Egyptian Unrest: Three Scenarios for Oil and Gasoline Prices

In the last week, Egyptians have taken to the streets of its major cities. This will cost you about 10 cents a gallon more at the pump -- around $3.21 a gallon for regular -- for the next few weeks after a 3% spike in crude prices in the last week. But it could be worse.

Although oil prices have risen -- futures are up from $89.11 a barrel on Jan. 24 to $92.19 on Jan. 31 -- the amount of oil that flows through Egypt's Suez Canal is tiny. According to the New York Times, only 2.6% of the world's crude flows through Egypt's Suez Canal -- and it's so narrow (only 1,000 feet wide at its narrowest) that tankers cannot fit through it. So the oil that travels through Egypt's pipelines -- mostly to India and to some Asian markets -- represents 2.9 million barrels a day, slightly more than the 2.5 million in global spare energy capacity.

But even though there's unrest in Egypt, it does not mean that the oil will stop flowing through the Suez Canal, according to Goldman Sachs. However, it also does not put an end to the uncertainty in the region because Egypt is not the only country in the oil rich region with a young population full of angry unemployed people frustrated with an authoritarian monarchy/dictatorship. For example, Saudi Arabia -- that controls 25% of the global oil supply -- is not exactly a bastion of democracy.

So if you're an investor, or just concerned about how much of your paycheck is going to gasoline in the months ahead, the uncertainty surrounding the political situation in the Middle East is worth considering. While there are many possible outcomes, we can frame them with these three scenarios (figures in parentheses represent my very rough estimates if oil prices -- in dollars/barrel  -- and gasoline prices -- in dollars per gallon -- under the various scenarios):

• Middle East Total Chaos ($300, $10). This worst case scenario would result in Saudi Arabian government losing control of the populace. CommodityOnline suggests that this scenario is not likely because so many large countries are pouring money into the Kingdom and that the population is getting enough of a share of that money to keep it calm. However, the Saudi government is probably quite concerned that unrest nearby could inspire the average citizen.
• Middle East Moderate Chaos ($150, $5). Under this scenario, the Egyptian unrest leads to a change in leadership which inspires other countries in the Middle East to send frustrated citizens into the streets seeking a change in leadership. For example, The Daily Beast suspects that Jordan could suffer a revolt. However, the country is run by a relatively reasonable monarchy and it's not a big oil player. So the biggest danger of instability in Jordan would be extending the period of oil market volatility.
• Middle East Swift Resolution ($86, $3.08). Under this scenario, the situation in Egypt is resolved with a relatively peaceful transfer of power to a new leader and the price of oil returns to where it was before -- around $86 and $3.08 a gallon.

Who knows which of these scenarios is most likely. My hunch is that the Egyptian situation will resolve itself peacefully with a new leader -- possibly Mohamed ElBaradei -- taking over in the next few weeks. But if this happens, the successful leadership changes in Tunisia and then Egypt will certainly inspire those in other nations to take to the streets to get their share of the revolutionary fun.

The really threatening issue for the rest of the world is what would happen if Saudi Arabia turned out not to be able to keep its populace under control. Instability there would really throw the global economy for a major loop -- particularly if control of its oil resources fell into the hands of leaders who strongly oppose the West.

While I hope that the Egyptian situation is resolved peacefully over the next few weeks, I would not be surprised to see "success" there -- as viewed by the average citizen in the Middle East -- inspiring more unrest.

Two Davos Takeaways: Stock Markets To Boom and CEOs to Resist Social Value Creation

This week the world's elite met at a Davos, a Swiss ski resort. Based on reading the breathless Davos dispatches, two things caught my eye: the elite are exuberant and they're annoyed by the idea that they should create societal value. The first has implications for investors -- stocks are likely to pop for the next several years, the second for managers -- they should turn to Value Leadership.

Just because an invite to the World Economic Forum's annual meeting in Davos, Switzerland is highly coveted and expensive, it does not mean that not being invited should give you a reason to ignore the elite meet-up. After all, between Jan. 26th and 30th, about 2,500 of the world's top leaders, thinkers and business titans showed up -- with the intent of building relationships, doing deals, and maybe learning a new idea or two.

