## Thursday, July 31, 2008

### Revisiting Return on Invested Capital

As I mentioned in an earlier post ("From Joel Greenblatt to Jim Rogers, Part I: The Magic Formula"), Return on Invested Capital (ROIC) is one of the two metrics that comprise Joel Greenblatt's Magic Formula.

A question raised on the Magic Formula Investing Yahoo! Message Board led to a discussion that highlighted the limitations of this metric. The question was why KSW, Inc. (Nasdaq: KSW), a micro cap HVAC contractor, was no longer on the Magic Formula list. One of the message board's moderators, Marsh Gerda (who also writes an MFI Diary blog) and I separately calculated the Magic Formula metrics to see if we could figure out why the company was no longer on the list.

Greenblatt's Formula for ROIC

Recall from the previous post on this that Greenblatt's formula for ROIC is EBIT1/(Net Working Capital + Net Fixed Assets).

My ROIC Calculation for KSW

KSW is a \$29.4 million market cap company with no debt and \$17.75 million in net cash on its balance sheet. Using the standard definition of Net Working Capital (Current Assets - Current Liabilities), I got an ROIC of 38% for KSW. Using that standard definition of Net Working Capital made intuitive sense to me, because it put KSW's excess cash in the denominator of the ROIC formula, so holding so much excess cash reduced the company's return on invested capital.

Marsh Gerda's ROIC Calculation for KSW

Marsh Gerda used Greenblatt's more idiosyncratic definition of Net Working Capital, which excludes a company's excess cash, to calculate KSW's ROIC. He got an ROIC of 1757% for KSW. It appears that he calculated this the right way (with respect to the Magic Formula method) and I calculated it the wrong way, by ignoring Greenblatt's different definition of Net Working Capital.

What The Numbers Mean

Theoretically, an ROIC of 1757% means that, for every additional dollar of capital a company invests in its business, it can earn \$17.57 in earnings. In reality, of course, there are a couple of problems with this. First, if a company could really earn 1757% on its cash by investing that in its business, it wouldn't be holding most of its market cap in cash, where, presumably, it is earning less than 4% in annual interest. This would be a problem using my calculation of ROIC as well: 38% may be a lot less than 1757%, but it's still almost an order of magnitude more than the company can earn on its cash.

The second problem is that the amount of capital KSW can profitably reinvest in its business appears to be limited, for a few reasons:

- As an HVAC contractor, it requires little tangible capital, so it can't simply spend a lot of additional capital on new plant and equipment.
- Theoretically, it could use additional capital to expand into other cities (most of KSW's business is in NYC), but the commercial construction business is highly local: a contractor needs relationships with local developers, politicians, etc. (KSW could perhaps get around this by acquiring an HVAC contractor in a different city, but it may not have enough information about that city's construction industry to be an intelligent buyer, and it may not have enough cash to make a suitable acquisition).
- As a construction contractor, KSW probably has to pay up front for supplies and labor before it gets paid on a project. It make sense for the company to hold a certain amount of cash to cover these upfront costs, particularly when credit is less available, and more expensive (especially the sort of construction factoring the company would likely have to rely on).

Similar real-world constraints prevent other companies with theoretically high returns on invested capital from reinvesting most of their cash in their respective businesses. This frequent inability of profitable companies to invest most of their excess cash in their core businesses leads in some cases to the companies returning that cash to shareholders, via dividends or buybacks, and in other cases, to spending that cash on acquisitions (sometimes of businesses that are less profitable than the acquiring company's core business).

1Earnings before Interest and Taxes

## Wednesday, July 30, 2008

### Barrett Business Services Up 35% intra-day on Earnings Surprise

Barrett (Nasdaq: BBSI) is the staffing/PEO company that I described buying too early in the "Anatomy of a Mistake" section of the post "From Joel Greenblatt to Jim Rogers, Part III: The Importance of Macro Trends". Today it's up after announcing 2Q earnings of 29 cents per share after the close yesterday, beating the consensus estimate of 22 cents per share. The company also raised its guidance for Q3. These earnings are especially surprising given the CEO's bearish comments on the California labor market during the last conference call. On that call, he estimated that California (where the company does more than half of its business) had an unemployment rate of about 7.5%. I'm still down a lot from where I bought BBSI, but I am content to continue holding this one.

## Tuesday, July 29, 2008

### Covered Bonds

Yesterday, the Treasury Department released a best practices guide to covered bonds. Here's a link to press release, which includes a link to the best practices guide: "Treasury Releases Best Practices to Encourage Additional Form of Mortgage Finance". In a nutshell, the way a covered bond works in the context of mortgage financing seems to be like this: instead of selling its mortgage loans to the securitization market, a bank keeps those mortgage loans on its books, and issues a bond using those loans as collateral. On the surface, this would seem to be a more transparent method of financing mortgage loans than the practice of selling those loans to the securitization market, where they are then bundled into MBS (which are then bundled into more complex CDOs and other complex securities).

David Merkel provides a detailed analysis in this post on his Aleph Blog, "Covering Covered Bonds", and in Forbes, Heidi Crebo-Rediker and Douglas Rediker claim that "Covered Bonds can Rebuild America". The co-authors' grandiose claim refers to infrastructure. They write,

Monday's embrace of covered bonds by U.S. Treasury Secretary Henry Paulson and senior representatives of the Fed, the Federal Deposit Insurance Corp. and the country's largest banks to help thaw the U.S. mortgage market is a laudable step, appealing to market proponents and skeptics alike. Introducing covered bonds to the U.S. is a great idea. In fact, covered bonds can help more than just the mortgage market.

At its most basic, a covered bond is a bond issued by a bank and backed by a dedicated group of loans kept on the issuing bank's balance sheet. While the introduction of covered bonds in the U.S. is not a magic bullet, covered bonds may be more than just a way to restart the mortgage market. They may also help unlock sorely lacking investment for U.S. infrastructure.

[snip]

Elsewhere in the world, many commercial banks and specialty public-sector banks use public sector covered bonds as a cheap source of funding. In particular, as a result of the enormous availability of funds for infrastructure projects through securities like covered bonds in Europe, European banks have developed great comfort with infrastructure as a core part of their general banking activities.

Crebo-Rediker and Rediker note that, because of their familiarity with financing infrastructure,

the loans for public-private partnership infrastructure projects like the Chicago Skyway, the Indiana Toll Road, the San Diego Toll Road and the Pocahontas Parkway in Virginia all came from European, not U.S., banks.

The authors slight (unintentionally, I'm sure) Australia's Macquarie, which has been involved in financing American infrastructure projects, including the Chicago Skyway.

### Hemisphere GPS Reports

Press release from Hemisphere GPS (TSX: HEM.TO): "Hemisphere GPS Reports Record Q2 Revenues, Earns \$0.06 per Share as Gross Margins Reach 52.5%". Those earnings were below the more optimistic consensus estimates. 2Q revenues were up 59% year-over-year, but total operating costs were up 63% year-over-year, partly due to the additional costs added with the acquisition of Beeline Technologies. Hemisphere's stock was down about 9% today. I haven't had a chance to listen to the conference call replay yet, but if I hear anything noteworthy when I do, I'll post it here.

## Monday, July 28, 2008

### Book Recommendation: Lives of the Monster Dogs

Last Friday, my girlfriend (hereinafter referred to as Cheryl) and I spent a few hours enjoying the free air conditioning at a local Barnes & Noble. I leafed through a stack of books and magazines, and jotted down a couple of investment ideas. On the way out, I saw a paperback copy of Kirsten Bakis's wildly original first novel, Lives of the Monster Dogs on a rack of used books. I had read the book when it was first published in 1997, and Cheryl picked it up on my recommendation. She finished it today and gave it the thumbs-up as well, so I thought this was as good a time as any to mention the book. The publishers of the paperback version wisely kept the great cover art of the hardcover edition, the malamute in a smoking jacket.

Here is M.G. Lord's New York Times review of the book, "Unleashed on Manhattan: An army of civilized, talking dogs, the dream of a mad Prussian scientist, descends on the city". The New York Times later named the novel one of its "notable" books of the year for 1997.

As far as I can tell, Kirsten Bakis hasn't written another novel since, but according to Wikipedia, as of 2005, she was working on her second novel. I'll have to keep an eye out for it.

### TV Recommendation: Startup.com

If you want to see an entertaining documentary about the rise and fall of a dot-com (GovWorks.com), and you have Showtime, set your DVR to record Startup.com tomorrow at 9:45am on Showtime's Showcase channel. I first saw the film a few years ago, and I'm looking forward to watching the whole thing again. One (out out of many) entertaining moments occurs when the GovWorks principals walk out of a meeting with Kleiner Perkins -- the storied venture capital firm that backed Google and Genentech among other companies -- and one of the twenty-something GovWorks employees says of the Kleiner Perkins partner they just met, "That guy just doesn't get it".

The GovWorks story reminds me of Aaron Edelheit's point in a post last month ("Thinking of Investing in China?") that "Sometimes large economic trends do not make great investments". The GovWorks founders were clearly ahead of the curve on a trend: the trend of individuals paying parking tickets and otherwise interacting with local governments online. The question they may not have considered was why the local governments would need to rely on the private sector to provide this sort of service for them. Here in the wilds of New Jersey, for example, the state has its own website where you can pay parking tickets online.

