potential, one having $30 selling for $10, now there are three $12 selling for $10 opportunities. So the broadly diversified strategy works better than concentrated due to lower risk.

He mentions he still believes there is potential appreciation in growth, though, if not in value stocks.

I think it is worth spending some time going deep on the good ideas I've come across so far: Contango, Delta Financial, and FreightCar America. Not only will this serve to firm up the exit plan, it will also build a comparable by which we can judge other related investment opportunities. If the opportunity at hand beats one of these, then it's interesting.

Look at some recent recommendations:

• Tyco break-up value

Some interesting stocks that are showing up in the magic formula screens:

• SAIC (20% ROTC, 23% earnings yield)
• Domino's Pizza (55% ROTC, 11% earnings yield): recap adding 1.85B debt, paid out $13.5/shr dividend. Debt/ebitda 7x (mgmt prev said comfortable w/ 3-6x), 2.2x interest coverage. Revenues $1.4B, I est 240MM ebitda. It generates cash, but can it pay down that debt? Interest according to Lehman paper is $113MM.

Asset allocation:
Continue reading on commodities - no rush as they're probably overpriced now

I thought Paul Lim's column in the NYTimes a couple of weeks ago was notable, particularly because it corresponded with Leon Cooperman's observations in Value Investor Insight's Nov 30, 2006 issue. Cooperman's factors (remember that these were made in Nov 06) driving his belief that the market is "moderately undervalued", "isn't susceptible to pronounced downside risk and that should deliver a high single-digit to low double-digit return over the next 12 months", and "relative to interest rates and inflation the market is attractively priced":

1. Expectation economy will continue to growth over next 12-15 months at annual 2-2.5% rate, which he considers the ideal rate to deliver corporate growth with moderate inflation so the Fed does not need to intervene. He believed that capital investment in energy and growth from foreign demand would make up for the housing downturn (housing would take 1% off gdp growth).


2. Inflation will continue to be moderate, as economy slows. Evidence is that inflation expectations built into fixed-income prices have been receding in prior six months and are at 12-month lows.


3. Corporate profits will continue to grow. 5 months into economic expansion period, 72% of companes are reporting positive earnings surprises. He expected next year earnings would slow to the 7-9% range. Moreover, ROE and margins are close to record levels, balance sheet leverage is down and dividends are growing 10-12% and share buybacks are near a peak.

I think the underlined expectation about growth rates is particularly interesting in light of Lim's article below because Lim indicates "at the start of April, the consensus forecast for Q1 S&P earnings growth was...3.7%. But now, it looks as if Q1 profits will jump 8.1%...according to Thomson Financial." So Cooperman had a better forward estimates than Thomson, even though their estimates were closer to announcements.

Cooperman also sites the same relationship between inflation and P/E ratio as Lim does: "when the rate of inflation has been between 1-3%, historically the S&P 500 multiple on forward earnings has averaged over 17x. Inflation is now in that range, but the current S&P multiple is around 15x." This relationship is (according to the NYTimes) from Charles Schwab, based on data from Jan 1960 to March 2007, although the Schwab data is based on trailing rather than forward earnings. Table follows: (don't know why there's blank space below)

Inflation Rate	Average P/E Ratio
>7%	8.5
6-7	9.5
5-6	13.1
4-5	14.8
3-4	17.6
2-3	19.7
<2	23.6

Inflation measured based on yoy changes in personal consumption expenditures, excluding food and energy. P/E ratios are for stocks in S&P 500 index, using trailing 12-month GAAP earnings.

May 20, 2007
FUNDAMENTALLY; The Bull Market That's Missing Something
NY Times ;By PAUL J. LIM

SO far, this bull market has benefited from several tailwinds, including the resilient economy, reasonably low interest rates, better-than-expected corporate profits and, most recently, a flurry of merger-and-acquisition activity. But one missing ingredient has been the willingness of investors to pay higher prices for earnings.

''So far, it's been an untapped driver of returns,'' said Jeffrey N. Kleintop, chief market strategist at LPL Financial Services in Boston.

In every bull market since 1942, investors gradually gave higher price-to-earnings ratios to stocks as those rallies unfolded. Indeed, the average P/E ratio for the S.& P. 500 has typically grown from 13.5 at the start of new bull markets to 17.3 by their fourth birthdays.
But the same can't be said for this rally -- at least not yet.

The current bull, which was born on Oct. 10, 2002, started with a P/E ratio of 27.1, according to S.& P. Four years later, the ratio was actually much lower, at 16.3. (All of these figures are based on trailing 12-month earnings, using generally accepted accounting principles, or GAAP.)
Why are investors stingier with their investment dollars this time around?

Part of the explanation may simply be the hangover from the bear market of 2000 to 2002, said Tobias M. Levkovich, chief United States equity strategist at Citigroup Investment Research. He argues that investors may be hesitant to push P/E ratios higher after getting burned so badly for doing so at the start of the decade.

The lack of a P/E expansion could also be tied to the surprising strength in corporate earnings growth. At the start of April, the consensus forecast for first-quarter S.& P. 500 earnings growth was a modest 3.7 percent. But now, it looks as if first-quarter profits will jump 8.1 percent when all is said and done, according to Thomson Financial.