Business Elite Exuberance Means Cross-Border Deals

I think the most important thing to come out of Davos is a major mood shift among the business elite. According to the BBC, the Jan. 2010 meeting featured a gloomy, fearful mood among the world's elite. A mere year later, the emotional shift is manic-depressive. Now, the business elite are filled with exuberance. BBC notes that "there's a really bullish feeling among many economists gathered at Davos."

And that represents a big turnaround from the last few years. As U.C. Berkeley economist Laura Tyson told the BBC, "Two years ago there was a lot of doom and gloom about the financial crisis, last year there was uncertainty, and now there's more confidence in the business community that the global economy is on a rebound."

Of course, this feeling is not unanimous -- perma-bears like New York University's Nouriel Roubini continue warning about debt and deficits (possibly hoping that the global economy will relapse again so he can get more media attention).

This mood shift is very relevant for investors. How so? The Davos elite control huge amount of capital. And if the U.S. performance is any guide -- with $1.66 trillion in 2010 profits and nearly $2 trillion in balance sheet cash -- the world's business leaders have a huge amount of money to invest in their confidence about the future.

While it is interesting to examine the list of attendees and imagine deals that might have been kicked off during the week that's ending, the general point is that when you combine massive amounts of cash with a recent mood of optimism, you have the ingredients needed to unleash a wave of investment -- most likely in acquisitions targeted at lowering costs and accelerating revenue growth.

This means that investors should expect to see deals in the wake of Davos. And it would not surprise me if those deals involve emerging markets like China, India and Brazil. The reason for that, as I posted last March, is for companies based in slower-growing developed nations -- expecting GDP growth of 3% -- to tap into the markets that are growing at least three times faster.

Can Michael Porter Convince Boards to Pay CEOs To Create Shared Value?

Davos also generated buzz, according to Justin Fox, for a Harvard Business Review (HBR) article, Creating Shared Value, co-authored by Harvard Business School professor Michael E. Porter (for whom I worked at his consulting firm, Monitor Company). The basic idea is that business and society should not be at odds with each other -- rather, business should work with society to profit by solving its problems.

This idea is not new nor is it universally accepted. As Fox pointed out, it is irritating to at least one economist. Fox wrote: "When a prominent economist pulled me aside last night to bend my ear for 10 minutes about how wrongheaded Porter's arguments were, I knew the piece had hit a nerve." And many others have written about this, including a former Monitor colleague, Roger Martin, who is now dean of the Rotman School of Management at the University of Toronto, an HBR article, The Age of Customer Capitalism.

I wrote a book on the topic in 2003, Value Leadership, that I hoped would put business on a more virtuous path in the wake of Enron's bankruptcy. And it contains a way to measure this broader concept of value, the Value Quotient (VQ) -- it measures how well a company performs 24 specific activities related to value creation. It is interesting to apply the VQ framework to different companies. As I posted on Jan. 21, Google (GOOG) earned a VQ of 88% -- pretty good, but not as good as Southwest Airlines' (LUV) 95%.

I am hoping that Porter succeeds where I have failed. But unless he can persuade boards of directors to adopt a CEO bonus scheme that's linked to a measure of social value -- and I'd nominate the VQ -- his efforts will fall on resistant ears. 

You can't afford to attend Davos unless you've got the big bucks. And for now those only flow into the pockets of CEOs who boost shareholder value. If Porter's efforts change how CEOs get rewarded, then corporate behavior will also change. Until then, look for a wave of developing-to-emerging markets deals to flow from the exuberance of 2011 Davos executives flush with cash.

How To Stop The Next Financial Crisis

Thursday, the Financial Crisis Inquiry Commission (FCIC) released its 633 page report on the causes of the financial crisis. But it took a Bloomberg article to finger the deeper cause of the latest financial crisis -- confirmation bias (CB) -- a common decision disease that leads the powerful to ignore data that's not consistent with the narrative they want to promote. To stop the next financial crisis, we need to create and fund an independent investigative process with a loud microphone.

The FCIC report points out, among its other findings about which I posted on Jan. 26, that regulators turned a blind eye to the problems in the housing finance system until it was too late. According to Bloomberg, Angelo Mozilo, who ran what had been America's largest mortgage lender, Countrywide, warned in Sept. 1, 2004 that reckless mortgage lending could "cause a bump in the road that could bring with it catastrophic consequences." But the Fed believed everything was fine -- as evidenced by a mid-2005 staff briefing arguing that the mortgage market had "solid fundamentals."

