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Seth Klarman was speaking at the CFA Institute earlier, and in typical fashion cut to the chase: in summarizing the current market, the Baupost founder said he “sees few bargains in the current environment and predicted on Tuesday that the stock market could suffer another lost decade without any gains.” And the punchline: his description of market conditions which he compared to “a Hostess Twinkie snack cake because everything is being manipulated by the government and appears artificial.” Such facility with words, there is a reason the man runs a $22 billion fund and his book “Margin of Safety” has been out of print for years, and sells for a $1000 on ebay.
“Given the recent run-up, I’d be worried that we’ll have another 10 years of zero returns,” Klarman, who rarely speaks in public, said at the CFA Institute’s annual conference in Boston.
“I’m more worried about the world broadly than I’ve ever been in my whole career,” Klarman said.
Inflation is a risk that Klarman said he is particularly concerned with given the government’s high rate of borrowing to bail out the financial system. Baupost has purchased far out-of-the-money puts on bonds to hedge the risk, he said.
The puts, which Klarman said he viewed as “cheap insurance,” will expire worthless even if long-term interest rates rise to 6 or 7 percent. But if rates rise to 10 percent, Baupost would make large gains, and if rates exceed 20 percent the firm could make 50 or 100 times its outlay.
Typically, Baupost focuses on out-of-favor stocks and bonds. Klarman cleaned up in 2007 and 2008 buying distressed debt and mortgage securities that later recovered.
One area Klarman said he is currently scouring for potential investments is private commercial real estate below the top quality. Publicly traded real estate investment trusts, however, have “rallied enormously” and are “quite unattractive,” he said.
…
“We’d rather underperform a huge bull market than get clobbered in a bear market,” he said.
For those of you who don’t want to shell out $1,000 on eBay for Seth’s out-of-print Margin of Safety and have only recently become aware that the Internet is available on computers, the Zero Hedge article includes a link to a scanned copy of the book, available at a price even an anarcho-capitalist could embrace.
Roger Lowenstein is the author of five books covering financial markets. His latest book, The End of Wall Street, was published in April. Mr. Lowenstein is also the author of an excellent biography on Warren Buffett written in 1995 which we reviewed previously. In an article for the Washington Post today, Mr. Lowenstein makes the case for more timely intervention by the Federal Reserve when financial market bubbles are forming. Here is a brief excerpt:
Critics of the Fed have long urged it to intervene in bubbles — an argument that seems even stronger now. Had the Fed raised interest rates more aggressively in the early part of the decade, it is possible that banks would not have made so many questionable loans. We can’t know for sure, of course. But we do know what did happen: From 2001 to 2003, the Fed lowered short-term interest rates 13 times, reaching a rock-bottom level of 1 percent. They stayed there another year, and thereafter rose at a painstaking pace. With credit so cheap, people and institutions borrowed as if there were no tomorrow. And when the bust came, it spawned the worst recession in 75 years.
Defenders of Alan Greenspan often claim that the current version of history is being written by Monday morning quarterbacks who failed to predict the bubbles at a time when action could have been taken. Mr. Greenspan himself has gone so far as to say that individuals who predicted the crash were merely “statistical illusions”. In other words, at any given time, there are people predicting any conceivable outcome and some will be correct purely by chance.
Vanguard Founder John Bogle and many others have pointed the disingenuous nature of Mr. Greenspan’s attempts to rewrite history. While it is certainly true that the Federal Reserve’s “dual mandate” to manage monetary policy both for “full employment” and for a stable currency leads to challenges, cutting interest rates to rock bottom levels from 2001 to 2003 clearly inflated the housing bubble particularly by making it possible for adjustable rate mortgages with impossibly low teaser rates to lure buyers into housing that they had no chance of affording in the long run.
Manipulation of the housing market had real long term costs both for the irresponsible buyers who made unaffordable purchases and later lost their homes and for responsible individuals who refused to purchase over priced housing for years and ended up with a lower standard of living in rental housing. These responsible individuals may now have opportunities to purchase homes at more acceptable prices but are also bailing out irresponsible homeowners as the Federal Government continues various housing support schemes.
The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.
In an interview with The Financial Times, Jeremy Grantham discusses a study on various financial bubbles that his firm has recently completed. Mr. Grantham found 34 examples of bubbles that fit his definition as a “forty year event” statistically. Of these 34 bubbles, 32 have moved back to trends prior to the bubble forming. The two bubbles currently outstanding are the U.K. and Australian housing bubbles which Mr. Grantham believes are driven by low rates on floating rate mortgages.
Mr. Grantham is critical of the Federal Reserve under Alan Greenspan and Ben Bernanke’s leadership and attributes recent bubbles in the United States to errors in monetary policy:
It is not usual that you get three bubbles in a ten or twelve or thirteen year period. Normally one bubble will chew up twenty years because it leaves such a painful experience people don’t queue up to put their hands on the same stove and burn themselves again. But under Greenspan’s incredible leadership, he managed to give us the tech bubble and then by keeping interest rates at negative levels for three years drove up the housing bubble and then finally the risk bubble — everything risky — was inflated by ‘07 and Bernanke has happily picked up the mantle and seems totally unconcerned about creating yet another bubble.
Where might the next bubbles form? Mr. Grantham is concerned about equities in emerging markets and commodity prices.
To view the interview, please click on the image below.
The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.
Soft Insurance Market Persists; Active Hurricane Season Forecast
By Ravi Nagarajan
National Underwriter P&C magazine recently reported that the soft insurance market is showing no signs of reversing as abundant capacity combined with diminished demand keep downward pressure on rates. This is the seventh consecutive year of soft overall market conditions. At the same time, forecasters are calling for a more active than normal Atlantic hurricane season with fifteen named storms, eight hurricanes, and four “major” hurricanes.