## Sunday, July 27, 2008

### William Poole Again

The former St. Louis Fed chief has an op/ed in today's NY Times, "Too Big to Fail, or to Survive". With all the hysteria exhibited by pundits on this subject, Poole's is a voice of reason. He's no fan of Fannie and Freddie, and thinks the federal government should eventually get rid of them, but he also acknowledges that, at this point, a bailout was necessary. Poole is also rightly skeptical that the promised tighter regulation of the GSEs will prevent future problems. He writes,

Some believe that tighter regulation is the answer. I am skeptical of that because I know the extent to which the regulatory system is tied up in Fannie’s and Freddie’s political activities. I find it deeply troubling that Fannie and Freddie, essentially in receivership to the secretary of the Treasury today, continue to employ lobbyists and hand out campaign contributions to influence the legislative debate over their own futures. Fannie and Freddie paid out more than \$170 million to lobbyists over the last decade — more than General Electric spent. Government departments cannot hire lobbyists or give money to campaigns — why should Fannie and Freddie, now wards of the government, be permitted to do so?

Those huge lobbying fees don't fully capture the political influence of the GSEs. Two politically well-connected former Fannie Mae CEOs come to mind, Franklin Raines, who was the head of President Clinton's Office of Management and Budget before returning to Fannie Mae as CEO, and James A. Johnson, the former Carter administration official and, until recently, the reported head of Barack Obama's running mate selection process.

### Precision Ag Update

Hat tip to Daniel Wahl ("Quick Notes") for noting Trimble Navigation's (Nasdaq: TRMB) earnings release last week. Trimble has a division that competes with Hemisphere GPS (HEM.TO) in the precision ag space. Daniel quoted this excerpt from Trimble's conference call:

"Second quarter 2008 Field Solutions revenue was \$90.1 million, up approximately 63 percent compared to revenue of \$55.3 million in the second quarter of 2007. Revenue growth was driven primarily by strong demand for agricultural products."

Daniel sees this as bullish for Hemisphere, and I agree. This space seems big enough for more than one firm to do well.

Hemisphere's 2Q conference call is scheduled for Tuesday morning.

## Saturday, July 26, 2008

That question was posed by a someone commenting on the previous post ("How One Investor Found a Home Run Stock"). I initially responded in a comment, but it was a good enough question to warrant answering it more fully in a separate post.

As I noted in my comment, the reason such small stocks are worth paying attention to is that these stocks are more likely to be mis-priced, since they usually have no analyst coverage, little media attention, are ignored by most institutional investors, etc. This gives them the potential for higher returns than more widely-followed stocks. Recent academic literature supports this. See, for example, "Information Diffusion Based Explanations of Asset Pricing Anomalies", by Bolmatis and Sekeris. In this study the authors found that,

Stocks that have no-trade days outperform other stocks by a wide margin, even after correcting for their higher risk as captured by their larger betas. This result is expected when comparing stocks with large differences in information availability.

Mark Hulbert, of the Hulbert Financial Digest, wrote about this study last month in the New York Times (Strategies: "Roses among the Wall Flowers"), and fund manager Aaron Edelheit commented on this article in his blog ("This is What I Do for a Living!"). In that post, Edelheit wrote,

Academic studies finally back up what I have found in 10 years of investing:

In addition to Edelheit, another professional investor who has achieved excellent returns by investing in these sorts of stocks is Paul Sonkin, of the Hummingbird Value Funds.

It's true that investing in such small cap stocks is risky, but it's also true that there's plenty of risk in investing in many large cap stocks, as investors who bought shares in such stalwarts as Citigroup or Motorola over a year ago can attest to. Perhaps the conventional wisdom of risk-versus-reward (i.e., large cap is less risky than smaller cap; domestic is less risky than foreign) needs to be reconsidered. If an investor is going to take on significant risk investing in common stocks, he ought to have the potential of a significant upside to compensate him for taking on that risk.

Here is another way to think about size-versus-risk. Think of a small, local business where you live, one that is profitable and that has been so for decades. If there were a way for you to buy a small piece of that business (at a fair price, of course) would you buy it? Chances are, if that small, local business were publicly-traded it would be a micro-cap. Would that, in and of itself, make it a more risky1 investment?

1Risky in terms of the chance of you suffering a permanent loss of principal, not risky in terms of price volatility.

## Friday, July 25, 2008

### How One Investor Found a Home Run Stock, Part III

Below is Littlefish's addendum to his recollection of how he found Mexco Energy (MXC):

LOL, the fun part was after doing some DD on it after that time period. I do recall early on I felt pretty good about the initial wave of DD and started whooping it up in the study room when I knew I ahd something good (kinda felt like AYSI but I wasn't real confident on the Tarrant Cty wells yet).

My wife wondered what was up when I had all the commotion going on. It was weird though, I felt rather sure it was an easy 50% gainer and told my wife so. I also told her it would take some patience or a little luck to get a lot.

So I waited for I think several weeks on the bid and attacking the ask whenever more than a few shares came up available. I built a moderate position but never got the big fat chunk I wanted cuz it never sold down and the volume was mostly anemic.

There were I think 3 times though where the MMs or someone traded thousands of shares BETWEEN the bid and ask (maybe \$4.2-\$4.35) and I was away from the computer each time AND was on the friggin' bid EACH TIME as I recall (the trades happened over maybe 3-5 minutes' time each and seemed to happen around 8-10:30 AM Pacific on difft days with the trades mostly 1 penny above the bid and one penny under the ask so kinda weird).

After it happened the first time, I made sure the next day I sat vigilantly in front of the screen during that time.

But it was a waste of time after a couple days and had other stuff to do so sure enough a few days later it happened that 2nd time. When I went in and saw the volume I felt like swearing LOL. I was pissed that someone was getting a few thou shares in a few minutes when I was getting that many over maybe a week or so on a light week. So I would up the bid and sit all day getting maybe 200-500 shares. Sometimes.

Whenever I'd see a retail investor put in an order at the ask, say maybe 500 or 1,200 shares I grabbed fast. When my position was OK, I got my daughter in on the act chanting "Let's Go Mexco" when it went up. Man, we were dancing around a lot for a little while there LOL. She's 5 years old.

After getting my position about half full I mentioned it on I-Hub. Then waited thinking some people would start getting in. But no one did. I even posted on the VMC board 'hey guys I see 1,000 shares (or whatever it was) that have been sitting on the ask for the last hour or so (I htink it was around \$4.5 or so), anyone want them?' or that was the gist of my post. No one grabbed them for awhile. So then I ate them up myself before the day ended.

Then after awhile with time it rather suddenly broke out to the upside so I sold a little. Then it pulled back a bit os I grabbed them back cuz I still ahd less than the position I wanted.
Then somewhere in there a PR announced the flow rates on the other 2 wells and I went ape sh#% when KiK posted the PR. I immediately started buying again and even drove it up a little.

Then eventually the whole market fell in love with micro energy plays and the thing took off way above anything I (or probably anyone) thought it would do. It was fun but way excesive

Anyhow, I got work to do now.

Oh ya, It;'s

'A NEW HIGH FOR AYSI!" in the house now:) Although haven't been able to pull that one out as much as the Mexco slogan...

### How One Investor Found a Home Run Stock, Part II

Littlefish's explanation of how he found out about Mexco Energy (Amex: MXC) continues below:

I've been writing this piece meal over the last 2 1/2 hrs of work as time permits so it may be disjointe das hell so sorry for that.
but anyhow, I then saw MXC had been in a heavy downturn for awhile (2-3 years) and had recently purchased their largest nat gas production interest. Volume was anemic and the sellers had been washed strongly out (kinda like GV now but GV needs to get clsoer to a turnaround in---dare I say it--- the Fla condo market).

Yet the stock hadn't responded so then I looked over reserves and production and saw that both those had also started increasing. Then I went digging around trying to find out about their drillings and what areas they were working on, where their acreage was, etc. A couple drillings were taking awhile so I called the CFO and asked for clarification as to what kinds of things might be delaying those coming online. I also wanted to find out what I could about the new purchases since they were a bit of mystery. I came to find out the CFO didn't know specifics either on the wells so I tired to find out on my own. I got production for one of the supposed 3 wells. But it had been in production for over a year and ahd a fairly steep decline curve (so I wouldn't be too excited owning MXC after another Q report or two since the other wells may decline too but also found otu it is a pool of wells and not the original 3 wells announced last I heard- they never did clarify that).

I had no idea about the other 2 wells and their potential until a PR came out about the flow rates in a PR. When that hit I bought even more (some of which I had recently sold because it had popped)...

OK enough LOL. I'm boring everyone in AYSI land.

But in retrospect it was nice to see that last Q rpeort to verify my thinking that they could probably set alltime records for earnings and revs (they did for both). What surprised me was the lack of interest in the company all along until suddenyl it went crazy.

Then specualtion took over, record earnings, the microcap energy sector went ape crazy, low float, it got added to the Russell, etc... And I only own 200 shares now LOL. It was a bigger chunk of my port than AYSI for a little while there.

It was total luck to get that return in that timeframe obviously. But seeing earnings confirm my thinking makes me feel better regardless of share price.
Plus the CEO is a bit of tightwad IMO and owns over 50% of the company (ahem, not that any other CEO out there would be that way- although for the record AYSI's website kicks azz compared to what used to be MXC's so MXC won the worst website award from me so I gave MXC a slightly higher point value score on web ugliness in my evaluation- although MXC redid their website recently so now it is all pretty and bling).

MXC and AYSI are the only 2 companies I've ever owned/controlled where my position was 1% of the company or more. But they are also the only 2 companies I can think of that have fiscally tight leaders that own over 50% of the company and bright prospects in their biz segments and are microcaps with near (or at) zero dilution.

That's my elongated, disjointed, semi-accurate recount (I think) of what I think is the general idea of how I went about refinding MXC.

Littlefish added an addendum to this which I'll post in Part III.

### How One Investor Found a Home Run Stock, Part I

On the Alloy Steel International (AYSI.OB) message board on the Investors Hub website, a poster who goes by the nome de Internet "Littlefish" mentioned offhand his successful investment in another company, Mexco Energy (MXC). In May, Mexco Energy shot up from under \$5 per share to about \$50 per share, before settling back to today's closing price of \$29.82. I'm always curious about how investors came up with their successful ideas, so I asked Littlefish how he came to invest in Mexco Energy before its big move. What follows is his response, verbatim and unedited. It's a little rambling, as Littlefish himself self-deprecatingly acknowledges, and has some of the deliberate and accidental misspellings common to these sorts of message board posts, but I found it an interesting read. Hopefully, you will too. Since it's long, I'll post it in three parts.