Mozilo's conclusion and the Fed's reaction reveal important insights into what went wrong. Mozilo's reaction to Countrywide's bad mortgages was not to stop making them but to get them off the company's books through securitization. The Fed was supposed to make sure that bad mortgages never got into the system in the first place, but instead it lapped up information suggesting that everything was fine.
Why was the Fed ignoring the subprime mortgage calamity brewing within its regulatory purview?  It was a clear cut case of CB. As Geoffrey Miller, director of New York University’s Center for the Study of Central Banks and Financial Institutions, told Bloomberg “What this shows is that the Fed had blinders on. They had some doubts about the market, but they chose to overlook them because they already had a view. They saw what they wanted to see.”

In order to understand how CB influenced the Fed, it is important to point out that the Fed Chair at the time, Alan Greenspan, had been a long-time proponent of financial deregulation. And he came by those beliefs through a long process of acculturation in the ideas of Ayn Rand. As a result, accepting the idea that deregulation could lead to catastrophe would force Greenspan to admit that his fundamental beliefs were wrong. As a result, Greenspan rejected the evidence of a crumbling mortgage securitization industry because it challenged those beliefs.

Fortunately, there are ways to fight CB. As I argued in my Autumn 2007 Business Strategy Review article, "When the Blind Lead," organizations that are good at fighting CB systematically seek out feedback from their customers to learn what's working and what's broken. And they also evaluate their people on a regular basis to reward the ones who are pushing for improvement and weed out the ones who block such positive change.

What does this have to do with stopping the next financial crisis? The ideal answer would be to put people in charge of our institutions who have a natural inclination to fight CB because they instinctively view it as a terrible threat to an organization's long-term survival. Unfortunately, our country tends to promote people into political roles based on how well they represent the talking points of the party in power. And this often means that in a face-off between ideology and reality, ideology will win.

This leaves us with the next best answer -- setting up an independent body of investigative journalists to seek out the weak signals of the next financial crisis before calamity strikes. Such investigators might be funded through an endowment from wealthy individuals who believe that a tireless search for the truth is a worthy cause in and of itself.  And these investigators ought to get access to very loud and pervasive means of getting their research findings out into the public discussion.

It's often said that generals are always fighting the last war. Similarly, financial regulators are now putting in place regulations that are intended -- with incomplete success -- to stop a recurrence of what caused the last financial crisis. Unfortunately, history shows that each financial crisis, including the crash that led to the Great Depression, the 1990's S&L crisis, the 1982 Less Developed Country (LDC) debt crisis, and the 1990's dot-com bubble whose bursting cost $5 trillion; has a different cause -- although many are precipitated by too much borrowing.

History also shows that there are always plenty of early warning signals of a crisis well before it happens. If we really want to stop the next financial crisis, we need to find a much better way to keep CB from drowning out those signals before it's too late to avert the next crisis. If we can't appoint leaders who fight CB on their own, we need to create muscular investigators who seek out the truth and amplify those weak signals while there's still time.

How Talent Pays Off For Investors

Companies that attract and motivate talent deliver better returns to their shareholders. That's the conclusion from an analysis of Fortune's "Best 100 Companies to Work For." Why should this be true? While I can't explain why stocks go up and down in general, it's possible that Best 100 companies attract and motivate top talent that delivers better products; customers gobble them up and, as a result, the companies achieve surprisingly superior growth and profitability.

This suggests an opportunity for a mutual fund to sell shares in a bundle of these top 100 companies -- but a better strategy might be to invest just in the ones that have stayed on the list for the last 12 years since it was started.

The stock market performance of these Best 100 companies is clearly superior. According to Fortune, the annualized return of an investment in the Best 100 companies on the 1998 list -- the year Fortune introduced it -- was 11.06% (far higher than the S&P 500's 3.83% return). And this superior performance also held up recently -- investing in all the publicly traded Best 100 companies on the 2011 list at the beginning of 2010 would have yielded a be 23.11% return by the end of 2010 (far better than the S&P's 15.06% return at year end).