Soft market conditions exist in a many different product lines:
As has been the case throughout much of the soft market phase, the report said, general liability was the most competitive line during the quarter, with the average premium falling 4.4 percent. The average property premium, which had been essentially flat over the past several quarters, fell 2.9 percent. The average workers’ compensation premium was down 2.0 percent, and average directors and officers liability (D&O) premium was off 1.1 percent. D&O average premium had been flat to slightly higher throughout 2009 due to rate increases in the financial institution sector, but those increases now have abated, according to the report.
Although rates are under pressure, insurers reported good results in 2009 and underwriters have not been pushing for higher premiums. Another way of interpreting this news is that insurers appear to be willing to compromise on pricing in exchange for volume or market share.
If lack of underwriting discipline is combined with higher than normal catastrophe claims in 2010, the overall industry could be looking at poor results for the year. Insurers that maintain underwriting discipline even at the cost of giving up market share should mitigate the damage and preserve capital for the harder pricing markets that inevitably return in periods following poor financial results for the overall industry.
Disclosure: The author owns shares of Berkshire Hathaway, a major provider of many lines of insurance through several subsidiaries, and also owns shares of other insurance companies.
The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.
Reuters Breakingviews has an article, Big Leveraged Buyouts May Soon Make a Comeback (via NYTimes.com), on the potential for a return of big LBOs. Breakingviews attributes the possibility to the availability of capital:
The money certainly has become available. In addition to dry powder held by the biggest private equity firms, banks are eager to lend again — even without demand from collateralized loan obligations to stoke the buyouts. Bubble accoutrements, including prearranged financing packages and loans with fewer restrictions, have re-emerged to make deals easier and more tempting for buyout firms. Interest rates also remain near record lows, and fixed-income investors have rediscovered an appetite for risk.
Debt multiples are also swiftly on the rise. After surpassing 10 times Ebitda in the heady days of 2006, banks beat a hasty retreat. But they’re again offering more than six times Ebitda. In return, they’re requiring buyout firms to provide 40 percent of a leveraged buyout price as equity, more than during the earlier exuberance.
What would the anatomy of a big LBO look like?
Consider a hypothetical $10 billion deal using rough-and-ready figures. A private equity firm could borrow about $6 billion for a company with $1 billion of annual Ebitda and well under $1 billion of existing debt. To write the accompanying $4 billion equity check, buyout firms could team up — in another replay from yesteryear — or bring co-investors in. Then, of course, the buyout price would have to deliver a premium to the target company’s market value.
Breakingviews has a few “plausible” candidates:
The online educator Apollo Group, the engineering group Fluor, the navigation technology maker Garmin, the discount retailer Ross Stores and the hard-drive manufacturer Western Digital are among firms that fit the bill, at least on paper. The $10 billion buyout may not become a regular occurrence again anytime soon. But what was recently unthinkable now looks in the realm of the possible again.
The ten-year inflation-adjusted ratio of price to earnings has been a favorite long-term indicator of market valuation that I regularly update on this website.
Another ratio, less familiar and more tedious to calculate, was developed by economist and Nobel laureate James Tobin. Tobin's Q Ratio is based on the assumption that the combined market value of all the companies on the stock market should be about equal to their replacement costs. John Mihaljevic, who served as Professor Tobin's research assistant from 1996-98, assisted Tobin in developing a new Q estimation methodology and in periodically updating data related to the Q ratio. John continues to maintain the Q Ratio in an online subscription service at The Manual of Ideas. In addition to monitoring the Q Ratio for the aggregate US market, the service also tracks Q for the 1,000 largest US-listed public companies ranked by market value.
The wonderful DShort.com blog has a post, Is the stock market cheap?, examining the S&P500 using Benjamin Graham’s P/E10 ratio. Doug Short describes the raison d’être of the Graham P/E10 ratio thus:
Legendary economist and value investor Benjamin Graham noticed the same bizarre P/E behavior during the Roaring Twenties and subsequent market crash. Graham collaborated with David Dodd to devise a more accurate way to calculate the market’s value, which they discussed in their 1934 classic book, Security Analysis. They attributed the illogical P/E ratios to temporary and sometimes extreme fluctuations in the business cycle. Their solution was to divide the price by the 10-year average of earnings, which we’ll call the P/E10. In recent years, Yale professor Robert Shiller, the author of Irrational Exuberance, has reintroduced the P/E10 to a wider audience of investors. … The historic P/E10 average is 16.3.
Here’s the chart from DShort.com to April 1st:
So what is the P/E10 ratio now saying about the market? In short, the market is expensive. The ratio has entered the most expensive quintile, which means it is more expensive than it has been 80% of the time. What are the implications for this? In his most recent Popular Delusions (via Zero Hedge), Dylan Grice has provided the following chart setting out the expected returns using each valuation quintile as an entry point:
Grice says:
If history is any guide, those investing today can expect a whopping 1.7% annualised return over the next ten years.
Doug Short has a more frightening conclusion:
A more cautionary observation is that every time the P/E10 has fallen from the first to the fourth quintile, it has ultimately declined to the fifth quintile and bottomed in single digits. Based on the latest 10-year earnings average, to reach a P/E10 in the high single digits would require an S&P 500 price decline below 540. Of course, a happier alternative would be for corporate earnings to make a strong and prolonged surge. When might we see the P/E10 bottom? These secular declines have ranged in length from over 19 years to as few as three. The current decline is now in its tenth year.
Or was March 2009 the beginning of a secular bull market? Perhaps, but the history of market valuations doesn’t encourage optimism.
Jim Grant on Alan Greenspan's Testimony: 'Self-Exculpating Nonsense'
Jim Grant of Grant's Interest Rate Observer calls it like it is in a Bloomberg interview following former Fed chairman Alan Greenspan's testimony before Congress today.
Why anyone still pays any attention to what Greenspan has to say is hard to understand. It is hard to think of one individual more responsible for the financial blowup of 2008 than Alan Greenspan. His policies laid the foundation for the house of cards that was built during his time as Fed chairman. For him to claim that nothing could have been done by the Fed to prevent the crisis is laughable.