LOL, sorry Dave. There's nothing at all tircky with MXC. I had an accnt that I manage where there were a few shares of MXC left in it from a long time ago (I think they were bought after Katrina). I had learned and followed the company back then so knew the background story.

I don't exactly remember how I went back to looking at it cuz the amount of shares was insiginificant (wait, I think I recall Bobwins sent me a list of nat gas producers and the name caught my eye and had me dig it back up) but remember spending a weekend with headphones on and no distraction from family.
I eventually was looking for a nat gas producer (thanx to BW for the list that clicked me back onto it) but think I started off by looking into untapped fert angles. I remember looking into a perlite producer since perlite is a bulk agent in home and garden fertilizer (LOL I went out in the garage and thought 'gee, I'll look at the ingredients in the fert mix to see what else beside nitrogen, potassium, and phosphorous are in there' and perlite is a big ingredient). Then I looked for perlite miners (go to the source) and found they're mostly in Greece and not really tradeable as pure plays. there would ahve been a good one somewhere in SW USA liek Arizona or New mexico but they went BK a couple years earlier.
Then I thought heck I'll look for eprlite expanders that make the perlite from the mined product and found a small Canadian company (forget the symbol- I think Gilead might know.. Wait, found it it is PCI.V).

Anyhow (now you know why I didn't touch this MXC question LOL, takes me awhile to ramble and remember and I'm working), when I saw PCI.V I looked into them and saw their expenses were going up because they used lots of nat gas to 'pop' or expand the perlite. So then I thought 'hey these guys are in like Saskatchewan and the big fert companeis are in Saskatchewan and making urea etc... takes lots of nat gas! I need to find a nat gas pipeline company in this area or even better a driller'. Then I think BW let me know there were NO nat gas producers in that area LOL. So it was back to scratching the head but contacting BW helped eventually get me to MXC.

I thought about the Pres candidates and what they all had in common (when it was down to 3). They all had some kind of plan for carbon emissions restrictions tighter than currently enacted. So I started dwelling on nat gas with fert producers consuming more, election probably spurring more nat gas usage than coal or oil if possible, etc. There were other things that turned me toward nat gas.

So I messaged BW (Bobwins) asking for a list or something of nat gas producers and that was when I saw MXC on the list and slapped my forehaed in a "DUH" moment (kinda like today when Gilead pointed out CXPO's ability to just sell the nat gas instead of having to cover hedged positions).

## Thursday, July 24, 2008

### Question for Aaron Edelheit regarding Destiny Media Technologies

In the question and answer thread following his write-up of Destiny Media Technologies (DSNY.OB) on the Value Investors Club, Edelheit predicted that the company would bring in about \$1 million in revenue in its fiscal Q3 and earn a profit. He also predicted that the company would bring in revenue of about \$4 million over four quarters. Since Destiny Media's fiscal Q3 revenue increased from Q2 but still fell well short of Edelheit's prediction, and since the company predicted turning profitable in its fiscal Q1 instead, I asked Edelheit on his blog whether he thinks that his thesis for Destiny Media is still intact and just delayed, i.e., does he still expect the company to bring in ~\$4 million in revenue over four quarters, starting with its fiscal Q1 '09?

If Edelheit responds, I'll post his answer here.

## Wednesday, July 23, 2008

### Agency Conflicts

Justin Fox offers a brief overview of some academic views on agency conflicts in this post, "The Social Responsibility of business is... what, again?". He concludes,

1) Having multiple organizational goals can be a recipe for underperformance and waste,

but

2) Focusing exclusively on a single, simple goal like profit maximization or shareholder value can lead an organization terribly astray [e.g., if corporate managers manipulate earnings or worse in pursuit of higher earnings and higher share prices].

One advantage of investing in small companies where the senior managers own significant stakes in their companies is that there are fewer agency conflicts. When the agents are also the biggest owners, the agents' interests are more closely aligned with those of their outside shareholders. One example is a company I've mentioned here a few times before, Alloy Steel International (AYSI.OB), where the CEO and the CFO together own more than 70% of the company's shares.

## Tuesday, July 22, 2008

### Did the U.S. Economy Grow at a 3% Annual Rate in Q2?

Brian Wesbury of First Trust thinks so. This was his rationale, in his Monday Morning Outlook PDF:

Below we set out the components of real GDP that
comprise our 3% forecast for Q2.

Personal Consumption: We already have full
consumption data for April and May as well as auto sales
and retail sales for June. The only piece missing is June
services. We estimate real consumption grew at a 2.0%
annual rate in Q2. With consumption accounting for 70%
of GDP, real PCE will contribute 1.4 points to real GDP
growth (1.4 equals 70% of 2).

Business Investment: Data through May show
business investment in equipment and software was
unchanged in Q2. However, business construction
continued to boom, suggesting overall real business
investment will grow at about a 6% annual rate in Q2.
GDP, this translates into 0.6 points for real GDP growth
(0.6 equals 10% of 6).

Housing: Data on home building suggests a decline
at about a 23% annual rate in Q2. Given that the sector
makes up roughly 4% of GDP, this translates into a drag
of 0.9 points on real GDP growth (0.9 equals 4% of 23).

Government: Federal defense spending and public
construction at all levels of government were unusually
strong, suggesting gov’t spending accounts for 0.5 points
worth of real GDP rather than the 0.3 or 0.4 trend.
shrinking rapidly. Even assuming no additional
points to real GDP growth.

Inventories: We assume businesses around the
country reduced stockpiles at an annual rate of \$37
billion, the largest reduction since the 2001 recession,
resulting in a drag of 0.6 points to growth.

Second Quarter GDP: = 3.0%

At the end of last year, Wesbury was one of the few economists predicting that the U.S. would avoid recession in 2008. So far at least, he has been right.

## Monday, July 21, 2008

### Another Op/Ed in support of Increased Infrastructure Spending in the U.S.

The latest call for increased U.S. infrastructure spending comes in this column by Felix Rohatyn and Everett Erlich in today's Financial Times, "Measures to avoid the worst recession in 30 years". One of the measures the authors recommend is the creation of a national infrastructure bank, as proposed by Senators Chris Dodd and Chuck Hagel,

which would provide assistance to state and local governments to inc­rease investment in infrastructure. With an initial capital base of \$60bn and the ability to insure the bonds of state and local governments, provide targeted and precise subsidies and issue its own 30-50-year bonds, the bank could easily provide \$250bn of new capital to invest in local infrastructure over five years, which would also create several million new jobs, just as the domestic recession threatens to gain momentum.

This isn't the first time Rohatyn has advocated increasing spending on infrastructure. See, for example, this Washington Post op/ed from 2005 coauthored by him and Warren Rudman, "It's Time to Rebuild America: A Plan for Spending More -- and Wisely -- on Our Decaying Infrastructure". In March of this year, Rohatyn and Rudman teamed up again in a Financial Times column titled Infrastructure is America's best Investment". Someone more politically astute than me might know how much influence Rohatyn retains within the Democratic Party. He was prominent during the Clinton administration, and was rewarded with the ambassadorship to France for his efforts, as I recall. It's worth noting that in today's column, Rohatyn teamed up with a fellow Democrat, the former Clinton administration official Erlich, instead of with his Republican friend Warren Rudman. Perhaps Rohatyn sees the current political environment as so tilted toward Democrats that he is less interested in making a bipartisan pitch for his proposals? Or perhaps I am reading too much into his choice of coauthors this time around.

This FT op/ed comes less than a month after the Economist editorialized about the need for increased infrastructure spending in the U.S., as I noted and commented on in this post, The Economist: "The Cracks are Showing".

## Sunday, July 20, 2008

### More on Electric Cars and Plug-in Hybrids

From Joe Nocera's column in yesterday's New York Times (Talking Business: "Costly Toys, or a New Era for Drivers?").

In the documentary “Who Killed the Electric Car?” — about the EV1, an all-electric car General Motors began making in 1996 and killed once and for all in 2003 — the filmmakers posit the theory that the vehicle was done in by a grand conspiracy involving the oil industry, the Bush administration and the car industry. But that’s not what happened. Gas was cheap when the EV1 was on the market; auto buyers preferred S.U.V.’s. And the technology didn’t exist to allow the EV1 to become a viable mass-market automobile. Among its flaws, the EV1 used a nickel metal hydride battery that couldn’t get more than 75 miles before needing a charge.

“My daily commute was 37 miles one way,” wrote a man named Michael Posner on a Web site called The Truth About Cars, who drove an EV1 for several weeks back in 1997. “Every trip was loaded with drama,” he added. “If I went to lunch, I gave up a few precious miles. That could mean disaster.” At General Motors, they took to calling this problem “range anxiety.” Is it any wonder the car didn’t catch on?

So far so good, although from reading the rest of the column, I get the sense that Joe Nocera doesn't seem to actually understand how the plug-in hybrid Chevy Volt works (it doesn't "switch back" to electric; it only runs on electric -- the gas motor is just there to recharge the battery). The salient point that he gets right is that it has mainly been technological challenges (primarily with the batteries), and not a grand conspiracy, that has delayed the mass-market introduction of electric cars. Nocera concludes by doubting the ability of Tesla Motors to field an all-electric mass-market sedan (the company's next project after the Roadster), and claims that GM's Chevy Volt is the "the one to root for".

For a more cynical take on the Chevy Volt, check out Holman Jenkins's column in the Wall Street Journal from earlier this month, Business World: "What is GM Thinking?". From that column:

GM executives are not nuts. They justify the costs and risks of the Volt as a way of changing GM's image in the minds of consumers and politicians. To commit a pun, the Volt is GM's vehicle for making a bailout of GM politically acceptable.

