I have planned to send out this earlier, but somehow I forgot. Peter Bernstein, one of the few shining stars in investing, co-founder of Journal of Portfolio Management, and author of nearly a dozen popular investment books, including Against the Odds, passed away in June. Here is a piece remembering him from WSJ (the highlights are mine). I truly enjoyed this piece, and his wisdom.

Mr. Bernstein saw the boom and bust of the 1920s first-hand in New York. In 1929, Mr. Bernstein’s father, Allen, sold the family leather factory “for a price he never dreamed he would get” and put all the proceeds into the stock market, buying “other people’s companies at prices they never dreamed they would see, either,” Mr. Bernstein recalled, paraphrasing his father.

In this FT piece, Maestro Greenspan identifies another channel that inflation may be the real threat down the road.  He hypothesizes that equity market does not purely reflect or predict what is going on in the real economy; but it causes the real economy to swing both ways, and it operates through company's balance sheet.   "I recognize that I accord a much larger economic role to equity prices than is the conventional wisdom. From my perspective, they are not merely an important leading indicator of global business activity, but a major contributor to that activity, operating primarily through balance sheets."

Having dealt with the Congress for many years, Greenspan is really worried about politicians messing up with the Fed. "But I see inflation as the greater future challenge. If political pressures prevent central banks from reining in their inflated balance sheets in a timely manner, statistical analysis suggests the emergence of inflation by 2012." 

Adding to the problem is the bleak fiscal health in the country and the huge budget deficits will induce politicians to print more money to finance the debt.

With Greenspan on board, now in the inflation camp, we have John Taylor (the author of Taylor Rule), Fred Mishkin (former Fed governor), Jim Grant, Marc Farber and Jim Rogers (all legendary investors); in the deflation camp, we have Paul Krugman (2008 Nobel prize winner in economics), Robert Shiller (owner of Case-Shiller index), David Rosenberg (former ML chief economist), Ben Bernanke (Fed chairman) and Janet Yellen (SF Fed president).  With so much divide in both academics and the profession, and so much uncertainties ahead of us, prudent investors should always hedge the inflation risk in their portfolio.  Both TIPs and gold serve the purchase.  If the Fed manages to rein the liquidity in a timely manner and inflation is under control, you are unlikely to lose your investment value on both; if inflation runs rampant, you are a sure winner.

Now here I give you Alan Greenspan:

Inflation – the real threat to sustained recovery

The rise in global stock prices from early March to mid-June is arguably the primary cause of the surprising positive turn in the economic environment. The $12,000bn of newly created corporate equity value has added significantly to the capital buffer that supports the debt issued by financial and non-financial companies. Corporate debt, as a consequence, has been upgraded and yields have fallen. Previously capital-strapped companies have been able to raise considerable debt and equity in recent months. Market fears of bank insolvency, particularly, have been assuaged.

Is this the beginning of a prolonged economic recovery or a false dawn? There are credible arguments on both sides of the issue. I conjectured over a year ago on these pages that the crisis will end when home prices in the US stabilise. That still appears right. Such prices largely determine the amount of equity in homes – the ultimate collateral for the $11,000bn of US home mortgage debt, a significant share of which is held in the form of asset-backed securities outside the US. Prices are currently being suppressed by a large overhang of vacant houses for sale. Owing to the recent sharp drop in house completions, this overhang is being liquidated in earnest, suggesting prices could start to stabilise in the next several months – although they could drift lower into 2010.

In addition, huge unrecognised losses of US banks still need to be funded. Either a stabilisation of home prices or a further rise in newly created equity value available to US financial intermediaries would address this impediment to recovery.

Global stock markets have rallied so far and so fast this year that it is difficult to imagine they can proceed further at anywhere near their recent pace. But what if, after a correction, they proceeded inexorably higher? That would bolster global balance sheets with large amounts of new equity value and supply banks with the new capital that would allow them to step up lending. Higher share prices would also lead to increased household wealth and spending, and the rising market value of existing corporate assets (proxied by stock prices) relative to their replacement cost would spur new capital investment. Leverage would be materially reduced. A prolonged recovery in global equity prices would thus assist in the lifting of the deflationary forces that still hover over the global economy.