And when the ''E'' -- the earnings -- in the P/E ratio grows at a faster-than-expected rate, it's not so surprising when the ''P'' doesn't keep pace.

Of course, ''as earnings slow from here, the markets will need an extra boost,'' Mr. Kleintop said. And there are some early indications that investors may be willing to pay slightly higher prices for stocks in coming months.

Sam Stovall, S.& P.'s chief market strategist, noted that at the end of March, the P/E ratio of the S.& P. 500 was 16.8 (again, based on trailing 12-month GAAP earnings). The multiple grew to more than 17 by mid-May. And if the S.& P. 500 breaks its all-time high of 1,527.46 within the next few days, the market's P/E will rise to around 18.

Yet this is only a short-term move. And few are expecting the type of P/E expansion that the market enjoyed in the mid-1980s and the mid-1990s.

From 1984 to 1986, for example, the P/E of the S.& P. grew to about 14 from around 8. The move was even bigger from 1996 to 1998. Investors started that period paying 14 times trailing 12-month earnings. But by the end of it, the multiple had grown to 24.

Market strategists note, however, that those periods were marked by significant declines in long-term interest rates and inflation -- both of which have an inverse relationship with market P/E ratios.

Given that 10-year Treasury notes are already yielding less than 5 percent -- and given that core consumer inflation is running about 2.3 percent, according to the Labor Department -- it's hard to imagine a huge kicker from similar trends this time around.

As a result, Jim Dunnigan, chief investment officer at PNC Wealth Management in Philadelphia, argues that while P/E ratios are likely to expand, ''it should be more muted than it was in the past.''

Mr. Kleintop agrees. Instead of a 6- to 10-point surge in P/E ratios, he says, we're more likely to see a bump-up of about 3 or 4 points. Still, based on trailing 12-month earnings of nearly $90 a share for the S.& P. 500, a climb to a P/E of 19 -- about 3 points above the level of last October -- would bring the index to a record level of about 1,700.

That, of course, is based on a lot of ifs. Whether market P/E's will climb this high in this bull market will depend on several factors, including these:

THE INFLATION OUTLOOK -- Liz Ann Sonders, the chief investment strategist at Charles Schwab, says that there is ''a perfect inverse correlation of inflation and P/E ratios.'' Since 1960, whenever the annual inflation rate (as measured by core personal consumption expenditures) has been 2 to 3 percent -- as it is today -- the average P/E for the S.& P. has been 19.7. But when inflation edges just above 3 percent, that average P/E has dropped to 17.6, close to the current number.

THE BUYOUT BINGE -- Though P/E expansion isn't likely to be aided by big drops in bond yields, the recent flurry of mergers and acquisitions could spur the market to bid stock prices higher -- at least to better reflect recent earnings growth, Mr. Dunnigan said. According to Thomson Financial, global merger-and-acquisition activity is on pace to shatter last year's record of $3.6 trillion of deals. If that holds true, there could be an uptick in P/E multiples.

THE PATH OF TECH AND HEALTH CARE STOCKS -- Historically, these stocks have had high P/E's, but both of these sectors have generally been out of favor since the start of the decade. That is one reason the P/E ratio of the S.& P. hasn't greatly expanded, Mr. Kleintop says. But now that tech and health care companies are again among the market's earnings leaders, the ratio could be driven higher.

Of course, the multiple could surge for another reason: if earnings fall off a cliff, as they did at the start of this decade. That would be about the worst type of P/E expansion imaginable, but, fortunately, few are predicting it. In fact, though earnings are slowing, the consensus is that earnings for the S.& P. will still grow 7.1 percent this year.

Paul J. Lim is a financial writer at U.S. News & World Report. E-mail: fund@nytimes.com.

How serious is the subprime debacle?

A Mar 07 Economist article cleared a few things up for me with a few facts.

1. US total market for debt: $40 trillion
2. US residential debt market: $10 trillion
3. US subprime loans: $1 trillion
4. US residential debt securitized: $750 billion
5. US ARM loans: $650 billion (1.6% of US total market debt market)
6. 13% subprime loans behind on payments

#4 is particularly important b/c securitization was the vehicle through which enormous amounts of new capital seeking higher returns (but also getting higher risk) found its way to subprime debtors.

Article follows:

Cracks in the façade
Mar 22nd 2007 NEW YORK AND WASHINGTON. DC From The Economist print edition
America's riskiest mortgages are crumbling. How far will the damage spread?

CASEY SERIN knows all about the excesses of America's housing bubble. In 2006 the 24-year old web designer from Sacramento bought seven houses in five months. He lied about his income on “no document” loans and was not asked for anything so old-fashioned as a deposit. Today Mr Serin has debts of $2.2m. Three of his houses have been repossessed; others could share that fate. His website, Iamfacingforeclosure.com, has become a magnet for those whose mortgages are in trouble.

Mr Serin and people like him are Wall Street's biggest uncertainty just now. How many Americans are saddled with mortgages they cannot afford on houses that are losing value? The answer matters to anyone who bought high-yielding mortgage-backed securities when a booming property market made mortgages look safe. It also matters to investment banks, which packaged the securities and often own subsidiaries that originate mortgages. It may determine whether America's economy falls into recession. It could even affect the outcome of next year's elections.