Here is Jim Grant on Alan Greenspan, The Worst Central Banker in History:
Eric Sprott Stays Bearish on Economic Recovery, Bullish on Gold
Click here to listen to an interview with Eric Sprott, dated March 27, 2010, or visit the source page.
"Eric Sprott has over 35 years of experience in the investment industry and manages roughly $5 billion. Eric has been stunningly accurate in his writings for quite some time and is one of the highly respected industry professionals who foresaw the current crisis and chronicled the dangers of excessive leverage as well as the bubbles the Fed was creating while correctly forecasting the tragic collapse we are all enduring. In this interview Eric discusses the stock market, bond market, inflation, deflation, gold, silver, gold stocks, consolidation in the gold sector, the economy, the US Dollar, paper currencies globally, tax revenues going down, layoffs in US government jobs in states, oil and much more."
Kevin Byun on Equity Market Folly, Dangers of Protectionism, and 'Mr. Magoo' Pretenders
H. Kevin Byun, managing partner of Denali Investors, provides some enlightening commentary in his just-released Q1 letter to investors. Byun argues that the equity market is behaving as irrationally on the upside today as it did on the downside in late 2008 and early 2009. He attributes some of the recently exuberant action to so-called "Mr. Magoo pretenders" who suffered big losses in 2008 and may still be chasing their high watermarks. In a quest to recoup losses and get paid, Messieurs Magoo appear content to gamble with their investors' capital, risking disaster yet again. Byun also discusses his concerns surrounding the recent rise of protectionism.
The first quarter of 2010 has been marked by a continued upward creep in the markets, in stark contrast to recent fear and dislocation. From the lows reached far back in March, when the S&P broke to 667, we have seen a rally of over 75%.
2010, as it turns out, is a make-or-break year for many funds. The severe drawdown in 2008 and massive run-up in 2009 showed once again that it is better to fail conventionally than to succeed unconventionally. With many funds still below high water marks, their urgency for near-term performance in 2010 is greatly magnified. How can these fund managers properly invest with a long-term view when a short-term sword of Damocles hangs precariously above? Can these Mr. Magoo pretenders make it another year? And so career risk, business risk, and behavioral finance, rather than the best interests of their investors, comes to the fore.
With 2010 shaping up to be another interesting year, my view remains that the potential big-picture range and probability of outcomes have widened considerably, although the expected value or average represented through the market may appear narrow. With all the dislocations, machinations, and interventions, the potential energy in the markets is building once again. Exactly how and when the kinetic shifts occur remain an unknown, but the set up to dramatic changes appears to be in place. Expect the water to be choppy.
One related area that has become a topic of increasing attention, just to pick one out of the hat, is that of exchange rates, namely the call coming from some corners for China to let their currency float. From my perspective, it is not analytically prudent to draw a line in the sand on the issue due to the tricky and ever present law of unintended consequences. There are many interpretations even for concepts far simpler than floating and fixed rate frameworks, but let’s venture through. Regarding these unintended consequences, I would like to humbly present the following words as food for thought.
I often see politicians on the news putting the issue in binary terms, as right versus wrong, as good versus bad, as us versus them. This may prove to be a great disservice. Indeed, our country has outsourced many jobs, and low level ones at that. But this means we have also outsourced our unemployment and social unrest. Can you imagine what our unemployment number would look like if the capital base and employee base that supplies our goods just from China were simply put inside the US? Would it surprise you that this would approach Great Depression numbers? The migrant workers and unemployed masses of the Great Depression actually do exist today. But it simply goes unnoticed here because that too has been outsourced!
Conversely, what I have never seen a politician ever mention in the exchange rate debate is the likely resulting inflation. Why not? The average person is already stretched and living paycheck to paycheck. The group that will be impacted the most, which is that same group to which politicians pander, will find costs for basic items moving further out of range. Does it make sense that twenty pairs of tube socks from China are available for $8 retail? For every dollar prices for these tube socks move up to reflect true domestic and rate adjusted costs, a dollar less is available for other necessities. Such limited financial resources create an increasingly desperate zero sum game. Do I buy food or do I buy school supplies for the kids? If exchange rates do float and there is inflation, what will be the call to action then? Who will be the scapegoat? This may result in further finger pointing and a resurgence of social unrest, trade tariffs, trade barriers, and protectionism. This will be part of a negative reflexive process that may have much more severe and unfortunate consequences. But no one is talking about that.
If you are intellectually honest, you have to admit this is not a simple scenario to figure out for which this discussion barely scratches the surface and does not do justice.
As such, I present the following parable not as an answer, but as a surprisingly liberating approach for the analytical mind. It is a story my father told me a long time ago.
“Seh-Ong Ji Ma” (Seh-Ong’s Wise Horse)
There was a farmer named Seh-Ong that had a beautiful and strong horse. The neighbors complimented, “You are so lucky to have such a beautiful and strong horse.” The farmer replied, “We’ll see.”
Days later, the horse ran away from the farm and could not be found. The neighbors wailed, “You are so unlucky to have lost such a beautiful and strong horse.” The farmer replied, “We’ll see.”
Days later, the farmer’s horse returned, but had brought back seven other wild horses that were equally beautiful and strong. The neighbors complimented, “You are so lucky to have so many beautiful and strong horses.” The farmer replied, “We’ll see.”
Days later, the farmer’s son was attempting to train one of the wild horses, fell off the horse, and broke his leg. The neighbors wailed, “You are so unlucky to have your son break his leg.” The farmer replied, “We’ll see.”
Days later, the king’s army came through to take all the able-bodied young men for war. The neighbors complimented, “You are so lucky to have your son spared from the war.”
The farmer replied, “We’ll see.”
For me, this is one of the most powerful, simple, and elegant lessons of life and, therefore, investing.
Interesting info on the shipping industry for all the contrarians out there...
(apn Photo/Frank Hormann)
"On today's Planet Money:
So there was a big shipping bubble that inflated about the same time the housing bubble did. It grew for some similar reasons -- a go-go economy, easy credit, a belief that prices never decline, etc. And, like housing, it's now turned ugly.