Incidentally, the challenges of fielding viable plug-in hybrids described in both columns are consistent with what I wrote in this post, "Why Oil Prices will likely be Higher in 5 Years -- but not necessary in 10 or 15".

## Saturday, July 19, 2008

### Update on PhotoChannel

When PhotoChannel (PNWIF.OB) dipped below \$3.25 per share last Tuesday, "issambres839" made the following comment:

I just wanted to post a note that nothing has changed fundamentally with this stock. I`m looking forward to earnings being released in August and the company having its first conference call ever.

I also think they will give guidance for the first time as well. I think this is a ridiculous price and clearly represents someone who is being forced to sell their stock.

I think the company will earn \$0.30 to \$0.40 next year (without Wal-mart, which they may win) and its a steal here.

### Hemisphere GPS in the Mainstream Business Press

Hemisphere GPS (HEM.TO) was recommended by Lisa Hess in her column in the July 21st issue of Forbes, as company to invest in to benefit from the commodity boom. She also recommended Titan International (TWI) in this space. Titan manufactures the giant tires used by mining and agricultural vehicles.

### A "Penny-Ante Carl Icahn"

That's how the self-deprecating fund manager Phil Goldstein describes himself in this Fortune article by Telis Demos, "The Man who beat the SEC". Goldstein's investment strategy is as clever as it is simple: he invests in closed-end funds trading at discounts to NAV, and then he plays activist investor to try to unlock shareholder value, e.g., pressuring the closed-end fund's management to convert the fund to an open-end mutual fund (so it will trade at NAV). According to the article Goldstein's main fund has had about double the cumulative return of the S&P since inception in the early-mid 1990s1 and has never had a down year.

1Unfortunately, the article isn't too precise here. It says that Goldstein started his first fund in 1993, but doesn't specify if this is his firm's "main fund".

## Friday, July 18, 2008

### Seven Questions for William Poole

The former St. Louis Fed president speaks with Foreign Policy about the GSEs, the credit crisis, and the economy, "Seven Questions: How Bad Will it Get?". Intro:

When William Poole warned in 2003 that Fannie Mae and Freddie Mac lacked the capital to weather a financial storm, his advice went unheeded. Five years later, the outspoken former president of the Federal Reserve Bank of St. Louis is far too polite to say “I told you so,” but he does have a message for the Fed: Wait too long to tackle inflation, and you’ll face an even worse recession in the years to come.

It's worth reading this brief interview in its entirety.

### The Axis of Hackensack

If I'd had a blog last fall, I would have posted a link to this great Vanity Fair article then. I think you'll still find it an entertaining read today. Herewith, a link to Michael Bronner's article, "The Axis of Hackensack: Meet Kim Jong-il's Best Friend in Jersey". Here's Vanity Fair's description of the article:

For more than 10 years, the United States has used an unlikely freelance connection to communicate with "axis of evil" member North Korea: Robert Egan, a barbecue-joint owner, former small-time criminal, and erstwhile F.B.I. informant from New Jersey. The author follows Egan into the wilds of Hackensack to reveal a mind-boggling story of espionage, covert diplomacy, and rib-lovin' North Korean envoys.

## Thursday, July 17, 2008

### Perritt on Micro-Caps

After a three month lag time, I received the semi-annual reports for Perritt Micro-cap Opportunities and Emerging Opportunities funds today. One statistic cited by Perritt portfolio manager Michael Corbett jumped out at me. Perritt broke down the performance of different market cap ranges within the Russell 2000 index and found that, over the 12-month period ending April 30th, 2008, the average stock in the \$5 million to \$295 million market cap range was down a 49.3%.

A couple of other observations from this report:

1) One of my current holdings, Vaalco Energy (EGY), was listed as one of the top ten holdings of the Perritt Micro-Cap Opportunities Fund. EGY was down today, with the pullback in oil prices.

2) One of the top ten holdings of the smaller (under \$250 million market cap, if memory serves) Emerging Opportunities Fund looks interesting: Mitcham Industries, Inc. (MIND). It leases and sells seismic equipment of the sort used by oil and gas E&Ps on land and in shallow waters. The company has no debt, is trading at a little over 10x next year's earnings estimates, and has had recent insider buying, according to Yahoo! Finance. I'll have to keep an eye on this one.

### An Update from Alloy Steel International (AYSI.OB)

Recently, on message boards such as the one on Yahoo! Finance and Investor Hub, some investors in Alloy Steel International (AYSI.OB) have expressed frustration that Alloy Steel's management hasn't provided more frequent updates on the company's progress. Today Alloy Steel released its second 8-K in a little more than a month. The previous 8-K announced the formation of a joint venture in Mongolia with Geomandal; below is the text of the current 8-K.

UPDATE OF SALES AND ORDERS FOR ARCOPLATETM

Fortescue Metals Group (FMG) has continued its preference for the use of ARCOPLATE in all their mining operations with placement of an order for one million eight hundred thousand dollars (\$1,800,000) worth of product this week.

ARCOPLATE was used predominately in the construction of their current mining operations in Northern Western Australia (Cloudbreak mine); the value of product utilised in Cloudbreak mine by FMG was \$5.5 Million making total purchases of ARCOPLATE \$7.3 Million by FMG (www.fmgl.com.au)

Part of this order is for their existing operation and the balance is for the start of the fit out of their second mine which is currently under construction.

Alloy Steel has been advised it is preferred supplier for this second mine's wear plate requirements.

Following a visit to Perth last week by a group of consultant engineers from Kuala Lumpur, a significant order has been placed for the first major use of ARCOPLATE in Malaysia.

The final order value is expected to be approximately \$630,000.

Unlike some of those commenters on the message boards, I'd actually prefer to not hear any updates such as these for a while -- at least until my outstanding GTC limit buy order is filled.

## Wednesday, July 16, 2008

### Tesla's Wild Ride

I meant to post a link to this Fortune article when I first read it over the weekend, but better late than never: "Tesla's Wild Ride". The subtitle gives a good summary of the rest of article:

Building the world's first electric supercar was never going to be easy - even without the hubris, infighting, and mismanagement that nearly sent Tesla spinning off the road.

## Tuesday, July 15, 2008

### HEM.TO Update: Four New Patents for Hemisphere GPS

See this press release ("Hemisphere GPS Awarded Four New Patents for Positioning and Automated Steering") for the Physics 903.

Hemisphere GPS (HEM.TO) is one of three positions I currently have that are Aaron Edelheit picks. Again, it's worth signing up for guest access to the Value Investors Club to read Edelheit's initial write-up, under his pseudonym "Issambres839". Hemisphere is also a holding of Daniel Wahl and Ravinsu (who doesn't have a blog yet, as far as I know, but occasionally graces us with his comments here). I've mentioned Hemisphere here before a few times, but I don't think I've explained what the company's business is. Here is a layman's description, in a nutshell:

If you've ever mowed a lawn or spread fertilizer or seeds on a lawn, you've probably overlapped your rows slightly, to make sure you covered the whole area of your lawn. Commercial farmers have long done essentially the same thing. When a commercial farmer is working with tens of thousands of acres, all that overlap can lead to the waste of a lot of (increasingly expensive) fuel, fertilizer, and seeds. Hemisphere is a "precision agriculture" company. By using satellite guidance systems, Hemisphere's equipment precisely steers tractors and other agricultural equipment, obviating the need for overlap, and saving farmers a lot fuel, fertilizer, and seeds -- and, consequently, a lot of money.

In a sense, Hemisphere GPS is to the agriculture industry what Alloy Steel International is to the mining industry. Both companies' products enable operators in their respective industries to operate more efficiently.

### USEG Update: Spudding of First Well with Petroquest Energy

In our conversation Friday, USEG's CEO mentioned that the first well USEG was participating in with Petroquest Energy was about to be spudded. Today USEG released this press release: "U.S. Energy Corp. Announces the Spudding of Its First Well With PetroQuest Energy".

## Monday, July 14, 2008

### Jim Rogers Speaks

To Bloomberg (hat tip to CCYork on GuruFocus). Excerpts:

[Carol Massar:]...What about this commodity boom? I think recently we talked to you and or I was reading something and it said that we are in the fourth inning of a baseball game. Still there, in your view?

ROGERS: Probably around the fourth inning, that sounds good enough. Maybe the fourth and a half, maybe the top or the bottom of the fifth, something like that. The commodities bull market has a long way to go.

There are going to be corrections along the way, Carol, there always are, but no, nobody has discovered any major oil field in over 40 years. There just aren't any supplies of anything.

MASSAR: Jim, what do you make though of the arguments out there about demand destruction, about a weakening global economy and that is going to start to bring down commodities. I know you talk about some near-term corrections.

So, anything out there though that will substantially drag down commodities, in your view?

ROGERS: Well, recession, if the world goes into recession, of course it is going to drag down the demand. But remember, Carol, in the 1970s we had one of the worst decades in a long time for the economy. And oil went up ten times, the oil commodity, we had one of the great bull markets of all time in commodities because supply went down faster than demand and that is what is happening now too.

Oil can go down - you know the bull market in oil started in 1999. Three times since 1999, oil has gone down over 40 percent. It wasn't the end of the bull market. It just scared the socks off everybody, including me. That can happen again, but it is not the end of the bull market.

MASSAR: So, any pullbacks for a buying opportunity, in your view, whether it is oil, whether it is grains, whether it is base metals?

ROGERS: Yes, of course. Everything. Base metals have already corrected a lot. Wheat has corrected a lot. Sugar has corrected a lot. Get yourself some sugar, take it home, take it home from your Bloomberg.

