Happy Holidays!

We will soon leave for Northern California to visit family and friends, play in the snow, and scout out some more possible retirement locales. Look for the next post sometime around the first of the year.

Thanks to regular readers of this blog, as well as passers-by, for all the kind words and support over the last year. Look for more of the same next year, along with a few surprises.

Wishing you all a pleasant holiday season and a prosperous new year, we leave you with a few wintry photos of one of our favorite parts of the Sierra Nevada Mountains - Calaveras Big Trees State Park.


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No Deal

Viewing NBC's new game show Deal or No Deal offers further evidence that the decline of Western Civilization is accelerating. While initially fascinated by the statistics and probabilities that are integral to the show, this emotion quickly gave way to the more overwhelming feeling of shame.

Shame that the Bread and Circuses in American society today are converging at a quickening pace.

Many years ago, when television was still in it's infancy and America was a net exporter and creditor to the world, What's My Line entertained the populace (a Mark Goodson and Bill Todman production - one of many).

Celebrity panelists tried to guess the occupation of contestants who would win a small cash prize if they were successful in stumping the panelists after a series of yes or no questions. It was entertaining and it was all in good fun.

Times sure have changed.

Back in 1999 when Who Wants to be a Millionaire debuted in the U.S., at least contestants had to answer questions. There was some skill involved - not completely a game of chance.

And, on Survivor, people actually get injured and vomit and otherwise become physically unable to continue in the competition.

NBC's Deal or No Deal has dumbed down prime time game shows to levels few could have imagined while at the same time offering huge sums of money and plenty of excitement.

It is strictly a game of chance, with a focus on the emotions experienced by a family making joint decisions involving sums of money that are multiples of the median family income.

If a contestant is lucky enough to make it onto the show and get selected as a contestant, they pick numbers and then make decisions to either take the $90,000 currently offered or risk it on maybe winning the half million.

Just by picking numbers - randomly.

With each round, the calculation changes - take the $68,000 or the shot at a quarter million.

Those familiar with games of chance will quickly deduce that all the offers coming down from the mysterious banker on the second floor are cold, hard calculations based on probabilities and the business plan for the television program.

[For some odd reason the mysterious banker is seen reviewing a print-out of something, when in fact all he really needs to do is punch in a few numbers on his PC and hit return.]

The excitement is all about the reaction of the family when confronted with decisions involving life-changing amounts of cash.

Bold or conservative, risk-taker or risk averse. In either case, the family must be animated. The populace must be entertained.

[As the holidays near, it is imperative that we offer something positive in this space - we will see what can be done in the coming days.]

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UPDATE (8:12 AM PST)

Slate has this to say:

When last a prime-time game show became a national sensation, the year was 1999, the Nasdaq index was doing ridiculous things, and Regis Philbin was spawning an appallingly viral catchphrase ("Is that your final answer?!"). Who Wants To Be a Millionaire was the right circus at the right time; a little knowledge and nerve could bring Joe Average a lot of dough. Deal or No Deal, which debuted to strong ratings on Monday night and runs all this week (NBC, 8 p.m. ET), is the opposite of a quiz show and does not require even the modest deductive skills of Wheel of Fortune. Its central theme is self-restraint.

Each contestant ascends to the Deal or No Deal stage to stand opposite 26 models in identical cocktail dresses—Barker's Beauties by way of Robert Palmer's "Addicted to Love" babes—each of them bearing a briefcase with a different dollar figure inside. The contestant selects one of the cases. There could be a penny or a million bucks or any of 24 figures in between; none of us will know until the end of the game, which is an exercise in game theory. The contestant opens the remaining briefcases, a few at a time, to find that hers was not the one with $5 or $500,000 or whatever within. Based on the dollar figures removed from contention, "the Bank," the shadowy embodiment of a mathematical model, relays "offers" through Mandel. The Bank will give the contestant a wad of cash in exchange for her chosen case. Will the player opt for the none-too-shabby guaranteed sum or take her chances? Deal or no deal? These offers fluctuate with the apparent odds. The contestant walks away with a jackpot or chump change or perhaps a midrange sum good enough for buying a new sedan.

Despite that twisty description—and despite its appropriation of Millionaire's ominous synthesizers and Star Trek's set design—Deal or No Deal is clean and minimal. Though it does a fine job of building tension slowly, I suspect that it has become a smash hit in more than 30 countries because it is good to yell at. In concert with the studio audience, you get to berate the contestants as they succumb to temptation and push their luck or bless them for checking their greed. If the show takes off, America will have discovered a new spectator sport: caution.

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Enron and Home Equity Wealth

Sometimes when a trend continues for a long enough period of time, people come to accept the trend as just another fact of life. Despite initial skepticism, if events continue to unfold in the same manner month after month, year after year, people tend to forget their initial misgivings.