Ships that cost more than $100 million a few years back now go for $40 million -- and the rates for freight have fallen accordingly. Ship owners have gone bust, and their ships have been taken by the bank and sold at auction.
Also on the podcast: The Gorton's fisherman, and what the shipping bust has to do with torn fiber-optic lines in Singapore."
Greenspan: Those Who Predicted Housing Bubble are “Statistical Illusions”
By Ravi Nagarajan
Perhaps no other government policymaker has suffered as much reputational damage due to the housing collapse as former Federal Reserve Chairman Alan Greenspan. Mr. Greenspan has defended his record in recent months and recently published a paper outlining his views regarding the housing bubble and subsequent crash. In Mr. Greenspan’s view, Fed policy actions had little to do with the crash.
One of the investors Michael Lewis highlighted in his recently published book, The Big Short, is Michael Burry who ran the Scion Capital hedge fund from 2000 to 2008. Mr. Burry was one of the first investors to spot the growing housing bubble and to devise a strategy to profit from the eventual collapse. Mr. Burry published an op-ed article in the New York Times yesterday that sheds some light on the attitudes that convinced policymakers that no bubble was forming:
I have often wondered why nobody in Washington showed any interest in hearing exactly how I arrived at my conclusions that the housing bubble would burst when it did and that it could cripple the big financial institutions. A week ago I learned the answer when Al Hunt of Bloomberg Television, who had read Michael Lewis’s book, “The Big Short,” which includes the story of my predictions, asked Mr. Greenspan directly. The former Fed chairman responded that my insights had been a “statistical illusion.” Perhaps, he suggested, I was just a supremely lucky flipper of coins.
Mr. Greenspan said that he sat through innumerable meetings at the Fed with crack economists, and not one of them warned of the problems that were to come. By Mr. Greenspan’s logic, anyone who might have foreseen the housing bubble would have been invited into the ivory tower, so if all those who were there did not hear it, then no one could have said it.
That’s Not a Real $100 Bill!
This is vaguely reminiscent of the old joke regarding two economists walking down the street and noticing a $100 bill lying on the sidewalk. One economist leans down to pick it up, but the other economist says that doing so would be pointless. If the $100 bill was real, someone else would have already picked it up.
Mr. Burry was able to pick up many “$100 bills” by being alert regarding the building crisis and figuring out ways in which he could profit from the eventual crash. Meanwhile, economists like Mr. Greenspan obviously failed to recognize the building crisis. At some point, those who were wrong about the housing bubble should simply step up and admit that they missed the warning signs.
While the free market is efficient most of the time, it does not follow that major inefficiencies cannot exist. Such inefficiencies appear all the time in the stock market and can also occur throughout the economy at times. Economists would better serve the public interest by studying the methods of those who were able to spot the housing crash rather than to explain it away as a “statistical illusion”.
The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.
Share Buybacks Gain Popularity as Stock Prices Rebound
By Ravi Nagarajan
It has become relatively common to read annual reports of companies that previously engaged in regular share buybacks yet mysteriously decided to halt the practice during 2009 even as share prices hit multi-year lows. As The Economist has noted, share buybacks are making a comeback in 2010 just as markets are approaching levels last seen prior to September/October 2008. Why is this happening now and how should shareholders evaluate management decisions on buybacks?
A Rare Skill Set
Shareholders employ a Chief Executive Officer with an expectation that he or she will intelligently run the business in a manner that is likely to maximize profitability over long periods of time. Over time and depending on the nature of the specific business, a good manager should be able to generate cash flow above and beyond maintenance capital expenditure requirements.
Operational excellence should ideally result in a growing pile of cash on a company’s balance sheet. However, simply because a manager is good at running a business and generating free cash flow does not mean that the manager will intelligently deploy the free cash flow for benefit of the company’s owners. Great operational managers are rare and so are great capital allocators. It is exceedingly rare to find a manager who is excellent in both areas.
Reinvest or Return Cash to Owners?
When a manager finds that cash is building up on the balance sheet, a choice must be made: Either the funds will be reinvested within the business or returned to shareholders. Reinvestment can be accomplished through internal growth or through acquisitions of other companies while returning cash to shareholders can take the form of dividends or share buybacks.
There are a number of factors that naturally predispose most operational managers to retain cash for reinvestment purposes:
First, excellent operational managers are normally optimists who have a history of seizing opportunities and finding success in areas where others may have failed. Accordingly, such individuals often have a healthy opinion of their own capabilities and feel that cash in their hands may be used in intelligent ways within their current business.
Second, it is natural for most managers to want to build up the size of the company they oversee in terms of annual sales, number of locations, number of employees, etc. When a manager says “I run a $10 billion company”, he is normally referring to annual sales volume rather than profitability. Just from an “ego” perspective, there is perceived value in running a larger enterprise.
Finally, and possibly most importantly, financial incentives often reward managers for growing the size of a business even if incremental returns on invested capital are substandard. If you start with a business earning high returns on capital, incremental investments at inferior returns will only show up slowly in overall results and only be apparent to alert shareholders who are paying careful attention.
Share Buybacks or Dividends?
In cases where the CEO (or the Board of Directors) has decided that there are no legitimate opportunities for internal investment, there are primarily two ways in which excess cash can be returned to shareholders: Share buybacks and dividends. Many managers prefer buybacks for a few reasons:
First, a buyback reduces the number of shares outstanding and can mask the effect of option grants to executives and others in the organization. In the absence of a buyback program, the share count of companies providing options to employees will creep up over time and make it more difficult for managers to achieve growth in reported earnings per share.
Second, managers who hold stock options have a clear incentive to favor buybacks over dividends. Paying dividends reduces the intrinsic value of options since cash is flowing out of the business to shareholders while the option strike price remains unchanged. In contrast, a share buyback effectively invests the cash on behalf of remaining shareholders in stock of the company itself which has a positive impact on option holders.