I recognise that I accord a much larger economic role to equity prices than is the conventional wisdom. From my perspective, they are not merely an important leading indicator of global business activity, but a major contributor to that activity, operating primarily through balance sheets. My hypothesis will be tested in the year ahead. If shares fall back to their early spring lows or worse, I would expect the “green shoots” spotted in recent weeks to wither.

Stock prices, to be sure, are affected by the usual economic gyrations. But, as I noted in March, a significant driver of stock prices is the innate human propensity to swing between euphoria and fear, which, while heavily influenced by economic events, has a life of its own. In my experience, such episodes are often not mere forecasts of future business activity, but major causes of it.

For the benevolent scenario above to play out, the short-term dangers of deflation and longer-term dangers of inflation have to be confronted and removed. Excess capacity is temporarily suppressing global prices. But I see inflation as the greater future challenge. If political pressures prevent central banks from reining in their inflated balance sheets in a timely manner, statistical analysis suggests the emergence of inflation by 2012; earlier if markets anticipate a prolonged period of elevated money supply. Annual price inflation in the US is significantly correlated (with a 3½-year lag) with annual changes in money supply per unit of capacity.

Inflation is a special concern over the next decade given the pending avalanche of government debt about to be unloaded on world financial markets. The need to finance very large fiscal deficits during the coming years could lead to political pressure on central banks to print money to buy much of the newly issued debt.

The Federal Reserve, when it perceives that the unemployment rate is poised to decline, will presumably start to allow its short-term assets to run off, and either sell its newly acquired bonds, notes and asset-backed securities or, if that proves too disruptive to markets, issue (with congressional approval) Fed debt to sterilise, or counter, what is left of its huge expansion of the monetary base. Thus, interest rates would rise well before the restoration of full employment, a policy that, in the past, has not been viewed favourably by Congress. Moreover, unless US government spending commitments are stretched out or cut back, real interest rates will be likely to rise even more, owing to the need to finance the widening deficit.

Government spending commitments over the next decade are staggering. On top of that, the range of error is particularly large owing to the uncertainties in forecasting Medicare costs. Historically, the US, to limit the likelihood of destructive inflation, relied on a large buffer between the level of federal debt and rough measures of total borrowing capacity. Current debt issuance projections, if realised, will surely place America precariously close to that notional borrowing ceiling. Fears of an eventual significant pick-up in inflation may soon begin to be factored into longer-term US government bond yields, or interest rates. Should real long-term interest rates become chronically elevated, share prices, if history is any guide, will remain suppressed.

The US is faced with the choice of either paring back its budget deficits and monetary base as soon as the current risks of deflation dissipate, or setting the stage for a potential upsurge in inflation. Even absent the inflation threat, there is another potential danger inherent in current US fiscal policy: a major increase in the funding of the US economy through public sector debt. Such a course for fiscal policy is a recipe for the political allocation of capital and an undermining of the process of “creative destruction” – the private sector market competition that is essential to rising standards of living. This paradigm’s reputation has been badly tarnished by recent events. Improvements in financial regulation and supervision, especially in areas of capital adequacy, are necessary. However, for the best chance for worldwide economic growth we must continue to rely on private market forces to allocate capital and other resources. The alternative of political allocation of resources has been tried; and it failed.

The writer is former chairman of the US Federal Reserve

California is broke; Texas performs the best during this recession.

A debate on two different American models and who may have America’s future. From my favorite On Point with Tom Ashbrook at local Boston station.

The earlier evidence was further confirmed by more data recently that China has been stockpiling copper and other commodities strategically. This is a smart move on Chinese side, but it shows the recovery in China was not strong as the commodity price would have indicated. Read this analytical piece from WSJ.

What is China going to do with all that copper? Move the futures markets, for one thing.