Why is this happening? My 2003 book, Value Leadership: The 7 Principles That Drive Corporate Value in Any Economy, presents a theory. I suggested that better performing companies implement practices that create consistent, measurable value for employees, customers, investors, and communities. And they do this differently for each stakeholder. Here's how:

• Employees. Create a work environment that attracts and motivates the most talented people in the industry.
• Customers. Develop new products that give customers more of what they want than competitors' do.
• Investors. Exceed investor growth expectations consistently.
• Communities. Invest in community projects that motivate employees, attract customers, and produce valuable spin-off effects. 

To illustrate how this idea of value plays out in the real world, I identified seven principles that companies use to put value leadership into practice. I then found eight publicly traded companies that came closest to applying these principles -- Value Leaders -- and compared them to peer companies in their industries. (One of my sources for such companies was the Best 100 list.)

The Value Leaders won on many key shareholder value dimensions. For example, I found that between 1997 and 2002, Value Leaders grew 35% faster and had 109% higher profit margins than the industry in which they competed. Moreover, between 1992 and 2002, the Value Leaders saw their stock prices spike 491% -- more than four times the S&P 500's 106% during that period.

Three of these Value Leaders were on the Best 100 list in 1998 and 2010. Below are the names and the change in their stock prices since the start of 1998:

• Goldman Sachs (GS): +139% (since its May 1999 IPO)
• J. M. Smucker (SJM): +149%
• Microsoft (MSFT): +78%

While I think the logic of investing in talent remains compelling, there are other important measures that investors ought to use to screen companies. For example, investors should assess whether a company uses that talent to invent market-beating new products in a productive way.

And to help with that, I developed a Value Quotient -- a measure between 0% and 100% that explains how well a company follows the seven principles. As I posted, Google earned a respectable 88% and its new CEO, Larry Page, faces the challenge of how to make more productive use of its huge pool of talent. 

If you lack the patience for such analysis, though, investing in a bundle of public companies that consistently make the Best 100 list is a reasonable bet on the value of superior talent management.

What Caused the Financial Crisis and Why It Matters Now

The Financial Crisis Inquiry Commission (FCIC) completed its report on what caused the financial crisis and it’s surprisingly good.  Of the five causes of the financial crisis I identified in September 2008, the FCIC has fingered all but two. (I later posted about some other ones.) Of these, the most important are excesses in bank leverage, deregulation, shoddy lending decisions, and Wall Street political contributions.

What it seems to have missed, in my view, are extremely weak disclosure of what Wall Street was selling – which made it impossible for investors to understand the risks and a compensation scheme for participants that encouraged them to care only about closing big Mortgage-Backed Securities (MBS) deals, rather than their long-term profit or loss.  In part because Dodd-Frank was passed last year before the FCIC report was released, important work must yet be done to prevent the next financial crisis.

The FCIC report lists seven causes of the financial crisis and as indicated below, I commented on them over the last five years. According to the New York Times, the FCIC report, based on 700 interviews and 19 hearings, will be a 576 page book that highlights the following causes:

• Fed chairs missing dangers of deregulation and risks of subprime. As I posted in 2008, Alan Greenspan was a tireless booster of securitization -- as far back as 2002. In 2007, I noted that Ben Bernanke wrongly insisted that subprime was contained.
• Bush administration inconsistency. In September 2008, I pointed out that it was confusing to investors that Bush bailed out Bear Stearns, let Lehman Brothers fail because he was smarting from criticism about moral hazard from his political base -- then bailed out American International Group a few days later.
• Deregulation of derivatives. In 2008, I commented on how then-presidential candidate's John McCain's economic advisor, Phil Gramm, pushed successfully to deregulate derivatives in 2000 -- a move that tanked AIG by letting it sell Credit Default Swaps (CDS) without disclosing its positions or setting aside capital to cover potential losses.
• Too much Wall Street money buying off regulators. In 2009, I posted about how billions in Wall Street campaign contributions and lobbying fees called off the regulatory dogs -- and continues to do so.
• Too much bank leverage. In 2008, I pointed out that due to 40:1 ratios of Wall Street borrowing to equity, it would take a mere 3% decline in asset values to wipe out that capital.
• Poor underwriting practices and risky bets by bankers. In August 2008, I argued that securitization was a flawed practice based on shoddy models that provided false comfort.
• Compromised ratings agencies. In August 2007, I argued that due to their compensation conflicts, ratings agencies had a powerful incentive to wrap financial toxic waste in gold.