When Buybacks Make Sense
If a company has reached the point where free cash flow cannot be invested internally or via acquisition at acceptable rates of return, the cash should be returned to shareholders either through buybacks or dividends. Buybacks are only appropriate when management believes that shares are trading at levels under a conservative estimate of intrinsic value. When such buybacks occur, all remaining shareholders are better off because the intrinsic value of each share will increase and eventually be reflected in market prices. In contrast, shares purchased indiscriminately at any price can destroy value when managers buy shares at inflated prices.
This leads to the question of whether managers who were repurchasing shares in 2007 and 2008 at high prices but failed to repurchase shares in 2009 were acting in the best interests of shareholders. There are no blanket answers since each situation is different. Many companies that had positive free cash flow in 2007 and 2008 were burning cash in 2009 due to the economic downturn. Continuing a repurchase program even at lower prices could be ill advised if doing so depletes working capital that could cause financial distress or collapse.
Red Flags
When red flags should appear are cases where a company remained profitable and generated free cash flow throughout the economic downturn but mysteriously halted buybacks as the share price declined. Such managements should answer for why they considered it appropriate to buy back shares at higher prices in 2007 and 2008 but not at bargain prices in 2009. There could be valid reasons such as a desire to keep dry powder available for acquisitions made possible by distressed conditions or ensuring that the company builds up even more cash reserves in case of a longer recession or depression. However, the burden should be on management to explain this decision to shareholders in a coherent manner. Building up cash far in excess of any conceivable need to protect the business could simply indicate that managers were hoarding cash to sleep well at night at the expense of owners of the business.
The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.
Charlie Munger’s Latest Parable: Basically, It’s Over
By Ravi Nagarajan
Those who have followed the career of Berkshire Hathaway Vice Chairman Charlie Munger know that he has a long history of using parables to educate the public regarding business, economic, and political issues. By far, the best compilation of Mr. Munger’s thoughts on business and life can be found in Poor Charlie’s Almanack, which is a must read book for anyone seriously interested in Berkshire Hathaway. The latest Munger parable can be found on Slate.com and the story lacks a happy ending.
Basically, It’s Over: A parable about how one nation came to financial ruinis obviously a warning regarding the current state of politics and economics in the United States. The reader learns how a fictional nation named “Basicland” grew over a period of two hundred years through a system that mirrored the early United States with encouragement of trade, strong property rights, and a simple banking system. Over time, a casino mentality took hold leading to speculative activity, high levels of debt, and a convoluted tax system perverted by the actions of special interests.
Does this sound familiar yet?
An elder statesman, the “Good Father” known as “Benfranklin Leekwanyou Vokker”, attempted to talk some sense into Basicland’s leaders, but to no avail. Eventually, Basicland came to be known as Sorrowland as the economic and political system collapsed.
As I read this obviously pessimistic warning to America, it slowly occurred to me that perhaps there is a contradiction between the latest parable and the optimism Mr. Munger expressed at last year’s Berkshire Hathaway annual meeting:
“As I move close to the edge of death, I find myself getting more cheerful about the economic future,” Munger, aged 85, said. Munger sees “a final breakthrough that solves the main technical problem of man,” he continued. By harnessing the power of the sun, electrical power will become more available around the world. That will help humans turn sea water into fresh water and eliminate environmental problems, Munger explained.
Putting aside the “edge of death” quip, this indeed was an optimistic comment showing great faith in the future prospects of mankind.
Upon further reflection, it dawned on me that there may not be any contradiction at all. Mr. Munger could very well be cheerful about the economic future for mankind while simultaneously holding negative views regarding the economic future of the United States. After all, one of the companies in Berkshire Hathaway’s portfolio that is directly engaged in many of the “final breakthroughs” that Mr. Munger talked about is BYD, a Chinese company.
Perhaps if the political leaders in Washington are unwilling to listen to “Benfranklin Leekwanyou Vokker”, they will pay attention to Mr. Munger instead. Better yet, someone may want to nominate Mr. Munger for the commission looking into solving the country’s fiscal problems. Of course, this will never happen because common sense is not a highly regarded virtue in Washington today.
The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.
During the hurricane season, the news media often reports forecasted losses even before a storm makes landfall. The same was not true during the epic blizzards that impacted the Mid-Atlantic states earlier this month. While there were a number of reports regarding damage to individual structures, few estimates were made regarding aggregate damages.
Official loss estimates for the storms will not be available until next week, but preliminary estimates reported by P&C National Underwriter Magazine peg the total at a minimum of $2 Billion. Each storm is being categorized as a separate catastrophe since each storm is likely to result in at least $25 million in insured losses.
Most of the losses are expected to come from roof damage, broken pipes, and ice dams forming in rain gutters which often result in flooding of structures. Many structures in the Mid-Atlantic and South are not constructed with enough strength to withstand the types of snow loads experienced in recent weeks. Warmer temperatures have returned to the region in recent days which has helped with snow melt.
Business interruption insurance is likely to generate significant losses. Many areas of the Mid-Atlantic were crippled for days which prevented workers from commuting. Many retail businesses had empty shelves for close to a week due to resupply problems caused by snowbound roads.
Winter storms typically cause $1 Billion in damages each year and are the third largest cause of catastrophe losses behind hurricanes and tornadoes.
The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.
Kansas City Fed President Hoenig: Act Now to Address Fiscal Situation
By Ravi Nagarajan
Kansas City Federal Reserve President Thomas M. Hoenig has been a voice in the wilderness for some time. Mr. Hoenig was the only dissenter of the policy action at the January meeting of the Federal Open Market Committee because he believes that economic and financial conditions no longer warrant the Federal Reserve’s commitment to keep the federal funds rate at “exceptionally low” levels for an extended period of time. Last year, Mr. Hoenig gave a speech outlining alternatives to the “too big to fail” doctrine that has become conventional wisdom in Washington.
In a speech in Washington yesterday, Mr. Hoenig argues that there are only three options for dealing with the unsustainable fiscal situation: Have the Federal Reserve print money to monetize the national debt; do nothing as long as markets are willing to fund borrowing at inevitably higher interest rates; or act now to implement programs that restore balance to fiscal policy. A few excerpts from the speech are provided below.