Most of the damage so far is in the “subprime” mortgage market, which lends to people whose income is too low, or whose credit history too patchy, to qualify for an ordinary mortgage. On March 13th the Mortgage Bankers Association reported that 13% of subprime borrowers were behind on their payments. Some 30 of America's subprime lenders have closed their doors in the past three months. The cost of insurance against default for the riskiest tranches of subprime debt has soared. The worst effects may not be felt until the mortgage payments of many borrowers with no equity in their homes rise sharply.

Is this a mere irritant in America's vast economy, or the start of something much worse? Opinion on Wall Street is divided. Most argue that the mortgage mess, though a blight on anyone caught up in it, will not spread. The number of mortgages at risk is too small for defaults to threaten everyone else. Even if a fifth of the $650 billion of adjustable-rate subprime loans went bad, that would be a blip in the $40 trillion market for debt. If repossessions extended the housing downturn, it would not derail an economy that—housing apart—remains healthy, with unemployment of 4.5% and jobs growing strongly.

Cellar signal
Growing numbers of pessimists disagree. They think the subprime squeeze marks the start of a broader credit crunch that could drag the economy into recession. Stephen Roach, the famously gloomy chief economist at Morgan Stanley, recently called subprime mortgages the new dotcoms. Just as the implosion of a few hundred internet ventures in 2000 sparked a much broader stockmarket correction and an eventual recession, so the failure of the riskiest mortgages may distress the rest of a debt-laden economy.

To try to assess who is right, you need to know the share of mortgages potentially at risk. And you need to understand the channels through which subprime defaults could spread to the wider economy.

America's residential mortgage market is huge. It consists of some $10 trillion worth of loans, of which around 75% are repackaged into securities, mainly by the government-sponsored mortgage giants, Fannie Mae and Freddie Mac. Most of this market involves little risk. Two-thirds of mortgage borrowers enjoy good credit and a fixed interest rate and can depend on the value of their houses remaining far higher than their borrowings. But a growing minority of loans look very different, with weak borrowers, adjustable rates and little, or no, cushion of home equity.

For a decade, the fastest growth in America's mortgage markets has been at the bottom. Subprime borrowers—long shut out of home ownership—now account for one in five new mortgages and 10% of all mortgage debt, thanks to the expansion of mortgage-backed securities (and derivatives based on them). Low short-term interest rates earlier this decade led to a bonanza in adjustable-rate mortgages (ARMs). Ever more exotic products were dreamt up, including “teaser” loans with an introductory period of interest rates as low as 1%.

When the housing market began to slow, lenders pepped up the pace of sales by dramatically loosening credit standards, lending more against each property and cutting the need for documentation. Wall Street cheered them on. Investors were hungry for high-yielding assets and banks and brokers could earn fat fees by pooling and slicing the risks in these loans.

Standards fell furthest at the bottom of the credit ladder: subprime mortgages and those one rung higher, known as Alt-As. A recent report by analysts at Credit Suisse estimates that 80% of subprime loans made in 2006 included low “teaser” rates; almost eight out of ten Alt-A loans were “liar loans”, based on little or no documentation; loan-to-value ratios were often over 90% with a second piggy-bank loan routinely thrown in. America's weakest borrowers, in short, were often able to buy a house without handing over a penny.

Lenders got the demand for loans that they wanted—and more fool them. Amid the continuing boom, some 40% of all originations last year were subprime or Alt-A. But as these mortgages were reset to higher rates and borrowers who had lied about their income failed to pay up, the trap was sprung. A new study by Christopher Cagan, an economist at First American CoreLogic, based on his firm's database of most American mortgages, calculates that 60% of all adjustable-rate loans made since 2004 will be reset to payments that will be 25% higher or more. A fifth will see monthly payments soar by 50% or more.

Few borrowers can cope with such a burden. When house prices were booming no one cared. Borrowers refinanced or sold their homes. But now that prices have flattened and, in many areas, fallen, those paths are blocked.

The greatest difficulties threaten borrowers whose house is worth less than their mortgage. Just under 7% of all American homeowners had this “negative equity” at the end of December 2006 estimates Mr Cagan, using a sample of 32m houses (see chart 1). Among recent homebuyers, the share is even higher: 18% of all people who took mortgages out in 2006 now have negative equity. A quarter of all mortgages due to reset in 2008 are in the same miserable state (see chart 2).

Higher payments and negative equity are a toxic combination. Mr Cagan marries the statistics and concludes that—going by today's prices—some 1.1m mortgages (or 13% of all adjustable-rate mortgages originated between 2004 and 2006), worth $326 billion, are heading for repossession in the next few years. The suffering will be concentrated: only 7% of mainstream adjustable mortgages will be affected, whereas one in three of the recent “teaser” loans will end in default. The harshest year will be 2008, when many mortgages will be reset and few borrowers will have much equity.

Mr Cagan's study considers only the effect of higher payments (ignoring defaults from job loss, divorce, and so on). But it is a guide to how much default rates may worsen even if the economy stays strong and house prices stabilise. According to RealtyTrac, some 1.3m homes were in default on their mortgages in 2006, up 42% from the year before. This study suggests that figure could rise much further. And if house prices fall, the picture darkens. Mr Cagan's work suggests that every percentage point drop in house prices would bring 70,000 extra repossessions.