I think this report appears to have missed two important reasons for the financial crisis (although they may appear when the report is released Thursday):

• Botched incentives. As I posted many times between 2007 and 2010, people do what they're paid to do. And on Wall Street, the pay goes to those who close the most big deals the fastest. That leads to quantity over quality when it comes to creating investments and all that money drains talent from more productive sectors of the economy.
• Conflicted financial reporting. I have written extensively between 2006 and 2010 about how letting managers write their own report cards gives them a license to steal -- as evidenced by Bernie Madoff -- who made up fake account statements to hide his $65 billion theft -- and Lehman Brothers -- that used an obscure accounting rule to keep from reporting how much money it was really borrowing.

If the FCIC could lead to iron-clad fixes to the seven problems outlined in its report and the two additional ones I highlighted could be repaired, I think we'd be able to feel more assured that Wall Street could fill its role of raising capital without putting the world at risk of financial collapse.

Here's the goal: A financial system that limits leverage and creates solid, long-term investments whose risks can be hedged at a reasonable price. That Wall Street would be run by talented people who get bonuses paid over a decade based on the long-term performance of the investments they create. And an independent government agency -- paid for by taxes on investment balances and free of Wall Street campaign contributions and lobbying fees -- would produce financial reports on that performance.

Does it Matter if the U.S. is Not AAA?

The U.S. is currently rated AAA by the major ratings agencies. But reports are surfacing that those agencies are getting nervous. The markets don’t seem to care though. A recent U.S. bond sale went off without a hitch after these reports.

While, the U.S. is not perfect, it’s the safest place on the planet as far as investors are concerned. And with uncertainty about the Euro persisting, investors do not seem ready yet to swap out the U.S. for China as a the globe's financial safe-haven.

Moreover, the ratings agencies are famous for closing the barn door after the cow has left – witness how many sub-prime mortgage backed securities they downgraded from AAA years after they were nearly worthless. Does it matter if the U.S. is not AAA-rated? Sure, but what would be worse is if China’s Capital Receptivity Index (CRI) surpasses ours.

(As I posted on DailyFinance, the CRI rates countries on the basis of their Entrepreneurial Ecosystems -- consisting of their financial markets, corporate governance, human capital, and intellectual property protection. And by that measure, the U.S., at 82%, is far from perfect but it's much better than China's CRI of 46%.)

Why are ratings agencies thinking about downgrading the U.S.? According to the Wall Street Journal, S&P and Moody's are thinking about changing their ratings on U.S. debt from AAA with a stable outlook because they do not see an end to rising debt and deficits.

And looking over the last 11 years, they have evidence to back up their concerns. After all, in 2000, the U.S. national debt was around $5 trillion and it's spiked 180% to $14 trillion. And the U.S. federal budget has gone from a $230 billion surplus to a deficit of at least $1 trillion forecast for 2011.

But these are not the only factors that go into the ratings. The ratings agencies also take into account future pension and health-care costs both of which it sees as too high in the U.S..  And Moody's Aaa Sovereign Monitor report estimates that the U.S.'s debt to revenue and interest to revenue ratios are too high -- staying at 397% of GDP and doubling to 17.6%, respectively, until 2020.

Even though member of the Tea Party and eminence grise, Pete Peterson, are all huffed up about this, investors don't seem to mind. Thursday, an auction of $13 billion in 30-year Treasury debt after the ratings agencies announcements went off fairly well -- with the U.S. government being required to pay 4.515% on the bonds, slightly more than the pre-auction 4.492%. according to the Journal.

The reason for the world's willingness to fork over cheap money to the U.S. is based on investors' perception that its next best alternative, the Eurozone, is much much riskier. And this perception is helped along by the fear that the Eurozone could collapse. In the New York Times, Paul Krugman describes four scenarios of what could happen to the Eurozone in light of the fiscal problems in Greece, Spain, Ireland, Portugal, and Italy -- one of them is a dissolution of the Euro.

The interesting question is why investors are not flocking to China instead of the U.S. The answer is that while China is able to sell debt at lower yields than the U.S., the quantities are not overwhelming. For example, in Dec. 15, 2010, China sold its 40th batch of 30 year notes -- $4.2 billion worth at a yield of 4.23% -- bringing the total sold in 2010 to about $160 billion worth. 