The question of what combination of spending and revenue actions the country might choose is the purview of Congress and the executive branch. As a central banker, it is my responsibility to anticipate and avoid the consequences that an unchecked expansion of the debt may have on monetary policy. It is a fact that the current outlook for fiscal policy poses a threat to the Federal Reserve’s ability to achieve its dual objectives of price stability and maximum sustainable long-term growth, and therefore is a threat to its independence as well.
The founders of the Federal Reserve understood this conflict. They understood that placing the printing press with the power to spend was a formula for fiscal and financial disaster. Aware of this danger, they designed our central bank to be responsible for stable prices and long term growth, and they gave it a degree of independence so that it could carry out this mandate.
Unprecedented Mountain of Debt
The immediate concern is the size of the deficit. The CBO projects the deficit was almost 12 percent of GDP in fiscal year 2009 and will be almost 8 percent in the current fiscal year—extraordinarily high levels by historical standards. In the entire history of the United 6 States, the government has run deficits over 10 percent of GDP in only a few instances, and usually only during or immediately following a major war.
As troubling as these deficits appear, even more disconcerting is the longer-term outlook for the federal debt caused by the accumulation of these deficits over time. The CBO’s long term debt projections clearly show that current fiscal policies are unsustainable. In one scenario, the liftoff point for federal debt—that is, the time when debt starts rising without any sign of stabilizing—occurs shortly after 2020. By 2035, federal debt held by the public reaches 80 percent of GDP—a level only exceeded during and just after World War II. In another, more pessimistic scenario, the liftoff in debt has already begun, with federal debt held by the public reaching 181 percent of GDP in 2035, easily exceeding the peak debt to GDP ratio of 113 percent that occurred at the end of World War II.
Importance of Maintaining Fed Independence
In the United States, the Federal Reserve’s policies in the early 1980s provide a vivid example of the benefits that arise from the exercise of central bank independence. During this time, high interest rate policies designed to lower inflation were deeply unpopular both among elected leaders and the broad public. But the Federal Reserve was able to exercise its independence and pursue long-term goals which systematically reduced inflation and changed the psychology of the nation regarding its expectation about inflation’s path. As a result, the United States has had nearly three decades of low inflation.
Will Corrective Action Occur Before or After a Profound Crisis?
Unfortunately, nations often must experience a profound crisis to focus the government’s attention on taking corrective action. Usually it is at this point that governments reestablish fiscal discipline and renew their commitment to an independent central bank. Ironically, however, these generally are precisely the reforms that would have prevented a crisis in the first place. The only difference between countries that experience a fiscal crisis and those that don’t is the foresight to take corrective action before circumstance and markets harshly impose it upon them. In time, significant and permanent fiscal reforms must occur in the United States. I much prefer this be done well before anyone feels an irresistible impulse to knock on this central bank’s door.
The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.
Volcker: Euthanasia Rather Than Life Support for Failing Non-Banks
By Ravi Nagarajan
The Financial Times has published a five part video interview with Paul Volcker who is the head of President Obama’s Economic Recovery Advisory Board. Mr. Volcker discusses his proposed “Volcker Rule” which would limit the proprietary trading activities of commercial banks. For institutions such as Goldman Sachs that may wish to avoid the ban on proprietary trading, Mr. Volcker suggests that they will have to do so without the benefits of a commercial banking license:
“Don’t expect the support you would get from being a bank within the club of insured deposits and access to the Federal Reserve and all the loving attention you get as a bank organization.”
In addition, he characterizes the resolution process for non-banks as “euthanasia rather than life support” implying that regulators will have the authority to quickly take over and close down a non-bank in an orderly manner. While it is not clear whether the Volcker Rule will pass in its proposed form, Mr. Volcker’s views are now clearly influencing the President’s policy choices. This was not the case for much of 2009.
Click on the image below or on this link to view the first part of the interview. Additional segments of the interview are available on the Financial Times website.
The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.
Warren Buffett Interviews Former Treasury Secretary Paulson
By Ravi Nagarajan
In a wide ranging discussion this afternoon, Berkshire Hathaway Chairman and CEO Warren Buffett interviewed former Treasury Secretary Hank Paulson at the Greater Omaha Chamber of Commerce annual meeting in Omaha. The topics discussed ranged from insights in Mr. Paulson’s recently published book, On The Brink, as well as broader questions regarding the 2008 credit crisis, relations with China, and prospects for the United States economy going forward. While the tone of the interview was friendly, a number of important topics were covered in a candid manner. The video of the interview appears below.
If the above video fails to load, watch the interview here.
The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.
Can Forced Recapitalization Solve the “Too Big To Fail” Problem?
By Ravi Nagarajan
From the perspective of an outside observer, the debate over financial regulatory reform can seem like nothing more than the typical Beltway chatter full of shrill voices and political posturing. While the current debate is not free of the usual nonsense, it is important to note that the discussion has at least refocused on the “too big to fail” problem rather than fixating on consumer protection issues that consumed a great deal of time last year. There is nothing wrong with inquiries into whether credit card and overdraft fee regulations should be changed, but action in such areas will do nothing to prevent the next financial meltdown.
Bail Outs or Bail Ins?
One interesting proposal was recently presented by Paul Calello and Wilson Ervin in a guest article for The Economist. Mr. Calello is the head of Credit Suisse’s investment bank and Mr. Ervin is the former chief risk officer of Credit Suisse. The authors argue that regulators should not have to choose between massive taxpayer bailouts and the potential for a catastrophic systemic collapse. Instead, they argue that a rapid modification of a troubled firm’s capital structure can result in a “bail in” that reduces systemic risks and mitigates the need for taxpayer funded infusions. Such a bail in would require regulators to have sufficient power to wipe out common equity holders and recapitalize the financial institution by converting preferred shares and debt into equity.