The direct damage to Wall Street is likely to be modest. A repossessed property will eventually be sold, albeit at a discount. As a result, Mr Cagan's estimate of $326 billion of repossessed mortgages translates into roughly $112 billion of losses, spread over several years. Even a loss several times larger than that would barely ruffle America's vast financial markets: about $600 billion was wiped out on the stockmarkets as share prices fell on February 27th.

In theory, the chopping up and selling on of risk should spread the pain. The losses ought to be manageable even for banks such as HSBC and Wells Fargo, the two biggest subprime mortgage lenders, and Bear Stearns, Wall Street's largest underwriter of mortgage-backed securities. Subprime mortgages make up only a small part of their business. Indeed, banks so far smell an opportunity to buy the assets of imploding subprime lenders on the cheap.

Discredited
Although subprime is a small direct threat to Wall Street it could still inflict pain on bankers—and the broader economy—in other ways. Investors are shunning subprime and all mortgages that seem risky. Spreads have dramatically widened on the securities backed by riskier mortgages and the pooled and debt-laden collateralised-debt obligations (CDOs) based on them. The issuance of subprime-related CDOs has plunged. That is a worry, because investors' appetite for these securities fuelled the boom in riskier mortgages.

Lenders' reluctance and tightening loan standards may combine to form a classic credit crunch. Several lenders, including Countrywide, America's largest mortgage lender, have stopped making no-money-down mortgage loans. HSBC has cut back on second-lien loans. Freddie Mac recently announced it would no longer buy some subprime loans. No one is sure how dramatic, or lasting, the pull-back will be, but Credit Suisse thinks the number of originations in subprime markets could fall by some 50% in the next couple of years and Alt-A loans may fall by a quarter. Even if the shift is confined to America's riskiest mortgages (and there is little evidence yet of tighter lending standards spreading), its effects may climb up the housing ladder.

Just when some would-be buyers find it harder to borrow, rising numbers of repossessions will increase the supply of homes for sale. The backlog of unsold homes is already high, at over 3.5m existing homes, or more than six months' sales. Counting the properties that have already been repossessed—and hence are all but certain to be for sale—that figure rises by about a fifth. Add the likelihood of some 1m more repossessions as adjustable-rate mortgages are reset, and you have the makings of a housing glut.

Falling demand and soaring supply bodes ill for construction and house prices, the main ways housing affects the broader economy. Builders have already cut back. The pace of housing starts is down 33% from its peak in January 2006. Plunging residential investment is the main reason America's GDP growth has slowed to 2.2%. But, as Nouriel Roubini and Christian Menegatti point out in a recent report, that retrenchment is modest by historical standards. In the seven construction busts since 1960, housing starts fell, on average, by 51% from their peak. The mortgage crunch makes matters worse. To work off inventories, builders will have to cut back more, dragging output growth down for longer. Job losses in construction and related industries, which have so far been mild, are likely to rise sharply.

A glut of unsold homes will also push down prices, particularly in areas such as California and Florida, which had a disproportionate share of riskier loans. House prices have already been falling in parts of both states, as they have in Midwestern states, such as Michigan, where manufacturing industry has shed jobs in recent years. Will those declines accelerate and spread?
By many measures, America's house prices are still too high. David Rosenberg of Merrill Lynch points out that the ratio of income to housing costs is still some 10% worse than its historical norm and 20% worse than levels at the end of the last housing downturn in the early 1990s. Take out a chunk of potential borrowers; add in some repossessed homes and house prices could be hit hard. If falling prices raise the rate of default, that could in turn worsen the credit crunch, putting yet more pressure on prices. Wall Street's gloomiest seers think average house prices could fall by 10% this year. If so, the economy could well enter a recession.

Consumers have shrugged off the housing slowdown thus far: real consumer spending is still growing at annual rate of some 3%, thanks largely to strong job and wage growth. But they are unlikely to shrug off a 10% plunge within one year, particularly since America's homeowners have become used to their housing wealth rising by well over 5% a year. No one is sure just how responsive consumer spending is to changes in house prices. Economists normally reckon that a $100 drop in wealth eventually reduces spending by $3-5 a year. But some recent studies suggest the “wealth effect” from housing may eventually be more than double that. Given that Americans have $20 trillion of housing wealth, a 10% price drop could easily halve the pace of consumer spending growth, sending the economy perilously close to recession.

Such a dramatic drop in national house prices this year is possible, but not yet probable. Unlike share prices, house prices rarely plunge in nominal terms. Unless repossession forces a sale, homeowners prefer to sit tight when markets are weak. If house prices stagnate, consumption may suffer a little, but not too much, so long as jobs stay plentiful and wages grow. If so, the mortgage crunch will be a grinding drag on America's economy; one that unfolds over several years, hitting some people and some regions hard, but not, in itself, a macro-economic disaster.
The bursting of the stock-market bubble in 2000 led to a plunge in investment at American firms. To stave off recession, the Federal Reserve loosened monetary policy. Short-term interest rates fell to historic lows, propping up consumer spending, but also fuelling the housing bubble and sowing the seeds of today's upheaval.