[snip]

MASSAR: 30 seconds left here. I know you mentioned you are kind of looking, eyeing at base metals. Anything else you think investors should be looking at, just kind of keeping on their radar, just quickly if you could?

ROGERS: Agriculture, agriculture. You should be buying agriculture. I am buying agriculture.

Read the whole transcript if you'd like to see Rogers's bearish take on financials, the dollar, etc.

### A Conversation with the CFO of Destiny Media Technologies (DSNY.OB)

After reading Destiny Media Technology's Q3 release, I spoke with Fred Vandenberg, the company's CFO, earlier today. I asked him about the decline in revenues y-o-y from its Clipstream product. He said that Destiny's focus had been on the MPE service (in terms of development, sales, etc.), so Clipstream suffered somewhat from that neglect, but he reiterated its advantages over Flash (e.g., that it uses 90% less bandwith, that it requires less processing power, etc.), and also reiterated his company's prediction in today's release that Clipstream revenues would increase significantly in the company's fiscal Q1 (since Destiny's fiscal year begins on September 1st, Q1 will be the Sep-Nov quarter).

I asked Vandenberg if he was familiar with Aaron Edelheit's VIC write-up of his company, and he said that he was. In light of today's announcement that Destiny expects to be profitable in its Q1 quarter, I asked him if he thought Edelheit's estimate of ~10 cents per share in fiscal '09 earnings sounded on target. Unsurprisingly, since Destiny Media didn't provide a specific earnings estimate for Q1, Vandenberg didn't want to get pinned down on a specific estimate for all of '09, citing some variables earnings would depend on (e.g., how many contracts get signed, etc.). He did, however, reiterate his confidence that Destiny Media would be profitable in its fiscal Q1.

In his VIC write-up, Edelheit had predicted that most of the companies that were using Destiny Media's MPE service on a trial basis would become paying clients this year. I asked Vandenberg about this, and he said that had been the case so far this year.

Vandenberg also said that one factor holding back MPE revenues somewhat has been that the pricing system has been complex. In trying to make the pricing flexible, Destiny Media may have gone so far in that direction that they made it too complicated, and that complexity may be inhibiting some clients from using the service as much as they would otherwise. Vandenberg said that Destiny was in the process of simplifying the pricing system and that process of simplifying it should be completed within the next few weeks. He said simplifying that pricing should lead to an increase in MPE service revenues.

### New Position: Photochannel (PNWIF.OB)

Photochannel (PNWIF.OB is another Aaron Edelheit pick. I actually put in a limit order on Friday for this one, and it was filled today at \$3.40. Currently, it's trading at \$3.31. I'll add a description of the company to this post a little later.

### Destiny Media Announces its Q3 Numbers

Today, apparently without any advance notice, Destiny Media Technologies (DSNY.OB) announced its Q3 numbers (the company's fiscal year ends on August 31st), Press Release: "Destiny Media Reports Record Revenues for Q3 2008". The company's revenue went up and its quarterly loss narrowed on a y-o-y basis.

Also today, I spoke with Fred Vandenberg, the CFO of Destiny Media. I have some business to attend to first, but I will post notes from our conversation here later today.

## Sunday, July 13, 2008

### Malapropism of the Day

I didn't expect to get a laugh out of an article about the Fed and Treasury attempting to calm fears about the big GSEs (AP: "US spells out Fannie-Freddie backstop plan"), but I did when I got to the second paragraph below:

A senior Treasury official said any increase in the line of credit — now at \$2.25 billion for each company_ would be at the Treasury secretary's discretion. The same would apply to any equity investment made by the government.

The official, who spoke on condition of animosity, also sought to send a calming message about Fannie's and Freddie's financial shape, saying: "There's been no deterioration of the situation since Friday."

### Kiplinger's on Bill Miller

In an article more balanced than its headline would suggest (Kiplinger's: "Is Bill Miller Toast?"), Russel Kinnel writes of the Legg Mason portfolio manager,

Many saw Miller as a cagey investor who was always one step ahead of other investors. They figured he could sniff out the right industry just in time to beat his peers and the market. But that's not an accurate description of how Miller operates. Rather than flitting from one industry to another, Miller invests with a five- to ten-year horizon and consistently favors the same sectors.

Right and wrong times. Miller likes financial, technology and Internet stocks. And he typically holds some retail, media and health-care stocks, too. However, he hates most commodity businesses, including oil and copper. Those sector biases were perfect for the markets of the 1990s but have hurt results since oil prices started to spike three years ago. It makes sense that Miller did well in low-inflation environments and has fared poorly in today's world, with financial stocks in crisis and natural resources very precious.

The article goes on to talk about the example of Amazon.com, how Miller bought it before the dot-com bust, but ultimately made good money on it, partly by averaging down, and partly by having the strength of conviction to hold it long enough.

One thought I've had recently, which I haven't fleshed out in a post yet, is what sort of investments would you want to own when the secular bull market in commodities is winding down and the next secular bull market in stocks is beginning? Bill Miller's holdings might be a source of ideas if he's still in the business then.

### Stratfor's Outlook for the Third Quarter

Via John Mauldin, below is Stratfor's global forecast for the third quarter. Since it covers the whole world, there's a lot there. A few points that standout: Stratfor is bearish on India, bullish on Brazil, and sees peace breaking out in the Middle East. Brazil has appeared to be the most attractive of the BRIC countries to me with respect to investment, so Stratfor's take on it isn't too surprising. Its forecast for the Mideast is a little more surprising, but Stratfor believes that one reason violence has been dropping in Iraq is because of behind-the-scenes negotiations between the U.S. and Iran. Stratfor also predicts a peace treaty between Israel and Syria, possibly as early as this year.

-------------------------------------------------------------------------------------

Quarterly Forecast: Third Quarter 2008

By George Friedman

### Introduction

For the first half of 2008, Stratfor focused its attention on three features of the international system. All three remain key factors, but all have also evolved notably.

First, we anticipated an endgame between the United States and Iran over the future of Iraq. We have been surprised at just how fast U.S.-Iranian negotiations have progressed, and consequently violence has dropped to its lowest levels since the 2003 invasion (something that would be impossible without Iranian assistance). What is truly amazing is how few items necessary for a deal are not already in place. We are unlikely to have a formal "Camp David" moment, but the U.S.-Iranian understanding seems to be building quickly on the ground.

Second, Russia's efforts to rebuild its influence throughout Eurasia have been at a critical point. With the Western-backed independence of Kosovo making a mockery of Russian foreign policy, we predicted that Moscow either had to strike back or see its credibility in key former Soviet Union territories crumble. As it turned out, Russia's internal factional struggles distracted and exhausted the Kremlin. Striking back at Europe and the United States in any place that would have caused harm proved impossible, forcing the Russians to concentrate on places such as Central Asia, the Caucasus and Ukraine. In the long run, this may well prove to be the worst of all worlds, as the Europeans are convinced they beat the Russians, while the Russians are equally convinced that they have drawn a line in the sand. For the moment, however, Russia requires time to plan and flesh out its new organizational structures. That will take up the bulk of the third quarter.

Third, we forecast that high energy prices would create a flood of petrodollars that mostly would end up flowing into U.S.-dollar assets, greatly stabilizing the financial system and helping the United States shake off its economic funk. This prediction proved true in spades, and U.S. economic growth has certainly turned a corner, but two related developments have taken root. First, having oil prices increase by 40 percent in three months cannot help but have an enervating impact on economic growth, particularly in the heavily industrialized states of East Asia. Second, all that oil income is beginning to have additional impacts.

The Arab Gulf states are grossing approximately \$2 billion per day, with half of that amount flowing into the coffers of Saudi Arabia. This provides the Saudis — and other Gulf Arabs — not only with tremendous wealth, but also with tremendous political power. A key trend in the third quarter will have these states using that wealth to invest, bribe and cajole their friends and enemies into following policies more to Riyadh's liking.

This money will be most politically active in two locations: Lebanon and Iraq. In both places the Saudis want to see some flavor of a peace deal. The common thread to the two issues is the Saudi fear of Iran. An Israeli-Syrian peace deal means reducing Tehran's influence within the Sunni world — specifically, the influence it holds over Damascus and Hezbollah. A U.S.-Iranian deal over Iraq means re-establishing Iraq as a buffer against Iranian expansion. In both cases, Saudi money is useful in bringing the various players to the table — most notably Damascus and the various Iraq Sunni factions — and paying them to stick to an agreement. In the case of Israel and Syria, the constellation of forces in play suggests a deal will be struck sooner rather than later.

There is one additional topic that will feature grandly in the third quarter: the Beijing Olympics. Ruling China has always been a difficult prospect, as the country is riven with urban-rural and coastal-interior splits. But while the Olympics were supposed to have been a celebration of China's "arrival" as a modern state, they are instead serving as a showcase for all the ways in which China falls short. But dealing with these issues — entrenched corruption, financial dysfunction, (unapproved) regional autonomy, unaffordable energy subsidies — is difficult for Beijing in the weeks leading up to the Olympics because, under the glare of international spotlights, it can no longer use the tried-and-true tools of an authoritarian state. The result is a string of patchwork fixes that highlight China's weaknesses, making the Asian giant vulnerable to any foreign power with an interest in demonstrating that the emperor is less than fully clothed. Not exactly the global celebration that Beijing intended when it bid for the Olympics all those years ago.

Note to readers: Our third-quarter forecast is intended to be a supplement to our annual forecast and second-quarter forecast. Within each section of this quarterly we have extracted the critical trends identified in our previous forecasts and indicated where we have been right or wrong and what is coming in the next three months. We have also examined new trends that have evolved from regional developments, independent of the earlier forecasts.

### Middle East

• Regional trend: The United States has successfully forced the countries that made al Qaeda possible into the American alliance structure. It will now use that structure to clamp down on those still resisting American power. In doing so it may inadvertently trigger tensions with Israel.