Bolstered by stockpiling, the country’s imports of the red metal in the first half jumped 69% from year-earlier levels. Seizing upon last year’s drop in prices, China’s State Reserve Bureau now holds at least 235,000 metric tons of copper, nearly as much as the London Metal Exchange warehouses hold to back futures trading.

Arbitragers followed suit, after the SRB’s buying helped push copper prices inside China well above those abroad. Deutsche Bank estimates factories and warehouses in the country hold as much as one million metric tons of copper in total — equivalent to nearly a month’s global consumption.

Meanwhile, LME copper futures are up 63% since February. What next? The market’s already proved its susceptibility to speculation about the SRB’s next move. In June, reports the government had turned seller fueled a sharp price retreat.

A paucity of information doesn’t help. An official from China’s National Development and Reform Commission last month said stockpiling had ceased. But not everyone’s convinced. After all, with copper still well below last year’s peak of nearly $9,000 a metric ton, China might want to keep building its position.

Bulls also say investment in power-generation capacity, a recovering construction industry, and buoyant car sales may see China gobbling up its copper reserves. This is all causing a wide divergence in views for the second half of the year. Price targets range from $3,500 a metric ton, a 31% drop from current levels, to $7,000 a metric ton, a 37% rise. Even more than usual, the outcome will be in Beijing’s hands.

Opinion piece from WSJ: Unemployment is worse than you think. This does not bode well for consumptions, which accounts for 70% of American economy, and may dash any hope of a quick turnaround.

The recent unemployment numbers have undermined confidence that we might be nearing the bottom of the recession. What we can see on the surface is disconcerting enough, but the inside numbers are just as bad.

The Bureau of Labor Statistics preliminary estimate for job losses for June is 467,000, which means 7.2 million people have lost their jobs since the start of the recession. The cumulative job losses over the last six months have been greater than for any other half year period since World War II, including the military demobilization after the war. The job losses are also now equal to the net job gains over the previous nine years, making this the only recession since the Great Depression to wipe out all job growth from the previous expansion.

Here are 10 reasons we are in even more trouble than the 9.5% unemployment rate indicates:

– June's total assumed 185,000 people at work who probably were not. The government could not identify them; it made an assumption about trends. But many of the mythical jobs are in industries that have absolutely no job creation, e.g., finance. When the official numbers are adjusted over the next several months, June will look worse.

– More companies are asking employees to take unpaid leave. These people don't count on the unemployment roll.

– No fewer than 1.4 million people wanted or were available for work in the last 12 months but were not counted. Why? Because they hadn't searched for work in the four weeks preceding the survey.

– The number of workers taking part-time jobs due to the slack economy, a kind of stealth underemployment, has doubled in this recession to about nine million, or 5.8% of the work force. Add those whose hours have been cut to those who cannot find a full-time job and the total unemployed rises to 16.5%, putting the number of involuntarily idle in the range of 25 million.

– The average work week for rank-and-file employees in the private sector, roughly 80% of the work force, slipped to 33 hours. That's 48 minutes a week less than before the recession began, the lowest level since the government began tracking such data 45 years ago. Full-time workers are being downgraded to part time as businesses slash labor costs to remain above water, and factories are operating at only 65% of capacity. If Americans were still clocking those extra 48 minutes a week now, the same aggregate amount of work would get done with 3.3 million fewer employees, which means that if it were not for the shorter work week the jobless rate would be 11.7%, not 9.5% (which far exceeds the 8% rate projected by the Obama administration).

– The average length of official unemployment increased to 24.5 weeks, the longest since government began tracking this data in 1948. The number of long-term unemployed (i.e., for 27 weeks or more) has now jumped to 4.4 million, an all-time high.

– The average worker saw no wage gains in June, with average compensation running flat at $18.53 an hour.

– The goods producing sector is losing the most jobs — 223,000 in the last report alone.