Any such loosening is much less likely today. As the statement at their meeting on March 21st made clear, America's central bankers are still more worried about inflation than about recession. And with reason. Core consumer price inflation, which excludes the volatile categories of food and fuel, has accelerated, to 2.6% at an annual rate in the three months to February. With inflation higher than they would like, the central bankers are in no hurry to slash interest rates. They would lose little sleep if output growth stays sluggish or unemployment rates inch up.

The Senate and the houses
In contrast to the dotcom bust, then, the consequences of the housing market's troubles may be felt more sharply on Capitol Hill than at the Fed. Politicians, particularly the Democrats now in charge of Congress, are clamouring for quick action. Hillary Clinton has declared the market “broken”, accused the Bush administration of standing by and demanded something be done. Chris Dodd, chairman of the Senate Banking Committee and another Democratic presidential candidate, is also up in arms.

George Bush often boasts about rising rates of home-ownership under his watch. Hundreds of thousands of repossessed homes, many of them from borrowers who are black and poor, would be politically incendiary. The Centre for Responsible Lending reports that half of the mortgages taken out by blacks in the past few years were subprime. If a fifth of those default, one in ten recent black homebuyers may end up losing his house. Many of these people have stories to tell of being duped into taking on mortgages that they did not understand and could not afford.
Pressure is mounting to right the wrongs—real and perceived. Attorneys-general from New York to California have started to investigate fraudulent mortgage lending. Rather as after Enron, the securities regulator in Massachusetts has demanded that UBS and Bear Stearns hand over internal details of their research coverage of subprime lenders. Congress has already held hearings on predatory lending. More are planned.

Ideas abound on what must be done. Mrs Clinton has called for a “ foreclosure time-out”. Pressure groups want Congress to rewrite the rules of the Federal Housing Administration (FHA), a federal organisation charged with providing affordable mortgages to the poor, so it can refinance subprime mortgage loans in default. Calls for other types of bail-out will rise.

America's four federal bank regulators are also scrambling to respond. Earlier this month they proposed stricter lending guidelines on adjustable subprime loans. But federal regulators play a limited role in subprime markets. Many of the riskiest mortgages were made by independent, non-bank lenders—such as New Century, Ownit and Fremont. These outfits (which are now collapsing) are overseen by state regulators, not federal ones—and the quality of state oversight varies widely. Only half of states have laws against predatory lending. Many lack rules requiring lenders to perform criminal background checks on brokers, as federal guidelines require.

Few doubt that the subprime mess was, in part, a regulatory failure. But now the mistakes have been made, the biggest risk is that populist politicians rewrite the rules hamfistedly. Fraudulent activity should be punished. The vulnerable need protection from predatory lenders. But an ill-conceived swathe of new “consumer protection” could easily make matters worse. If restrictive regulation scared investors away from the subprime market for good, that really would hurt the poor.

NY Times article on Seth Klarman

May 13, 2007
Investing
Manager Frets Over the Market, but Still Outdoes It
By GERALDINE FABRIKANT
EARNING 22 percent on your investments while holding half of your portfolio in cash is no easy trick, but last year Seth A. Klarman pulled it off, and it was not the first time.

Mr. Klarman, a 49-year-old hedge fund manager, has turned in market-beating performances since 1983, while perpetually warning that the markets were dangerous and that investors should minimize risk.

What is his investment approach? He will not spell it out, although lots of people would like to know. On the Web, the price for his out-of-print 1991 book — “Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor” — has gone for $1,200 on Amazon and $2,000 on eBay.

At a time when hedge fund managers seem to be grabbing headlines with stories about their homes, hobbies, philanthropy and outsize compensation, Mr. Klarman keeps a low profile, and is reticent about the investments of his $7 billion Baupost Group of hedge funds, which has been closed to new money for the last seven years.

But his book, his letters to investors and other fund documents provide some clues about his thinking, and he added to the picture in a telephone interview. Mr. Klarman clearly sees himself as a deep value investor, in the mold of Warren E. Buffett or Benjamin Graham, the Columbia professor who pioneered value investing.

He is also a world-class worrier. In one letter, Mr. Klarman said, “At Baupost, we are big fans of fear, and in investing, it is clearly better to be scared than sorry.” In an earlier note, he wrote, “Rather than ratchet up risk, our approach has been to hold cash in the absence of opportunity.”

Last year, the cash holdings of his hedge funds amounted to 49.8 percent of assets, an enormous proportion for actively managed investments, but not an anomaly at Baupost: a year earlier, the cash holdings amounted to 45.8 percent. To add safety to his portfolios, he said that he usually eschews leverage, or debt, in his funds, using it only in some real estate investments. Instead, he has profited handsomely from investing in the debt of other companies, particularly those in financial distress.

Mr. Klarman, who is based in Boston and works with a team of 24 people, does not make bets on the overall market. Instead, his funds look for specific opportunities that he deems worthy. But he warns that Wall Street often tries to sell customers overvalued assets. For example, he said that he is wary of new issues because in the pursuit of large fees, banks may underwrite overpriced or highly risky securities.

Mr. Klarman’s record has generated intense loyalty from investors. Since he began Baupost in 1983, it has posted an average annual total return of 19.55 percent, according to data provided by the hedge fund group. Declines have been posted in only 11 of the total 97 quarters since Baupost’s debut.