A Rapid Form of Pre-Packaged Bankruptcy
The authors are actually proposing a very rapid form of pre-packaged bankruptcy since such restructurings are not uncommon in other industries. The problem with most negotiated recapitalizations is that the process can take a significant amount of time before all stakeholders agree to the terms. With a major financial institution, such time is simply not available since confidence in the franchise would be harmed beyond repair in a matter of days.
In order to make this approach work, regulators will need to have the power to dictate terms of the recapitalization over a very short period of time – most likely over a “marathon” weekend working around the clock. As a result, the process and terms of such a recapitalization would need to be known by all parties well ahead of time. Looking at it from this perspective, the approach is not much different from the “living wills” that some have suggested all financial institutions must set up ahead of any crisis.
A Treatment, Not a Cure
The idea of a regulator having the power to make massive changes to a financial institutions capital structure over a 48 hour period is enough to make free market advocates cringe. But if the alternative is to permit a massive systemic collapse of the financial system or to expose taxpayers to the costs of bailing out the banks, something like the “bail in” plan may be the best of several undesirable options.
From a free market perspective, the better approach is to examine ways to reduce the number of financial institutions that are too big to fail without creating systemic risks. While it is true that regulations would need to be imposed that limit the size and/or scope of activities the banks are permitted to engage in, these regulations would be of the “blocking” variety rather than the “micromanagement” variety. In other words, regulators would block banks from becoming systemically important but would otherwise leave management alone to run the business. Then managers and owners of the business can be left to determine the appropriate level of risk to accept without putting the taxpayer on the hook for cleaning up after a failure.
The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.
Former Fed Chairman Paul Volcker's "rule" for reigning in banks is already facing stiff opposition from financial institutions. The latter, of course, were one of the primary victims of loose financial regulation. Nonetheless, financial institutions are the ones most opposed to regulation. The underlying problem might be that financial institutions are not really acting in their long-term best interest. Rather, the senior executives of such institutions are working to maximize their personal upside in the next economic up-cycle, no matter the long-term consequences for shareholders of those companies.
Did Government's Q4 GDP Growth Estimate Overstate Reality?
By Ravi Nagarajan
While reviewing the Bureau of Economic Analysis (BEA) “advance estimate” of Q4 2009 GDP, it seems instructive to revisit the Q3 2009 “advance estimate” which was discussed here exactly three months ago. A quick review suggests that there is little point in treating preliminary reports too seriously due to significant inaccuracies which often result in subsequent revisions. While investors and politicians always fixate on the advance number, few outside the economics profession seem to pay much attention to subsequent revisions.
Q3 2009: 3.5% Estimate vs. 2.2% Reality
The advance GDP estimate for Q3 was 3.5% while the current estimate is 2.2%. This is obviously a very significant change. The BEA does not pretend that advance estimates are accurate. In each quarterly GDP release, the BEA publishes a table showing “vintage comparisons” between the advance estimates and subsequent revisions. From the advance estimate to the final figures, the average revision in Real GDP, without regard to sign, was 1.3% for estimates made between 1983 and 2006. This happens to be the difference between the advance estimate and latest revision for the Q3 GDP data.
Q4 Advance Estimate: 5.7% Growth
Since we know that subsequent revisions are likely, the advance estimate should be treated with some skepticism. Nevertheless, a quick review is still interesting. In addition to the data in the main release, the BEA has an interactive tool that can be used to generate tables such as the report shown below which breaks down the contributions to the percentage change in real GDP (click on the image for a larger view of the data):
From the table, one can quickly see that inventories accounted for the bulk of the growth in GDP for the quarter with a 3.39 percent contribution. Private business decreased inventories by $33.5 billion in the fourth quarter compared to a decrease of $139.2 billion in the third quarter. Real GDP measures production, not final sales, so changes in inventories can often have a major influence on reported GDP numbers. In this case, the decrease in the rate of inventory liquidation accounts for a major boost to GDP.
The report shows signs of weakness in other areas including anemic growth in personal consumption. Notably, final sales of domestic product (GDP less changes in private inventories) only increased 2.2 percent in the fourth quarter. Although this is a slight improvement over the 1.5 percent increase in final sales in the third quarter, growth is still quite slow. It appears that GDP growth in the first quarter may depend on whether companies decide to begin building inventories rather than only reducing the rate of inventory liquidation.
Pay More Attention to Revisions
While it is understandable for markets to react to the advance estimate, it is less obvious why revisions to the initial estimate attract little attention in comparison. To the extent that investors consider macro factors at all, which is itself a debatable practice, more attention should be given to the second and final revisions to GDP and less to the advance estimate which is only an “educated guess” based on incomplete data.
The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.
"The International Monetary Fund is forecasting positive growth in 2010; yet, it warns the pace of growth will be too sluggish to prevent further increases in unemployment across the global economy. What is the outlook for the global economy in 2010?"
Speakers: Josef Ackermann, Montek S. Ahluwalia, Dominique Strauss-Kahn, Lawrence H. Summers, Zhu Min, Martin Wolf, Yoshito Sengoku
Davos: Global Industry Outlook: Finance, Services and Media
"No industry is immune to the global, cyclical and structural changes reshaping the world economy. Chairs of the World Economic Forum Governors Meetings each share their industry's evaluation of the most important challenges and opportunities in 2010."
Speakers: Josef Ackermann, Hans-Paul Burkner, Colin Dyer, Eric Mindich, Jeff Zucker, Kevin Steinberg
Davos: After the Financial Crisis: Consequences and Lessons Learned
"The financial crisis has caused an economic crisis around the world. Drastic state measures have prevented the collapse of the economic system: governments have established rescue funds for failing banks or nationalized banks for relaunching economic growth. At the same time, central banks have intervened with important injections of liquidity and have lowered interest rates." (source: World Economic Forum)
Speakers: Ziya Akkurt, Christine Lagarde, Patrick Odier, Nikolaus Schneider, Joseph E. Stiglitz, Stephan Klapproth, Juan Somavia
"I'm pretty confident that Greece will do whatever is necessary to meet the conditions that the ECB sets," George Soros, chairman of Soros Fund Management, told CNBC in Davos Wednesday. "Germany is not in the mood to be the deep pocket," he added. (Source: CNBC)
"The result of extensive input throughout the previous year by experts from business, academia, and the public sector, Global Risks 2010 highlights a number of slow-moving risks exacerbated by the financial crisis and global economic downturn, and stresses the continued need to further enhance global resilience to risks. Global governance gaps, an issue already to the fore in Global Risks 2009, continues to be at the nexus of global risks and the need for coordinated global action is increasingly urgent."