In the second quarter, U.S. efforts in the Middle East received a surprising boost in the form of petrodollars. Like the United States, Saudi Arabia wants to see Iraq stable and Iran blocked from expanding its influence. High oil prices are bringing the Saudis more than a billion dollars a day in revenues, some of which they are using to push Sunnis into Iraq's governing coalition.

Syria has found a role in the tightening Arab-American alliance, but that role has taken an unexpected form: peace talks with Israel. Soon after the negotiations came into the public eye, political instability in Israel threatened to derail them, but a deal between Israel's Kadima and Labor parties now ensures that the talks will proceed even if Israeli Prime Minister Ehud Olmert is replaced toward the end of the third quarter. While Washington certainly has its reservations about an Israeli-Syrian detente, the United States is refraining from sabotaging the talks — in part because Saudi money is supporting the initiative, in part because Turkey is hosting the talks, and in part because Hezbollah will be defanged if the talks prove successful.

The third quarter could well prove to be a decisive turning point for many actors in the region. Hezbollah has no good options. It needs to find a way to scuttle the Israeli-Syrian peace talks, and an attack on Israel might be the only way it can do so — but then it risks inviting a major retaliatory attack by Israel. Iran and the United States need to seal a deal on Iraq before the U.S. elections in November, or else risk the situation remaining unresolved for years. If a U.S.-Iranian deal proves elusive, Israel needs to ensure that Iran is knocked down a few pegs before a new U.S. administration potentially restricts the Jewish state's military options. Israel can bomb Iran only with U.S. approval.

The player that will work the hardest to ensure none of these situations spins out of control is Saudi Arabia. High commodity prices are showing signs of eating into global demand, and the last thing Riyadh wants is a war-related price spike that would push many economies over the brink. So Saudi oil income will play a growing role in buying calm throughout the region.

We expect rapid progress in the region's major peace negotiations — those between Israel and Syria and those between Iran and the United States — because most of the heavy lifting has already been done. There has been a near-halt to violence in Iraq, and Israel has been preparing its public to give up the Golan Heights. We would not be surprised at all to see deals materialize in the third quarter, with Syria and Israel more likely to be successful than Iran and the United States.

In the Israel-Syria talks — assuming that they are not derailed — we expect the traditional fanfare of a peace deal, complete with public handshakes. The U.S.-Iranian negotiations, however, are unlikely to present such a tableau. Tehran and Washington seem content to dial back tensions without dropping their public hostility, for fear that their respective populations would not approve of a public burying of the hatchet.

• Regional trend: Turkey is emerging as a major regional power and in 2008 will begin to exert influence throughout its periphery — most notably in northern Iraq.

Turkey is becoming bolder on the international stage: sending troops into northern Iraq, mediating Israeli-Syrian peace talks, pushing energy projects in the Caucasus and Central Asia and making its influence felt in the Balkans. But internally, the country is paralyzed. A domestic power struggle over the nature of the state, pitting the new socially and religiously conservative elite against the established ultrasecular elite, has stalled not only local economic growth and foreign investment but also Ankara's progress toward regional player status.

We expect Turkey's court system — operated by the ultrasecularists — to dictate terms to the elected Islamist-rooted government, likely resulting in the ruling Justice and Development Party's dissolution. A verdict is expected in mid-August on a pending case that seeks to do just that, though we cannot rule out the possibility of a compromise. Toppling the government will not reverse or deflect the underlying trend of Turkey's re-emergence as a leading regional power, but it will delay it significantly.

### Eurasia

• Regional trend: Should it occur over Russian objections, Kosovar independence would deliver a massive blow to Russian credibility. Thus, Kosovo will serve as the litmus test for either the return of Russian power or a surge in the West's expansion.

• Regional trend: Russia's internal power struggles will hamper Moscow's ability to pursue its international agenda.

Russia spent the bulk of its energy in the second quarter on managing the transition from Vladimir Putin the president to Vladimir Putin the prime minister. In the shuffle, Russia's restless power clans struggled for supremacy, with the conflict reverberating through some of Russia's most crucial institutions, including the Federal Security Service, Gazprom, Rosneft and the defense sector. This struggle is now over — with the battle lines ending roughly where they began — but the fighting consumed nearly all of Moscow's attention and energy for the bulk of the second quarter.

During this reorganization, the West — particularly the Europeans — did manage to force Kosovar independence over Russian objections, making a mockery of the Russian position in Europe. But Russia did not exact any retribution — or at least, not in Europe. What Russia did do was focus some of its energy on the area where its influence is strong: its immediate periphery. Belarus, Ukraine, Armenia, Azerbaijan and Georgia all witnessed a surge in Russian attention as Moscow locked down its positions in regions it feared the West was eyeing.

The result is a continuing mismatch of perceptions: the Europeans feel that their victory in Kosovo proves the Russians are more bark than bite, while the Russians feel that they have made their true red-lines clear by focusing on their near abroad. Major Eurasian conflicts have been rooted in far smaller misperceptions, but that will be a crisis for another day.

Luckily for both sides, each has other issues to occupy it for now. The Europeans have turned inward after yet another failed attempt at a constitution, and the Russians have to get their affairs in order in the third quarter before venturing outward again.

Putin has implemented major personnel reshuffles across the length and breadth of the Kremlin, with the biggest changes in the energy industry, the military and the defense-industrial complex. Additionally, Russia is a major energy exporter and a moderate food exporter, but it still struggles with inflation — doubly so now that qualitative and quantitative labor shortages are starting to bite, courtesy of Russia's deepening demographic crisis.

While Russia might be in its best posture financially, politically and militarily since the end of the Cold War, it faces a number of nagging problems that it is organizationally ill-suited to solve. Finding a way to get through these problems is not a severe challenge, but it will take time. We expect no major moves out of the Kremlin until the very end of the third quarter at the earliest. But when Russia does return, it will do so with the most money — courtesy of petrodollars — and the best leadership team it has had in 20 years.

• Regional trend: The Concert of Powers will return as the dominant organizing structure of inter-European relations.

Europe is returning to its roots. Countries are arguing over monetary policy, France is making a grab for control of Europe's Mediterranean policy, Poland is aggravating Russia, Greece is complicating Balkan policy and the United Kingdom stands aloof as ever. Any serious thoughts of pan-European integration were thrown into disarray in June when Irish voters defeated the Lisbon Treaty, the latest attempt at a European constitution.

For the third quarter, all eyes will be on France, which will hold the rotating EU presidency for the remainder of the year. Since France is one of Europe's heavyweights, its turn at the presidency would have been notable even had Ireland ratified the EU treaty — but with political integration efforts in limbo, France now has a chance to realign European structures with its own national interests. This will not take the old Gaullist form of ambitions for French superpower status. Instead, Paris will seek to wrest the economic and political leadership of Europe away from Berlin by subtly (and perhaps not-so-subtly) undermining the EU institutions that France perceives as giving Germany an advantage.

Economically, France is better poised than Germany to weather the storm of sustained high commodity prices: It has a less-industrialized economy, is an exporter of foodstuffs and has a huge capacity to generate electricity from nuclear power rather than petroleum fuels. But Paris is well-positioned politically as well. President Nicolas Sarkozy's honeymoon might be over, but Germany finds itself distracted and divided by a failing, conflicted governing coalition that is about to enter an election campaign. Germany is still the rising star of Europe, but that rise has hit a bit of a pause, and France will seize the moment to adjust Europe's direction to its own liking as much as possible.

• Regional trend: Serbian elections will end Belgrade's position in geopolitical no-man's-land — one way or the other.

Europe has seen Serbia as the litmus test of whether the Balkan region as a whole will move decisively toward the West — with each of the Balkan states eventually joining the European Union — or whether there will be a radical wild card in the center of Southeastern Europe, which could give Russia a foothold in the region.

However, we should have known better than to think that the Serbian election could generate a clear result. While Serbia enters the third quarter with its most stable government yet, it would be a mistake to label it firm enough to execute a clear break with the country's past. Undoing 18 years of contradictory policies and international isolation is simply too large a task for any government to complete in short order, much less an untested coalition containing five parties and three ethnic groups.

Nevertheless, steps toward Serbia rejoining Europe — complete with halting steps toward EU membership — appear to be in the cards for the third quarter. Vojislav Kostunica, whose power plays have often upended Serbian policy, will not be in the new government, leaving pro-Western factions with more flexibility than they have known in years. But it will take far more than three months of progress before the probabilities for success can be assessed.

### Global Economy

• Regional trend: Oil prices will soften in 2008 due to the fading of geopolitical risks in key locations. The price drop, however, is contingent upon an expected weakening of geopolitical risks.

Things are going to get worse before they get better. Global crude oil prices have risen by 40 percent since the beginning of the year — and all of that took place in the second quarter — largely because of geopolitical risks that Stratfor believes will likely ease. We envision four events occurring in the third quarter that should take some of the heat out of the markets.

First, the U.S. Congress appears to be moving toward regulations intended to lessen the impact of speculation in oil trading. This will almost certainly have some unintended consequences, but will probably result in at least a minor cooling of prices.

Second, we expect a planned Nigerian energy summit to result in additional sums of oil income being funneled to the ethnic Ijaw of southern Nigeria. The Ijaw, who typically feel cut out of the oil patronage system, are responsible for most of the large attacks on oil infrastructure. A deal that enfranchises them should result in more stable Nigerian output.

Third and fourth, we expect two deals to slide into place in the Middle East: one between Iran and the United States on the future of Iraq, and another between Israel and Syria on the future of Lebanon. The Iranian-U.S. negotiations are taking place largely behind the scenes, but will impact the oil markets indirectly if they succeed in finally stabilizing Iraq. Meanwhile, Israeli-Syrian moves toward a very public peace deal should calm those parts of the oil markets that get jumpy every time they see a headline containing the words "Israel" and "Arab."