After repeated positive reinforcement, new beliefs become entrenched and the current reality is projected into the future. Regardless of its enduring qualities, what at first seemed unbelievable, becomes believable over time.

Enron

Enron is a good example of this phenomenon. Living in California during the rolling blackouts of 2000 and 2001 and reading news reports about the energy crisis, it became clear that Enron had mastered the business of trading just about anything that could be traded.

With a partially-deregulated energy market, the State of California and its hapless Governor were hopelessly outclassed by savvy Enron traders - Enron's stock soared as California's lights dimmed.

Named "America's Most Innovative Company" by Fortune Magazine, Enron traded such exotic items as internet bandwidth and weather derivatives while earning record profits. They led the way with sophisticated financial instruments such as derivatives and employed innovative accounting practices such as special purpose entities.

At the height of their success in late 2000, as the NASDAQ stock market bubble was bursting, Enron's star shone bright. At the end of 2001, things began to unravel quickly, and in 2002 the company was exposed for what it was - a fraud.

Stock and bond holders were aghast, as the entrenched belief of Enron success was laid bare to reveal few enduring qualities. Vindication for California's governor was much too little and came far too late.

Home Equity Wealth

Like Enron's rise in the late 1990s, the rise in home prices in many parts of the country has occurred over many years - until recently, it has been a gradual process. In 2001 and 2002, as the Enron meltdown progressed, mortgage lending rates plunged, spurring wave after wave of home refinancing - home prices began to rise more quickly.

Slowly, year after year, millions of homeowners became accustomed to rising home prices, and they became more aware of the latest "market value" of their home. Initially, many homeowners reacted to this simply by feeling more secure in their financial condition.

An "equity cushion", as Fed Chairman Alan Greenspan has called it, had begun to grow larger, faster, and that made household balance sheets more secure - job loss or family emergencies were no longer viewed as devastating financial events because an increasing amount of "emergency money" was there at the ready.

A year or two later, as home prices rose more quickly, a funny thing started happening. Long time homeowners of otherwise modest means, began driving nicer cars and taking better vacations.

Everyone seemed to be remodeling something - additions, swimming pools, landscaping, granite counter tops. Rising tuition costs were less of a problem and elective medical procedures became more and more common. People ate out more often.

Soaring real estate prices over the last few years combined with the newfound ease of home equity withdrawal have led many homeowners to spend money like they've never spent money before in their lives. When measured by consumption and the material goods that they have acquired, these homeowners have become "wealthy" far beyond what they could have imagined just five or six years ago.

Their standard of living has markedly improved.

But, excluding the market value of their home, many of these newly "wealthy" homeowners have a balance sheet that is in worse shape than it was just a few years ago - newly purchased goods lose value quickly after their purchase. It is only with high and still rising home values that overall net worth remains substantial, as wages have risen at a sluggish pace, many have discontinued saving, and other expenses have continued to rise.

The positive reinforcement of rising home prices over a period of years has caused many homeowners to believe that rising home prices, or at least the current value of their home, is something that can be projected into the future. And why not? Nothing in the last ten years would lead anyone to believe that home prices do anything but go up.

What If?

But what if the real estate market of 2005 turns out to be a lot like the energy trading market of 2001?

After many successful but unspectacular years, Enron rose toward the heavens on the back of "new era" thinking. Within a period of just a year during 2001-2002, they failed spectacularly causing much anguish and pain for many who became true believers on the way up.

In the end, their business model was revealed to be fundamentally flawed - it was fraudulent and unsustainable.

There are those who argue that the business model behind today's real estate market is fundamentally flawed. Derivatives offsetting risk in asset backed securities are new and innovative. And, when 82 percent of home purchase loans in the state of California last year were either interest-only or negatively amortizing loans, that should cause potential homebuyers to question the prices that are being paid these days - to question how sustainable current real estate trends are.

But beliefs about real estate and home equity wealth are now entrenched after many years of positive reinforcement. Beliefs change slowly, and most people are reluctant to cast doubt on something that has been so good to them over the last few years.

Like the hourly Enron worker with a million dollar retirement account in 2001, the hourly California worker with a million dollar home in 2005 looks to the future with every expectation that what they've come to believe in recent years will continue.

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The Yield Curve

The flattening of the yield curve has been much talked about lately and there will be plenty more talk in the coming months. For those new to this topic, the yield curve is most often represented by a chart with U.S. Treasury yields of varying durations - shortest on the left, longest on the right - at a particular point in time.

Readers are again directed to the always informative Dynamic Yield Curve over at StockCharts.com, where many hours can be spent investigating some of life's economic and financial mysteries.

To the left is the yield curve as of March of 2003, around the time that U.S. equity markets hit their lows for the decade. Economic growth, as measured by real GDP, had gone negative for a few quarters in 2001 and 2002, and heading into 2003 was uncomfortably in the two percent range.