In 2006, Baupost’s portfolio held an array of assets, including United States, European, Asian and Canadian equities, which accounted for 17.1 percent of the portfolio; debt and real estate, which each made up 10 percent; and 4.7 percent in private equity funds. And there was that big dollop of cash.

“Seth has a remarkable record, and even more so when you realize that he has achieved it by holding significant amounts of cash,” said Jack R. Meyer, who until 2005 ran Harvard’s endowment, which has been a longtime investor in Baupost.

“In other words, his risk-adjusted numbers are spectacular. What is unusual is the high return and the high cash levels,” added Mr. Meyer, who now runs the investment fund Convexity Capital.

Mr. Klarman grew up in Baltimore, where his father was a health economist. After graduating from Cornell with a degree in economics in 1979, he worked for Max Heine and Michael Price at Mutual Shares for a year and a half, then went on to Harvard Business School, where he graduated with an M.B.A. in 1982. Immediately afterward, four wealthy families, including those of two Harvard professors, put up $27 million for Mr. Klarman to manage.

While his actual compensation has not been disclosed, years of high returns have made him wealthy. Baupost charges a 1 percent management fee on investments in its funds, as well as 20 percent of annual profit. It was managing roughly $6 billion at the end of 2005 — which would mean a $60 million management fee for Baupost. In addition, its 22 percent return on investments last year would suggest profit of about $1.3 billion — generating a 20 percent share for Baupost of about $260 million. The only leverage Mr. Klarman said he used was on the 10 percent of holdings in real estate, where the leverage was one to one.

Despite more than two decades of smart choices, Mr. Klarman seems to obsess continually about potential crises. In his most recent letter, he said that while investors had been upbeat because of relatively low market volatility and inexpensive credit, he was worried about trade imbalances and high levels of consumer debt, which he said could set off market declines. Writing about the stock market rally in 2006, he said: “There was nothing about this party that would have made you want to leave early, unless you were a value investor. The only adverse trend was the scarcity of mispricing opportunities.”

One place in which he said he had found some mispricing was in the shares of News Corporation stock, which rose 37 percent in 2006. While Baupost sold 1.8 million shares last year, at the end of December, it still owned 4.19 million shares, according to company filings. Last week, Mr. Klarman said he believed the stock was still undervalued. He added that he was not concerned about Rupert Murdoch’s bid for Dow Jones & Company, at a price many have described as extremely generous, because it would be a relatively small transaction for a company the size of News Corporation.

Other Baupost equity holdings include Home Depot and Posco, a Korean steel manufacturer, two stocks that happen to be held by Berkshire Hathaway, Mr. Buffett’s company.

Figuring out which distressed bonds Baupost owns is more difficult. For competitive reasons, Baupost does not name the companies, but last year Mr. Klarman told investors that its second-largest single annual gain came from an holding in NationsRent, a company that rents equipment to builders. NationsRent filed for bankruptcy in 2001. The next year Baupost invested about $100 million in the defaulted bank debt.

A year later, NationsRent reorganized. Baupost put in about $50 million in fresh capital in exchange for stock and ended up with a total of more than two-thirds of the stock. Last year, Sunbelt Rentals bought the company for $1 billion in cash and the assumption of debt. Mr. Klarman said that Baupost more than doubled its investment.

In the interview, Mr. Klarman said that he found bankruptcy investing appealing because the process of bankruptcy itself can help unlock the value of an investment.

“There is a catalyst,” he said, “because the way you make money is dependent on specific situations; the bankruptcy process itself will deliver you securities in the reorganized company.”

DESPITE Baupost’s stellar returns, Mr. Klarman’s team continues to take out what he calls “disaster insurance.” Last year it emphasized gold, which would appreciate if the dollar and other currencies declined in value. Although Baupost did not indicate the size of its wager, it did tell investors in one of its funds that 2.87 percentage points of about 20 percent in total fund profit came from a bet that the precious metal would rise. He wrote that gold was underpriced because investors in this “goldilocks” era have not worried enough about currency devaluation.

Baupost has had its setbacks. In 2006 it lost money on an investment in TRM, which operates automated teller machines. “It seemed cheap on cash flow, but its business deteriorated after Hurricane Katrina,” Mr. Klarman said. “It did not turn out to be as stable a business as we thought.”

Baupost has done better with real estate. Last year, Coastal Management Resources, a company in which Baupost has an equity stake, bought the neighboring Cojo and Jalama Ranches north of Santa Barbara, Calif. Although neither the size of Baupost’s investment in Coastal Management nor the purchase price of the ranches is known, the asking price was $155 million.

The ranch purchases may reflect Mr. Klarman’s passion for horses. He has owned racehorses, and even at the track his penchant for details is manifest. One of his horses, now retired, is named Read the Footnotes.

NBER Prog. on Economic Fluctuations and Growth

I ran across work done at the National Bureau of Economic Research’s program on economic fluctuations and growth (www.nber.org/programs/efg/). The bureau is the nonpartisan, nonprofit institute whose macroeconomists conduct their own research and ascertain the timing of the nation’s booms and recessions. There are 177 current members from academia (primarily, i believe). Their recent report on the current business cycle was notable for its comparison to current post-recession gdp performance vis-a-vis average for previous 6 recessions.