So while global investors are making a big long-term bet on China, China is making a six times bigger bet on the U.S. -- holding $907 billion worth of U.S. government securities as of Oct. 2010. And for now it appears that China is getting more and more concerned about domestic inflation -- soaring at 10% -- through moves, such as increasing bank reserve requirements from 18.5% to 19%.

The ratings agencies seem to be late to the party here -- as they were to the subprime mortgage crash. But my hunch is that investors don't rely on the ratings agencies to decide where to park their money.

Perhaps they depend more on some form of the CRI. If China's CRI overtakes the U.S.'s, we will probably be in really bad shape. To prevent that, we need to keep a close eye on our relative CRIs to make sure we maintain our advantage.

Is There a Zone of Cooperation in U.S./China Economic Relations?

The economic game between China and the U.S. is changing. For the last decade, we were both better off in trade because China bought U.S. commodities like coal and steel and the U.S. bought China's low priced manufactured goods and used China’s trade gains to finance our doubling debt.

But as the leaders of both countries prepare to meet next week, that grand bargain is showing signs of crumbling. The U.S. wants to boost exports to China but argues that China’s weak currency and trade barriers make this too difficult. Meanwhile, China has pumped so much money into its economy that it is suffering from 10% inflation which is way above the 5% level that its population can tolerate.

Is there a way out of this mess? If so, what moves are likely to make both the U.S. and China better off? The answers: Yes; through a two-pronged strategy of encouraging China to shift to more of a consumer-driven economy while the U.S. adjusts from a consumption- to an innovation-led export economy with lower deficits and debts.

China's Booming and Its Inflation's Looming

China is phenomenally successful on many fronts -- but its economy is overheating. GDP is growing at 10% a year with 10% inflation (twice the official rate according to the New York Times) -- food prices were up 11.7% in 2010 and the median Chinese house price rose 7.7% in 2010 and costs 111 times the median Chinese income, according to my DailyFinance post. 

Meanwhile, China's economic policies are yielding huge reserves of capital that dwarf those of other large countries. For example, according to the Washington Post, Beijing's foreign cash and securities spiked 20% from the year before to $2.85 trillion in 2010 -- a third of total IMF reserves -- with $200 billion of it coming in the fourth quarter alone. And China is complaining that the Fed's $600 billion QE2 program is boosting the flow of capital into China just when it does not want it.

If only China didn't have to worry about the well-being of its 1.3 billion people, all this would be great news. But when inflation exceeds 5%, the populace gets restive and its anger becomes difficult to control. So China has taken steps to try to keep that inflation under control -- including raising interest rates to 5.81% in 2010 and perhaps 6.56% in 2011, limiting the flow of foreign capital and boosting bank reserve requirements above the current 18.5%.

Is The U.S. Too Dependent On China?

Meanwhile the U.S. business sector has been booming while its consumers, millions of whom don't have jobs, have been suffering despite low official inflation. U.S. GDP is growing at 2.8% but its inflation is lows, CPI that was up 1.1% in November. And the U.S. economy, 70% of whose growth is due to consumer spending, still suffers from a 9.4% unemployment rate -- leaving some 15 million in search of work and bringing into question how much longer the U.S. can sustain the 5.5% growth in retail sales it enjoyed during the 2010 holiday season.

But America's corporate sector earned record 2010 profits of $1.66 trillion and piled up cash balances near $2 trillion. Corporate profit has been growing rapidly -- the S&P 500 enjoyed 47% operating earnings growth in 2010, according to S&P's Howard Silverblatt, and in December 2010, that growth was forecast to continue at a 13% rate in 2011.

A big reason for the growth is globalization. Specifically, exports into faster growing markets like China, India, and Brazil are helping U.S. companies grow. But the U.S. is complaining that China wants to give too much of its business to China-owned enterprises and that it does little to protect intellectual property, according to the Times. Meanwhile the U.S. also benefits from globalization as a way to reduce costs by outsourcing services to lower wage countries like India and the Philippines and manufacturing goods in China.

China is also aiding the U.S. by helping to finance its deficit and debt. U.S. budget deficits exceed $1 trillion while our national debt has risen 180% to $14 trillion from $5 trillion a decade ago. China's $906.8 billion in U.S. debt securities as of Oct. 2010 is helping to keep U.S. interest rates very low (the 2-year government bond yields a mere 0.64%).