– The prospects for job creation are equally distressing. The likelihood is that when economic activity picks up, employers will first choose to increase hours for existing workers and bring part-time workers back to full time. Many unemployed workers looking for jobs once the recovery begins will discover that jobs as good as the ones they lost are almost impossible to find because many layoffs have been permanent. Instead of shrinking operations, companies have shut down whole business units or made sweeping structural changes in the way they conduct business. General Motors and Chrysler, closed hundreds of dealerships and reduced brands. Citigroup and Bank of America cut tens of thousands of positions and exited many parts of the world of finance.

Job losses may last well into 2010 to hit an unemployment peak close to 11%. That unemployment rate may be sustained for an extended period.

Can we find comfort in the fact that employment has long been considered a lagging indicator? It is conventionally seen as having limited predictive power since employment reflects decisions taken earlier in the business cycle. But today is different. Unemployment has doubled to 9.5% from 4.8% in only 16 months, a rate so fast it may influence future economic behavior and outlook.

How could this happen when Washington has thrown trillions of dollars into the pot, including the famous $787 billion in stimulus spending that was supposed to yield $1.50 in growth for every dollar spent? For a start, too much of the money went to transfer payments such as Medicaid, jobless benefits and the like that do nothing for jobs and growth. The spending that creates new jobs is new spending, particularly on infrastructure. It amounts to less than 10% of the stimulus package today.

About 40% of U.S. workers believe the recession will continue for another full year, and their pessimism is justified. As paychecks shrink and disappear, consumers are more hesitant to spend and won't lead the economy out of the doldrums quickly enough.

It may have made him unpopular in parts of the Obama administration, but Vice President Joe Biden was right when he said a week ago that the administration misread how bad the economy was and how effective the stimulus would be. It was supposed to be about jobs but it wasn't. The Recovery Act was a single piece of legislation but it included thousands of funding schemes for tens of thousands of projects, and those programs are stuck in the bureaucracy as the government releases the funds with typical inefficiency.

Another $150 billion, which was allocated to state coffers to continue programs like Medicaid, did not add new jobs; hundreds of billions were set aside for tax cuts and for new benefits for the poor and the unemployed, and they did not add new jobs. Now state budgets are drowning in red ink as jobless claims and Medicaid bills climb.

Next year state budgets will have depleted their initial rescue dollars. Absent another rescue plan, they will have no choice but to slash spending, raise taxes, or both. State and local governments, representing about 15% of the economy, are beginning the worst contraction in postwar history amid a deficit of $166 billion for fiscal 2010, according to the Center on Budget and Policy Priorities, and a gap of $350 billion in fiscal 2011.

Households overburdened with historic levels of debt will also be saving more. The savings rate has already jumped to almost 7% of after-tax income from 0% in 2007, and it is still going up. Every dollar of saving comes out of consumption. Since consumer spending is the economy's main driver, we are going to have a weak consumer sector and many businesses simply won't have the means or the need to hire employees. After the 1990-91 recessions, consumers went out and bought houses, cars and other expensive goods. This time, the combination of a weak job picture and a severe credit crunch means that people won't be able to get the financing for big expenditures, and those who can borrow will be reluctant to do so. The paycheck has returned as the primary source of spending.

This process is nowhere near complete and, until it is, the economy will barely grow if it does at all, and it may well oscillate between sluggish growth and modest decline for the next several years until the rebalancing of excessive debt has been completed. Until then, the economy will be deprived of adequate profits and cash flow, and businesses will not start to hire nor race to make capital expenditures when they have vast idle capacity.

No wonder poll after poll shows a steady erosion of confidence in the stimulus. So what kind of second-act stimulus should we look for? Something that might have a real multiplier effect, not a congressional wish list of pet programs. It is critical that the Obama administration not play politics with the issue. The time to get ready for a serious infrastructure program is now. It's a shame Washington didn't get it right the first time.

In 2007, Americans spent $92.3 billion on legalized gambling; but saved only $57.4 billion. This Intelligent Investor piece by Jason Zweig offers some interesting perspective on how to offer “exciting” incentives for Americans to save.

If you believe stock market, like the economy, has its own cycles, then we’ve got a trouble.