Quarterly Real GDP: The dark line shows the movement of quarterly real GDP in 2000-2003 and the shaded line the average over the previous 6 recessions. Source: Bureau of Economic Analysis, U.S. Department of Commerce (www.bea.doc.gov).

The current recovery has not seen as high a growth rate of real GDP as in the average recovery. In addition, productivity has grown unusually rapidly during the recession and recovery. As a result, employment has continued to decline slightly during the recovery. In dating the trough, the committee relied on the tradition of the Bureau's business-cycle dating procedure that emphasized output as the measure of economic activity, rather than employment.

BizWk article on China economy

Economics April 23, 2007, 12:01AM EST text size: TT
Why Taming the China Dragon Is Tricky
Slowing down China's high-speed economy is devilishly hard to do, and may even be beyond Beijing's control
by Brian Bremner

It's a problem a lot of developing countries would die for. Yet Beijing faces a policy quandary of the highest order. China's $2.6 trillion economy, which blew away market expectations and clocked 11.1% growth in the first quarter, is rushing along like some blisteringly fast, runaway maglev train. Chinese President Hu Jintao's economic team in Beijing has been trying to tap the brakes to avoid a reprise of the painful boom-and-bust scenario that hit the country in the mid-1990s, yet hasn't managed to do so despite three years of effort.

China's seemingly unstoppable surge was a big topic on the podiums and in the hallways at the 2007 Boao Forum for Asia, a gathering of regional leaders and executives held in the southern province and resort island of Hainan on Apr. 20-21. Another prime subject: the global economic risks of a China that might jump the rails.

While China's restrictive currency policy that has kept the yuan relatively cheap gets much of the blame, Beijing is having trouble wrestling with this economic beast for lots of reasons that cut to the basic structure of China's economy. Among them is a massive savings glut in the corporate sector, the globalization of manufacturing networks, and the still vast developmental needs of an economy that must generate 15 million-plus jobs annually to avoid widespread joblessness and social unrest. Here is a quick guide to some of the issues:

Just how strong is the Chinese economy right now?

The world has never seen such a sudden and sustained rise of an economy that was so desperately poor just three decades ago. China has averaged 9.6% growth rates for 30 years and is now the fourth-biggest economy in the world—and likely will overtake Germany as No. 3 in the next year or so. It's the third-biggest trading nation: Two-way trade between China and the rest of the world hit $1.76 trillion last year.

China's nearly $1.2 trillion stockpile of foreign currency is the biggest on the planet, a reflection of the mainland's role as the biggest creditor economy and massive capital power. Lured by cheap labor and a white-hot Chinese domestic economy, foreign companies pumped about $60 billion in direct investment last year, and the country's global trade surplus came in at a record $177 billion. "No nation has moved as fast as China in establishing a global footprint," marveled Pakistani Prime Minister Shaukat Aziz at the Boao gathering.

Sounds like party time. Why are Chinese leaders worried?

Lost in all the breathless talk about China's overall economic performance is the cold, hard reality that the country's per capita gross domestic product is only $2,000 per person. There are huge income imbalances between China's big-city and rural provinces, years of rapid development have ravaged the environment, and the pressure to create fresh jobs and provide adequate social welfare policies is awesome in a country that is home to 1.3 billion people, about one-fifth of humanity.

"China remains a developing economy that has a long way to go before it can achieve modernization," says Wu Bangguo, chairman of China's National People's Congress standing committee. A big runup in inflation or an economic bubble that bursts would be absolutely catastrophic for hundreds of millions of Chinese families barely making ends meet—not to mention for Hu and his comrades running the show in China's one-party Communist regime.

Why doesn't Beijing just ratchet up interest rates to cool things off?

China did so in March, when the People's Bank of China increased a key benchmark, the one-year interest rate, by 27 basis points, to 6.39%. The one-year deposit rate was nudged up by the same amount, to 2.79%. It was the third such interest-rate hike in the past 12 months—and one or two more credit tightening moves are likely in 2007.

Yet here's the thing: China needs to slow down investment in factories and public works projects, which drive 40% of overall gross domestic product growth. Slowing down loan growth helps, but not in a country where all manner of state-owned companies (about 50% of the corporate sector) are enjoying double-digit profit growth and don't have to pay dividends like big publicly traded companies in the West. They are awash in cash and will keep investing into overcrowded sectors like autos, steel, cement, and construction.

China has an enormous pile of savings (the national savings rate is an awesome 50%), and the retained earnings the corporate sector is now generating is a big reason for this. Gang Fan, an economist and president of the Beijing-based National Economic Research Institute, points out that 5% to 10% of the national income the economy generates is now getting socked away by state-owned companies because the government doesn't require a dividend payment, which publicly traded foreign companies have to pay to shareholders. "It's quite a serious problem," he says, regarding the efforts by Beijing to slow things down.

What about throwing some ice water on the export sector by letting the yuan appreciate?

Beijing financial authorities probably could do more in this area, but it is not a magic bullet for two reasons: the weak consuming power of most individual Chinese consumers and the mainland's critical role as a final assembly platform for global companies. One big driver of China's rapidly expanding trade numbers is that ordinary Chinese families aren't spending enough on foreign goods.