A rise in U.S. rates would likely choke off the U.S. economic recovery as interest expense crowded out capital investment. And such a rise is imminent if we start to import China's 10% inflation rate and the Fed raises interest rates to keep inflation below its 2% target. Fortunately, a spike in U.S inflation is not a guaranteed outcome because only about 25% to 40% of the price to U.S. consumers of Chinese imported goods -- that climbed an uncomfortable 3.6% in the fourth  quarter -- is attributable to the cost of the product, according to the Times.

U.S. retailers have other ways to keep prices from rising. The final sticker prices also includes the costs of shipping, storing, store rent and wages and some of those costs can be reduced to keep a lid in price increases. And retailers are afraid of losing sales due to price increases to economically traumatized consumers. So they are likely to try to keep the lid on price increases.

But price increases from Chinese-made goods are not going to be held off forever. Since Chinese wages are growing at 15% a year, according to the Times, many companies are trying to shift production to lower wage countries like Vietnam and Bangladesh -- but those countries do not always have sufficient factory capacity to handle the boost in volume.

Zone of Cooperation

If we think of trade between China and the U.S. as a game, there are four possible outcomes:

• The U.S. wins as China loses
• China wins as the U.S. loses
• China and the U.S. go down together
• China and the U.S. rise together

The best outcome is for both countries to be better off. One way to achieve that would be for the U.S. to become more like China in some ways and for China to become more like the U.S. in others. More specifically, the U.S. should become less dependent on consumer spending for economic growth and China should become more-so.

How would this work? If China lets its currency rise so it's no longer about 10% undervalued, then consumers there will become a bigger part of China's overall economic growth. This will benefit China's politicians because they will have fewer worries about political instability since a stronger yuan will boost Chinese consumer spending power.

A stronger yuan would also reduce Chinese surpluses as U.S. exporters to China would become more price-competitive there. But that would not be enough for U.S. exporters -- they also would also welcome some loosening up of the requirement that China's state-owned enterprises (SOEs) buy mostly from other SOEs.

China should open up its markets to real competition from the U.S. and other countries so that market pressure provides an incentive to upgrade its skills. The fear that China lags the world in innovation could be overcome by exposing it to the gales of global competition.

Meanwhile, the U.S. needs to build an economy that is less dependent on consumption and finance and puts greater emphasis on innovation-led exporting. At the same time, the U.S. must find a way to lower its budget deficits and debt levels.

If China and the U.S. could pull off such changes, they could both grow while making life better for more of their citizens.

Hedge Funds Overcharge and Underperform

Hedge funds – those special places for the very rich – do a fantastic job of enriching their founders. Unfortunately, their investors would be better off in an S&P 500 index fund. Based on 2010’s performance, hedge funds have much higher fees and generate returns that are slightly more than half those of the average stock.

For example, according to Bloomberg, hedge funds rose 7% in 2010, while the S&P 500 was up 13%. Meanwhile, those hedge funds charge investors a 2% management fee and 20% of the profits. This compares to a sub 1% expense ratio for the typical S&P 500 index fund. So why do the wealthiest people invest in hedge funds? Maybe they’re smarter when it comes to making money than they are when investing it.

The performance of the hedge funds in 2010 was not monolithic. Some investment strategies performed better than others, according to Bloomberg. Here are five examples:

• Mortgage securities funds that seek to profit from price inefficiencies of mortgage securities were up 24% in 2010.
• Short funds (sell shares short): +7.5%
• Multi-strategy funds (use many strategies): +2.9%
• Macro funds (global themes or trends): +2.2%
• Statistical equity arbitrage (using quantitative analysis to find small profit opportunities): +0.4%

Compared to this mediocre performance, the compensation of the hedge fund managers is absolutely breathtaking. Here's how much the top five made in 2009 (the most recent information available) along with their funds' 2010 returns of their top-performing fund from Bloomberg Markets:

• David Tepper ($4 billion, 20%)
• George Soros ($3.3 billion, not available)
• James Simons ($2.5 billion, 15.9%)
• John Paulson ($2.3 billion, 16.9%)
• Steve Cohen ($1.5 billion, 11%)

To be fair, these managers out-performed their peers by a long shot. But if 2010's performance is any indication, they missed the boat and their investors would have been better off putting their money in an S&P 500 index fund.

I hope they have better luck in 2011 but I would bet the only ones really making out are the fund managers.

Is Each Dollar of Facebook Earnings Worth $106?