• Regional trend: Countries the world over will pull their energy sectors back from the free market in order to stave off social instability and/or maximize profit.

The primary manifestation of this forecast in the second quarter came in the form of reinforced energy subsidies, with Russia, France, Italy, India, Venezuela, Argentina and Iran being the most obvious players. Technically, such steps are not nationalizations, but they make the liberalization of energy sectors de facto impossible (no private firm wants to supply a subsidized market).

In the third quarter, we expect more dramatic steps toward direct management of energy sectors in Malaysia and China — two states in which recent efforts to lighten the subsidy burden are likely to backfire. Europe, too, will wrestle with moves to involve the state more deeply in energy questions, as high energy prices finally begin to bite hard enough to force a government response.

• Regional trend: Despite much talk to the contrary, the United States will enjoy strong economic performance. In part, this is because of the massive inflow of money into the United States from Asian and Arabian states.

While talk of recession in the United States remains par for the course, the U.S. Federal Reserve is both becoming optimistic and leaning toward interest rate increases to contain inflation. The Fed will always err on the side of triggering faster growth (and inflation with it) rather than slower growth that could lead to deflation and induce a Japanese-style depression. Add in roughly \$100 billion in stimulus checks, and the United States is well past the worst that the slowdown of the latter half of 2007 presented. This does not mean that the "strong economic performance" we anticipated has materialized — but the truth so far is much more positive than the doom-and-gloom talk that dominated American media the first half of the year.

Obviously, not all things are cheery. The American property market is far from recovery — the rising inventory of unsold homes in particular is a critical factor to watch — and strong commodity prices are making the U.S. consumer take pause. Additionally, a combination of American subprime contagion and regional structural and cyclical weaknesses could trigger a European banking crisis in the third quarter. But Stratfor's primary economic concern for U.S. growth remains tied to the election cycle. Neither presidential candidate has any interest in pointing out positive aspects of the current government's economic management. And, in past elections, "It's the Economy, Stupid" has not only garnered votes, but also has had the side effect of amplifying public perceptions of the economy's problems.

• Regional trend: Inflation is on the rise on a global scale.

But while the United States is looking toward better times, the reverse could prove true elsewhere. The sheer size of combined American purchasing power means that the United States can weather high energy and commodity prices relatively well — runaway commodity inflation plus the subprime meltdown still did not push the U.S. economy into negative growth. The same cannot be said for the rest of the global system, where inflation is now pushing 5 percent.

And of course \$140 a barrel oil is still \$140 a barrel oil. Most countries can no longer absorb such cost increases, and Stratfor expects to see the cracks that developed in major industrialized economies in the second quarter begin to lead to fundamental breaks in the third. Barring a truly deep price drop, a great many states are beginning to have a great many problems. Between robust prices for energy and food, there is not an economy in the world that has not had to make some sort of adjustment. Stratfor divides the effects into two categories.

First, food shortages impact political stability immediately; so food prices have been — and remain — the key issue to watch. In the second quarter, the world witnessed only sporadic, minor, localized food shortages. While grain prices continue to rise, there is some light at the end of the tunnel: plantings and weather have been favorable for most crops, and most grain forecasts for harvest in the next few months are atypically large (with corn in the U.S. Midwest being the notable exception.) It is far too early to predict a price drop, but it seems safe to say that there will not be onerous supply crunches.

Second, the broader inflationary trend remains firmly in place and will disproportionately impact the heavily industrializing — and thus energy-intensive — economies of East Asia (which is hardly to say that the rest of the developing world will escape). The country facing the biggest problems will be China, which imports massive amounts of increasingly expensive commodities. Beijing will face a growing risk of widespread social unrest as these pressures take their toll on its economy, but it will be constrained from restoring order in its accustomed fashion — that is, a security crackdown — in the third quarter because of the international spotlight brought by the Olympics. Efforts to manage the problem thus far have not proven very effective, and they are complicating parallel efforts by the government to recentralize control of the energy sector.

High commodity prices — specifically high energy prices — have also had an unforeseen impact. The political power of countries raking in large numbers of petrodollars — the Arab states of the Persian Gulf now gross a combined \$2 billion daily — is at its highest point in a generation. The last time these states had this amount of financial power they underwrote projects such as the Afghan mujahideen and contributed to the fall of the Soviet Union. This time around, they are concerned with Iran's involvement in Iraq and Lebanon, and are applying their riches toward pushing the Israeli-Syrian and American-Iranian peace processes forward.

### East Asia

• Regional trend: The Chinese government intends for the year 2008 to be China's day in the sun, with the Olympics showcasing how advanced and stable the country has become. This requires Beijing to act preemptively to prevent anyone with an interest in marring China's image from disrupting the Olympics.

Anti-Chinese foreign activist campaigns have been neutered with a mix of visa policy and slick organizing of counterprotests, while security has been tightened ostensibly in response to the threat of domestic terrorism. But these small victories belie much larger problems that have nothing to do with the Olympics.

The Olympic Games have created an inflection point in Chinese development, disrupting the stability of Beijing's political decision-making process. On some issues, this break point has caused the government to postpone decisions beyond when they would usually have been made, while on others, decisions have been accelerated ahead of the time frame Beijing would have preferred. Reducing energy subsidies was a policy from the former group, but the attempt to delay skidded out of the government's control. Meanwhile, allowing more media access because blackouts proved no longer feasible is an example of the latter.

In short, the Olympics have forced what is normally a gently-gently decision-making process into chaotic fire-fighting mode, and rising commodity prices are forcing the entire system into the pressure cooker. All things considered, China is juggling the issues admirably, but the scope and depth of the challenges it faces guarantee tension and a continuous trickle of small crises for the next quarter (not to mention that everyone who has an interest in seeing a weaker China will use the next several weeks to nudge the country toward as many of those crises as possible).

But the Olympics are still the Olympics, the Chinese people are still very proud to be hosting them, and regional leaders fully realize that the Politburo will certainly come for them if they spoil the show. Stratfor expects this combination of nationalism and fear to see the government through the worst of the problems. Then, once the last hungover tourist steps onto the last departing plane, cracks will likely start showing, the system will start creaking, and the gloves will come off — with the acceleration of price reforms the most likely first order of business.

• Regional trend: In order to tighten its grip on an often unstable and chaotic economy and Communist Party, the Chinese Central Committee is reshuffling the bureaucracy, with an eye to creating energy, aviation and finance superministries directly under its control.

Efforts to consolidate the energy sector are proceeding, but not quickly. The central government is meeting resistance from all of the expected groups — state oil firms, local distributors and retailers, and especially regional leaders — who stand to see their influence, wealth and sources of income all subjugated to Beijing's will. With the added complications of the Olympics and global high energy prices, the central government has been forced to shuffle and reshuffle the plans several times to keep them more or less on track.

In the quarter to come, President Hu Jintao will attempt to bring all the disparate threads of the energy sector more or less under his personal control, a task that will become even more complicated once the burning incentive of the Olympics has passed and all the players take a good hard look at their bottom lines. But in many places, the push for consolidation will not rise above the level of rhetoric, given that many of Hu's key supporters are local leaders who continue to resist change on multiple issues in order to maintain their own viability and profitability. As such, Hu will likely take his campaign to provinces and regions led by people outside of his personal network — a move that will create some tensions and contradictions in the inconsistent application of central government directives across the country.

By comparison, consolidation of the aviation sector will be a cakewalk.

• Regional trend: The U.S. alliance structure in Asia is being readjusted as states feel out both bilateral and multilateral relationships in order to maximize their influence in an evolving world.

This readjustment intensified in the second quarter, with several states becoming increasingly proactive in how they manage their bilateral relations with the United States and their neighbors. As we expected, U.S. allies sought not to sever, but simply to adjust, the ties that bind.

Australia short-circuited several plans to exclude the United States from various proposed Asian clubs by proposing to create and lead its own version of the Asia-Pacific Economic Cooperation to manage the region's economic and military affairs. South Korea, despite domestic opposition, continues to put finishing touches on a free trade deal with the Americans, still vying to become the only major Asian state to land such an agreement. Taiwan's new government sought to find a middle ground that keeps its American alliance intact while allowing it to nudge closer to Beijing. And the United States took advantage of a hurricane disaster in the Philippines to demonstrate vividly that, while it might not be flying the flag in Asia as much as in times gone by, it has hardly vacated the premises. Meanwhile, one state that is by no means a U.S. ally — North Korea — saw its relations with the United States continue shifting away from crisis management toward routine bureaucracy.

This process is only in the beginning stages and will continue to intensify and accelerate in the third quarter. Bear in mind that all four of Washington's primary allies in the region — South Korea, Australia, Thailand and Taiwan — have freshman governments that are feeling their way forward. And with China's attention absorbed by the Olympics and the Americans preoccupied by the Middle East and their own election cycle, all four realize that the time to adjust their alliance relationships is now.

### South Asia

• Regional trend: The Pakistani army/state will hold together even as confusion and distractions in Islamabad greatly reduce the Pakistani government's ability (and willingness) to rein in jihadists.

This has certainly proven to be the case. Pakistan's incoming coalition is fractious, inexperienced (it has been 10 years since civilians ran the government) and certainly not in the mood to rock any domestic boats. This has led Islamabad to do everything in its power to avoid unduly angering Islamist militants operating in the country's northwestern reaches. The dawning problem is that this ungoverned land is providing opportunities for militants battling NATO forces in neighboring Afghanistan to rest, recruit and rearm — re-creating precisely the sort of environment that allowed al Qaeda to operate so efficiently until Sept. 12, 2001. In response, NATO forces are beginning to target these militants regardless of the political border, critically damaging the credibility of the Pakistani government.