To make matters worse, job creation was anemic and people were talking about the dreaded "deflation" monster.

Still reeling from the stock market bubble and the 9/11 tragedy, growth, job creation, and inflation were much too low for the folks at the Federal Reserve.

While long term rates have held generally above 4 percent in the last few years, the 10-year note occasionally dipping into the 3 percent range, the difference between short term rates and long term rates has been at least two or three percent during this time.

This is a highly stimulative condition, as with no apparent limit to the amount of money available to be borrowed, many have seized the opportunity to borrow at low short-term rates, seek a higher return elsewhere, and pocket the difference. This is otherwise known as the "carry trade".

This has worked well in the U.S. until short term rates began rising last year - today it only works well in Japan, where short-term interest rates have been near zero for the better part of the last fifteen years, following the zenith-like rise of their economy in the 1980s.

To the right is what the yield curve looks like today. The difference between long-term rates and short-term rates has narrowed precipitously since June of last year as short term interest rates have moved from 1 percent to 4.25 percent in a series of 13 quarter point hikes. During this time rates for the 10-year Treasury actually fell from 4.6 percent to 4.4 percent.

Thus the conundrum.

Why have long-term rates refused to move up as short-term rates have risen?

Why is this a conundrum? Why is this significant?

Because a continuation of the current trend will cause an inverted yield curve.

What's Wrong with an Inverted Yield Curve?

An inverted yield curve has been the single most reliable economic indicator in predicting coming weakness in the economy - it has, in fact predicted the last five recessions. In an article from yesterday's L.A. Times, Tom Petruno explains:

Normally, long-term interest rates are higher than short-term rates, which makes sense. If you're going to tie up your money for a lengthy period you would expect to be compensated for the risks that entails.

When short-term rates exceed long-term rates, an "inversion" is said to occur. The last one was in 2000: The Fed held its key rate at 6.5% in the second half of that year. But as the economy weakened, bond investors began to sense that the Fed soon would be easing credit. Long-term bond yields slid.

By the end of December 2000, the 10-year Treasury note yield was 5.11% — about 1.4 percentage points below the Fed's short-term rate.

The Fed began cutting its rate in January 2001, but it was too late. A recession began in March.

That has been par for the course, according to David Rosenberg, an economist at Merrill Lynch & Co. in New York. In the last three decades there have been five Fed-induced rate inversions, Rosenberg said.

"The economy slipped into recession a year later all five times," he said.

Hmmm...

"Too late" in cutting rates and "Fed-induced" rate inversions leading to recessions - that's not something that you hear a lot about. The Fed is supposed to be assuring things like price stability, maximum sustainable growth, and full employment, not "inducing" recessions by cutting rates too late.

In fact isn't "inducing" a recession really the domain of 1980s Fed Chairman Paul Volcker? Does anyone think of current Fed Chairman Alan Greenspan as inducing recessions? There have been so few recessions in the last 18 years, and comparatively mild ones at that.

But, back to the yield curve...

Given the course that has been taken for the last year and a half, and should current trends continue, an inverted yield curve would likely appear sometime in the first few months of 2006, as short-term rates move up to between 4.5 and 5 percent. It's been almost four years since the ten-year note was over five percent, and it shows little inclination of late of cooperating anytime soon. It seems the only way to avoid a rate inversion would be to stop raising short-term rates.



But, maybe this time it's different. Maybe an inverted yield curve in this new era of global trade and international finance is not such a big deal. The L.A. Times article continues:

This time around, however, no less than Fed Chairman Alan Greenspan himself has said that an interest-rate inversion might not signal an economic slowdown. The implication is that the bond market has its own special issues these days.
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Some on Wall Street believe that demand for bonds has remained robust, keeping yields down, because of a global savings glut — meaning that so much money is looking for a place to go that investors in effect are forced to out-compete one another for bonds, depressing returns.

"So much money is looking for a place to go" - now on the surface it sounds like there could be a lot worse problems than having too much money. And, there is no question that U.S. debt is popular with our overseas trading partners, who coincidentally, on a monthly basis, have just about exactly the same amount of new savings as the U.S. has new debt. That is very convenient for a nation such as the U.S. that would much rather spend than save.

Some analysts also contend that bond yields have softened because the market believes inflation has been vanquished in the long run, the jump in energy prices notwithstanding. Government bond returns have averaged 2.3 percentage points above the inflation rate since 1926. If inflation falls back to, say, 2%, a 4.44% bond yield would look fairly generous.

So much money but so little inflation - inflation has been "vanquished in the long run" - a savings glut and low long term interest rates to keep mortgage rates low to enable the continuation of the world wide real estate boom.

Again, it's hard to see where the problems are here. What is everyone concerned about with this inverted yield curve?

It appears that we are living in the most perfect of all possible worlds. The only thing that doesn't make sense is why gold is rising so dramatically.

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