Thanks to the release of a private placement memorandum (PPM) for Facebook, we now know how broken our system is for valuing companies.  By annualizing its reported first nine months of earnings, we can estimate that it will report $473 million in profit for 2010. Since Facebook is valued at $50 billion, this makes each dollar of its earnings worth $106.

This valuation makes little sense when compared to two of the leading high tech companies. Apple – a much larger company with a stream of successful innovations trades at a surprisingly modest P/E of 22 and Google’s P/E is 25. Is there any rational basis for Facebook’s P/E? Only if you value it based on supply and demand for the shares in the context of an 11-year drought for hot IPOs.

Star System: Baseball, Banking, and Social Networking

At the heart of Facebook's exorbitant valuation is America's notion of a star system. Here, in many talent-based industries, we have thousands of competitors where there is a huge gap in pay between the average participant and the top ranked player. Simply put, to the victor go the spoils.

For example, in baseball, the average 2010 salary was a hefty $3.3 million, according to About.com. But the top-paid player -- the Yankees' Alex Rodriguez -- earned 10 times that amount ($33 million) and the players right below him -- A-Rod team mates CC Sabathia ($24.3 million, 7.1 times the average), Derek Jeter ($22.6 million, 6.8x) and Mark Teixeira ($20.6 million, 6.2x) -- made several times the average.

Both Goldman Sachs -- that's helping raise the latest round of financing -- and Facebook are the product of a similar star system. In order to get a job at Goldman, the top graduates of the top schools are winnowed through dozens of interviews. Of the ones who survive that, only a fraction make partner.

And Goldman's 375 partners make more than those at any other investment banking firms. One indication is that for the first nine months of 2010, the average Goldman employee made about $371,000, 94% more than Morgan Stanley's roughly $192,000, according to Bloomberg.

Similarly with Facebook, there are many social networking companies -- most notably, News Corp.'s imploding MySpace -- but only one with 600 million users. This is certainly valuable for advertisers who may want to concentrate their bets on those sites that are likely to get the biggest audience.

Of course, Facebook ought to be able to charge a price premium for that privilege. But as long as advertisers get a return on their investment in the higher priced Facebook ads, this price premium makes sense.

Is Facebook Worth Its P/E?

But for those betting on Facebook stock, the risk is greater. According to Facebook's PPM, it earned $355 million on $1.2 billion in revenue during the first nine months of 2011 -- leading to annualized earnings of $473 million for the year.

To be fair, Facebook's net margin of 30% is higher than Apple's 22% and a bit above Google's 29%. Moreover, one analyst told the New York Times that he thinks Facebook could be worth $200 billion by 2015 as its revenues double every year. (Obviously this trend won't continue forever but that may not be for a few years -- by which time investors will have a chance to take their profits.)

Zuckerberg Wins On The Ultimate Star System Statistic: Net Worth/Age

That would make CEO Mark Zuckerberg's 24% take quadruple from $12 billion to $48 billion. Of course the key statistic for the business star system is net worth divided by age. If Facebook quadruples by 2015, that statistic for Zuckerberg will rise from $462 million/year to $1.6 billion/year. By this measure, Zuckerberg currently outshines Google's 37 year old Larry Page who has a net worth of $15 billion for $405 million/year.

With Goldman raising $1.5 billion for Facebook coupled with its $450 million investment, the implied valuation of $50 billion seems high at a P/E of 106.This valuation is grossly distorted by the fever of investors who want to make easy money by getting into Facebook stock a year before it goes public when there is no business risk associated with the investment.

And that fever is made even greater by the many investors willing to fork over $2 million to get into Facebook who Goldman is deciding are not worthy of their share. Indeed, the star system is working for those who want to get into this investment -- and a big part of that system is the envy of those who have been deemed unworthy.

Meanwhile, there's at least one party that will enjoy the privilege of taking advantage of Facebook's excessively high valuation -- Goldman Sachs. How so? Bloomberg notes that Goldman "may at any time further reduce its exposure to its investment in Facebook (through hedging arrangements, sales or otherwise), without notice to the fund or investors in the fund.”

This is just another smart thing that Goldman does for itself that the rest of the non-stars can't. And the simple reality is that given its control over a chance for the rich to get even richer, this economic star system perpetuates itself and there's not a darn thing you can do about it.