(click to enlarge; source: David Rosenberg)

China’s recent Q2 GDP grew by 7.9%, showing the economy is in strong recovery, also confirming my early observation that despite its high openness to international trade, China’s growth is largely independent from the US. With China’s green shoots greener, investors worldwide poured in huge amount money into the region. Since Chinese stock market is still largely closed for the foreign investors, Hong Kong has had a big surge. Are we witnessing another great stock bubble forming in China? This piece from Economist says it’s still too early for the bubble talk.

CHINESE growth was already the envy of the world. Now recession-stricken countries will be turning an even brighter green. On July 16th new figures showed China’s GDP growth quickened to 7.9% in the year to the second quarter. That is healthy enough by anyone’s standards but the headline number conceals a more astonishing rebound. Goldman Sachs estimates that GDP grew at an annualised rate of 16.5% in the second quarter compared with the previous three months (see chart 1). Over the same period, America’s economy probably contracted again. China’s economic stimulus has clearly been hugely effective. So effective, indeed, that some economists are now worrying it may be working rather too well.

In the year to June fixed investment surged by 35%, car sales rose by 48%, and purchases of homes by more than 80%. After falling last year, home prices are now rising briskly in some big cities, and share prices have soared by 80% from their November low. Domestic spending has been spurred partly by the government’s stimulus package, but probably even more important was the scrapping of restrictions on bank lending late last year. In June new lending was more than four times larger than a year earlier (chart 2).

One reason why the economy has rebounded so quickly is that much of the slowdown was self-inflicted, rather than the result of America’s economic collapse. In 2007 concerns about overheating prompted the government to curb the flow of credit for construction and home buying. This caused China’s economy to slow sharply even before the global financial crisis. Then, last November, the government turned the credit tap back on full.

That has given a big boost to domestic spending but raised concerns that the flood of liquidity will push up inflation, fuel bubbles in shares and housing, and store up bad loans. The M2 measure of money surged by 29% in the year to June. In fact the risk of high inflation in the near future appears low: Chinese consumer prices fell by 1.7% in the year to June, and spare capacity at home and abroad is holding down prices. But asset prices could be a bigger danger. According to one estimate, 20% of new lending went into the stockmarket in the first five months of this year.

It is probably too soon to use the word “bubble”. The stockmarket is still at only half its 2007 peak and, although house prices have risen sharply this year in Shanghai and Shenzhen, the nationwide average is barely higher than it was a year ago. But the pace of bank lending is unsustainable, and America’s recent experience suggests that it is better to prevent bubbles forming than to mop up the mess afterwards. Several officials at the central bank have said lending should be curbed.

At the moment, the prime minister, Wen Jiabao, is signalling that he wants monetary policy kept fairly loose. Exports remain weak and the government fears premature tightening could derail the recovery. It is also keen to create jobs and maintain social stability in the months before the 60th anniversary of Communist Party rule in October.

Still, the central bank has begun to tug gently at the reins. It has nudged up money-market interest rates and warned banks that it intends to increase its scrutiny of new bank loans. The China Banking Regulatory Commission has warned banks to stick to rules on mortgages for second homes, which require a down-payment of at least 40% of a property’s value.

The recent rebound in house sales is, in fact, exactly what the government is aiming for, since it is using property as a way to spur private consumption. Higher house sales encourage more spending on furniture and consumer appliances. Construction also creates lots of jobs; indeed, it employs almost as many workers as the export sector. Since October the government has encouraged people to buy houses by cutting the minimum mortgage down-payment on their main home from 30% to 20% and by reducing stamp duty and other taxes on property transactions. Stronger sales are now feeding through into new house building: housing starts rose by 12% in the year to June, the first growth in 12 months.

Given the importance of property to domestic demand, the government is highly unlikely to want to clamp down hard on the housing market. Despite the recent lending boom, Chinese banks’ mortgage lending is still very conservative compared with that in America—at the peak of America’s housing bubble it was easy to get a mortgage for 100% or more of the value of a home. Nevertheless, the lesson of America’s financial crisis for China’s government is plain: overly loose lending should never be ignored.