The third quarter will force the new government in Islamabad to decide whether it is more afraid of NATO forces or of its own militants — who now have made leaps eastward out of the tribal areas into the North-West Frontier Province (NWFP). Ultimately, we expect the government to choose to target the militants, however half-heartedly, rather than make a stand against NATO's incursions into territory that is nominally under Islamabad's writ. The government will be driven by the fear that a conflict with NATO could, at worst, destroy Pakistan or, at best, trigger a military coup — which would end the first civilian government in a decade. In the meantime, U.S. forces will escalate their overt operations in the tribal badlands and perhaps even in the NWFP, which will complicate both the security and political situation in the country.

• Regional trend: India's schizophrenic policies regarding everything from tax regimes to special economic zones to basic infrastructure are proving that the idea of "Shining India" is a myth and will lead to a waning in foreign investment.

Hopes for a "Shining" India have all but darkened, and even that assumes that there is no fallout from the deepening militant struggle in Pakistan.

With oil prices skyrocketing, India's energy subsidized economy cannot cope and state oil refiners are buckling under the pressure. This not only spells a highly uncertain political future for the ruling Congress party, but it also raises the specter of fuel shortages in an extremely riot-prone society should the government slip in managing this fuel crisis. Add in infrastructure bottlenecks and a government that is paralyzed due to rising food prices, and it is clear even to the Indian government that New Delhi's foreign direct investment (FDI) hopes are overinflated. But with inflationary pressures in the country nearing a critical point, maintaining FDI has slid well down the government's priority list.

In the third quarter, India will continue to be squeezed by economic pressure and stymied by political paralysis, both getting worse by the day. A break point is unlikely in the next three months, however. New Delhi still has enough quick fixes at its disposal to manage the impact of the commodity crisis day-to-day, but its attention is now almost fully consumed with containing domestic dissent. The political tension will continue to intensify, but with elections still more than half a year away, the situation will continue to simmer without quite boiling over.

• Regional trend: The rest of South Asia will be consumed with domestic issues.

In the rest of South Asia, domestic squabbles between governments and their opponents took place as per our predictions with one exception: Afghanistan. The advances made by the Taliban, the diversion of U.S. attention to Afghanistan because of progress in Iraq, and the rise of Pakistan's own indigenous Taliban movement has pushed Afghanistan into a world very different from the self-contained situations in Sri Lanka, Bangladesh and Nepal. In the third quarter, the decaying security situation in Pakistan will intensify Afghan militant activity, and will push NATO in general and the United States in particular to boost the involvement of their troops in southeastern Afghanistan.

### Latin America

• Regional trend: Brazil is rising as the continental hegemon of South America.

Politically, financially and militarily, Brazil is truly prospering by Latin American standards. Independent of the fact that the country discovered yet more oil fields in the second quarter, Brazil certainly surged ahead of the rest of the continent by any measure.

The economic realm is where Brazil is shining brightest. It exports or is self-sufficient in many of the commodities whose prices are causing the rest of the world no end of problems — but its governance is professional and competent enough that it is, so far, managing the stress of high prices at home.

In the meantime, its primary regional competitors — Argentina and Venezuela — are struggling, falling backward in relative power as Brazil strides forward. Brazil is leveraging this growing space competently. In the second quarter, Brazil became the largest single investor in Argentina. And in the third, it will take its first shipments of liquefied natural gas, setting the stage for it to declare full energy dependence from its unreliable neighbors. And with its investment into the energy industries of those same neighbors, Brazil is laying the groundwork for controlling their energy options, not the other way around.

• New regional trend: Crises are brewing in Latin America's leftist bloc.

In the annual and second-quarter forecasts, we dealt with Argentina, Bolivia and Venezuela separately. We now weave those three trends together: The populist policies that all have adopted are coming home to roost.

Argentina's financial, political and economic stability is taking a sharp turn for the worse. Argentine President Cristina Fernandez de Kirchner's populist efforts to placate a variety of groups have consistently laid the foundations for future, greater problems. The juggling already has radically increased Argentina's debt and reduced the country's trade surplus by a quarter — despite soaring international prices for all of Argentina's exports. This shortsightedness is triggering unrest on a national level, sparking runaway inflation of the type that has made previous Argentine governments fall. It also is gutting the country's productive capacity in industries in which it was until recently a global leader, and is raising the specter of food shortages in the not-so-distant future — quite possibly before the end of the third quarter.

Meanwhile, Bolivia is slowly sinking into chaos as the divisions deepen between the poorer, populous and indigenous highlands led by President Evo Morales and the more European and richer lowlands. Morales will hold a referendum on centralizing power in the third quarter, essentially attempting to force the lowlands into economic and political submission. So long as the lowlands physically control the economy on which the government depends, however, they cannot be talked or voted or threatened into submission. When the government realizes it cannot resolve the situation through constitutional channels — and we do not expect this realization to occur in the third quarter — Bolivia will have its defining crisis. Until then, the imbalance of political and economic forces in the country will only become more skewed, making the eventual conflict that much worse.

In Venezuela, it appeared at the beginning of the year that the opposition was beginning to coalesce into a meaningful political force that could challenge President Hugo Chavez. That trend has since faded away, but Chavez's own economic and political mismanagement has more than compensated for the lack of threats to the regime. Chavez has in many ways become his own worst enemy. Rising food and commodity prices, combined with self-destructive means of dealing with them, have soured the Venezuelan population on Chavez's leadership and fractured the ruling party. Many of Chavez's attempts to rally nationalist sentiment — threatening war against Colombia, for example — have instead backfired badly.

The country's social stability has been reduced to the point where it depends on Chavez's lavish social programs. But the cost of these programs is rising faster than the country's oil income, making Venezuela unique among oil exporters as the only one getting poorer with global crude prices at historic highs. Against this backdrop, it would be logical for foreign states hostile to Chavez to take a swipe at him, or for domestic opposition to rally against him, but no one with the capability to hurt Chavez has a deep enough interest to take any dramatic steps (the same, incidentally, goes for the Argentine and Bolivian governments). In the third quarter we expect Chavez's credibility to take hits — abroad, but even more so at home — as the system's coherence begins to crumble.

The problems of all three states feed upon each other. Bolivia's secession crisis and poor economic management are reducing natural gas flows to Argentina, complicating Argentina's existing power crisis. Venezuela's political — and by some reports, military — support for Bolivia's Morales only outrages and emboldens the secessionist lowlanders there. Venezuela's financial support for Argentina not only reduces the cash Caracas has to stabilize its own system, but several billion dollars of debt linkages now tie the economic problems of one state to the other. These connected problems, mostly rooted in the three countries' populist economics, have been building for years. In the first two quarters, cracks in the facade began to show — but in the third quarter the depth of the problems will become apparent. We do not expect any catastrophic failures in the next three months, but it is time to start thinking of just that.

• New regional trend: Mexico is facing a moment of truth in the government's war against the drug cartels.

In our annual forecast, we predicted a continuing intensification (but not a resolution) of the Calderon administration's war against the country's powerful drug cartels, particularly along the Mexican-U.S. border. But in the second quarter, the cartels began carrying out high-profile assassinations of top law enforcement personnel in Mexico City itself, and this has forced the country to a decision point that will evolve the war into something new. Sustained attacks on key personnel in the halls of power are something that no state can tolerate. If they continue, it will mean that one (or a combination) of three things must happen eventually:

1. Mexico City could strike a truce with the cartels to save the central region.

2. Mexico could hurl every asset it has into the war in an effort to at least secure the country's core.

3. The cartels could strike a truce with each other and force the government away from the border and onto the defensive. In essence, this would turn Mexico into a failed state.

None of the options is easy or pretty — and none might come to pass in the third quarter — but this much is clear: the current situation is untenable.

### Africa

• Regional trend: In contrast to previous years, there will be little direct involvement of the major outside — or even inside — players. The one exception will be Angola, which will enjoy a rare day in the sun as the continent's up-and-comer.

It would have been hard to hit this one any more directly: Africa simply has not seen any meaningful direct involvement from the traditional players, whether from the continent or beyond. China has made a couple of commodities deals, but little more. India and Japan each hosted Africa summits but have not pursued other engagements. The French are participating in the European Union peacekeeping force (EUFOR) in eastern Chad, but they are keeping their heads down and have not intervened between the Chadian government and opposing rebels. The United States pulled back on plans to relocate its Africa Command (AFRICOM) headquarters from Germany to Africa. Nigeria is preoccupied with managing the Niger Delta, and South Africa has engaged in very little direct activity in Zimbabwe. Even Angola, the region's up-and-comer, is currently focused on internal development. (In the second quarter, it overtook Nigeria to become Africa's leading oil-producing state.)

But if the second quarter was quiet, it will seem like a roar compared to the third.

China has the Olympics, France has the EU presidency, and the United States is in the middle of an election campaign season and has little capacity for putting pressure on its African allies over relocating AFRICOM.

Nigeria's perennial problems with internal stability will take center stage as the country's Ijaw ethnic community makes its firmest — and, if necessary, most violent — bid for a larger slice of the country's oil revenues when Nigeria's government convenes the Niger Delta Summit, expected to commence in late July.

In South Africa, the internal issues that absorbed the country's attention for the past quarter continue to beckon. President Thabo Mbeki truly is already a lame duck and has minimal room to maneuver in either domestic or international politics. A leadership transition is only a year away, and the likely next president, African National Congress chief Jacob Zuma, continues to be hounded by corruption allegations, complete with court cases. The single issue on which Mbeki can act is Zimbabwe, where growing international condemnation has provided an opening for Pretoria's more nuanced policy of engagement.

Only Angola, awash with oil revenues, will have the luxury of picking the issues it wants to address without fear of reprisal or competition. But even Angola will have internal issues to keep it busy. Parliamentary elections — the first since 1992 — will occur in the third quarter, and the government wants to add a stamp of electoral legitimacy to its list of achievements. The rest of the world, it seems, can wait for another day.