True, there is plenty of conspicuous consumption in prosperous coastal cities such as Beijing, Shanghai, and Shenzhen, but there are also 700 million Chinese in the hinterland who don't buy Rolls-Royce Phantom sedans and Gucci handbags. China is reluctant to risk a major slowdown because these folks would get crushed. Beijing needs to keep the economy stoked in high-speed mode until China's vast income gap closes more. "The income disparity is behind the low consumption," figures Yifu Lin, a professor and director of the China Center for Economic Research at Beijing University (see BusinessWeek.com, 4/30/07, "China's Cautious Consumers").

Consider, too, that some of the biggest exporters out of China are actually foreign companies from Taiwan, Japan, the U.S., and Europe. There are some 600,000 overseas-funded companies operating in China. They import goods, assemble them on the mainland with cheap labor, slap on the "Made in China" label, and then ship mobile phones, desktop computers, and sedans to the rest of the world. These products get counted as Chinese exports but are really pieced together with components from around the world.

China can't really order Honda (HMC) or Nokia (NOK) to export less out of China. And the kind of trade sanctions being contemplated by trade hawks in the U.S. would ultimately hurt foreign corporate interests in China, too. "This is a problem of economic globalization," not just Chinese policies, reckons Yongtu Long, a former Chinese trade negotiator and secretary general of the Boao Forum.

What's the way out of all of this?

Short term, China needs to boost private consumption by shifting tax breaks away from the cash-rich corporate sector and toward Chinese families. A stronger social safety net—more affordable health care and education and secure pensions—would give them more confidence in their futures and get them spending more.

Beijing also needs to crack down on banks and local governments that keep lending and spending, despite the risks to the entire country if the economy overheats. Phased-in liberalization of the yuan, interest rates, and capital flows is another needed reform. This would allow market forces to send price signals to policymakers and executives alike about when to slow down and speed up.

Yet this is going to take many years, if not a decade, to realize. Chinese authorities, naturally enough, are far more concerned about the living standards of their own people than those of the comfortable middle class in the U.S. They probably will do just enough to avert trade sanctions from the U.S. It would take a dramatic currency shift to really improve the trade balance with the U.S.—but that would risk destroying China's fragile social balance. From China's perspective, "it's about hundreds of millions of rural workers," says Chinese economist Fan.

Bremner is Asia Regional Editor for BusinessWeek in Hong Kong.

% of Population Under 25

(Report from ICICI Securities – Info Edge (India), December 22, 2006)

India has the potential to become global manpower supplier
India’s young population, in an environment where most developed countries are
aging fast, offers a big opportunity for India to become the global supplier of skilled manpower to the developed world. Table 7 shows the percentage of total population less than 25 years (as of ’04) for developed and developing countries.
Table 7: India – Youngest country with scale
Country % of population below 25 years of age

Germany	26
Japan	27
Brazil	29
Indonesia	30
US	30
China	42
India	53

Source: ILO
Population alone is not an advantageous factor. However, given that India produces the largest number of graduates and engineers in the world, we believe the country has the potential to become the service hub of the world.

WSJ: China to Continue Birth-Rate Control

China to Continue Birth-Rate Control
By ANDREW BATSON, January 13, 2007

BEIJING -- Concluding a three-year review of its controversial population policies, China says it has no choice but to continue controlling birth rates despite increasing population imbalances.

The government acknowledged that its one-child policy will produce a surge in the number of single men and elderly -- trends with worrisome implications for social stability and government finances. But the nation can't support a population much larger than the current 1.3 billion, according to the review.

State controls on childbearing have "eased the pressure of population growth on the economy, society, resources and the environment," the National Population and Family Planning Commission said in a report published this past week, although that "relationship is still strained, and is bringing many serious challenges."

The government wants to keep the birth rate low, at the current average of 1.8 children per woman. The report says this will ensure the population will rise only slowly in coming years and peak at 1.5 billion people after 2033 -- and then start declining.
China's family-planning policies were launched in 1973, in response to a wave of births that threatened to send population growth out of control. Now, the government officially "encourages late marriage and childbearing and advocates one child per couple."

The restriction on births is applied most strictly on women living in cities, and less so elsewhere. But local governments have leeway in implementing policy, which has sometimes led to abuses when they try to meet their family-planning targets.
The commission's report called for greater "innovation" in family planning and for the creation of a social-security system for the elderly in rural areas, so that couples don't feel they must have children to provide for them.

The population controls have brought their own set of unintended problems. Because the one-child policy effectively means that each generation will be smaller than the one preceding it, the elderly will have to be supported by a shrinking number of younger people. That is becoming a challenge for a country trying to expand a rudimentary social-welfare system.

Another consequence has been the creation of a gender imbalance. If a Chinese couple can have only one child, they usually prefer to have a boy. As a result, births have become heavily skewed to boys. In 2005, there were 118.6 boys born for every 100 girls.

That means that by 2020, there will 30 million more men than women in the 20-to-45-year age group, the report says, which is likely to bring greater "social disorder." This gender imbalance may push increasing numbers of Chinese men to move to other countries in search of partners.