Public Pension Funds Attempt “Hail Mary” With Leverage
By Ravi Nagarajan
In the late 1990s, pension funds decided that it would be a good idea to purchase stocks near the peak of the technology bubble. Strike one. In the mid 2000s, the idea was to join the private equity and hedge fund wave sweeping over Wall Street just in time for the 2008 financial crisis. Strike two. Now, The Wall Street Journal reports that public pension funds have decided to employ leverage in order to boost the low returns offered by bonds.
All of these moves have been made because the rate of return assumptions set by pension funds determines the perceived solvency of a system. Since defined benefit pension plans have fixed liabilities, the rate of return expected on plan assets can mean the difference between a fully funded plan and one that is insolvent and in need of major capital infusions. In the case of public pension funds where benefits are fixed by law, the problem is even more severe particularly given the current fiscal situation facing nearly all states due to falling tax receipts caused by the recession.
When In a Hole, First Stop Digging …
The Wall Street Journal article describes the motivation for employing leverage:
Wilshire Consulting, which advises pension funds on investments, says leverage helps the funds meet their long-term return targets without relying too heavily on volatile stocks, or tying up their money for long stretches in private investments. Low interest rates make it impossible to meet those targets with simple bond investments. Wilshire managing director Steven Foresti says he has been in discussions with about a half-dozen funds that are interested in the leverage strategy.
So having given up on investing in “volatile stocks” or in private investments, funds are now returning to the bedrock investment of choice for pension funds in the past: boring bonds. Yet, with interest rates at multi-decade lows, how are pension funds supposed to meet the return assumptions that make their systems seem marginally solvent?
Most big public pensions have expected annual rates of return between 7.5% and 8%. Wisconsin, for example, assumes 7.8%. Many analysts consider those return rates unrealistic. Yet pension funds are loath to change them because that would require local governments to get more money from taxpayers to compensate for lower projected returns. Even at an 8% return, the average public fund will have about 55% more in liabilities than in assets 15 years from now, due to recent losses and challenges in raising contribution rates, according to PricewaterhouseCoopers.
So we are at the point where the average pension fund is severely underfunded even with an 8% rate of return assumption. If pension funds wish to invest primarily in high quality bonds, they will need to trim this return assumption even further which would make the solvency of the typical pension system even more dismal than it already is. New Jersey’s dysfunctional system is a good case study of what awaits public pension systems across the country.
Reality Check Needed
It is very likely that the move to employ leverage is going to be “strike three” against the public pension plans. While there is a great deal of debate regarding prospects for inflation going forward, Warren Buffett’s views on the subject seem to make the most sense. Mr. Buffett believes that inflation is likely to pick up significantly in the future, even going as far as to discuss his concern over an “onslaught of inflation”.
If the bond market begins to price in the risk of higher inflation in the future, bond prices will decline significantly. The leverage employed by pension funds will then have the opposite effect of what plan managers are hoping for and bond losses will be magnified.
Maintaining the illusion of higher than achievable returns will do nothing to improve the pension funding situation and could cause great harm in two ways. First, leverage could magnify the losses experienced by the funds if inflation picks up in the coming years. Second, politicians will be emboldened to ignore the pension problem or even make it worse if actuarial projections show a rosier picture than can be justified by a sober attention to the facts and a prudent investment policy.
Roger Lowenstein has attempted to warn policymakers regarding this mistake in his book While America Agedwhich was reviewed here nearly a year ago. Unfortunately, Mr. Lowenstein’s warnings seem to have fallen on deaf ears.
The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.
Spitzer Rips Government Regulators, Says Bureaucrats Routinely Promoted Beyond 'Point of Incompetence'
It's a shame that former New York Governor Eliot Spitzer ruined his career the way he did, because he is one of the smartest guys we've had in government in a long time. Having someone like him sit on the sidelines while Tim Geithner leads Treasury is not good for the country.
Bloomberg: Siegel Sees Stocks Rising 10%-15%, Mid-Year `Correction'
The author of Stocks for the Long Run, Wharton professor Jeremy Siegel, "sees stocks rising 10%-15%, mid-year `Correction'," according to a Bloomberg interview (watch video). It's always interesting to see how irresistible pundits find the temptation to predict short-term market moves, even though they have no clue -- let us emphasize this: NO CLUE -- about where the market will go next. Stocks for the long run? Yes, but if you listen to me right now, you can make 10%-15% and then get out just in time for a mid-year correction.
Already the biggest auto market and steel maker, China edged past Germany in 2009 to become the top exporter, yet another sign of its rapid rise and the spread of economic power from West to East.
Total 2009 exports were more than $1.2 trillion, China's customs agency said Sunday. That was ahead of the 816 billion euros ($1.17 trillion) forecast for Germany by its foreign trade organization, BGA.
Perhaps the biggest surprise of this news to those who don't closely follow the rankings of the world's exporters may be the fact that China had not overtaken Germany much earlier. China's might as an export superpower has been writ large in the media for years, so much so that a relatively small nation such as Germany should have been left in the dust long ago. Yet, Germany's export strength has been known for decades, and the latest news simply serves as a reminder that there are export nations other than China that are also crucial to world trade. Japan, of course, is one such nation, as are some of the emerging Asian countries, such as Taiwan and Korea.
An Entertaining Commentary on Natural Gas Economics
By Ravi Nagarajan
With Exxon’s planned acquisition of XTO Energy, investor interest in natural gas has increased and many observers are also excited about the possibilities for substituting gas for crude oil based fuels to save money as well as reduce greenhouse gas emissions. Exxon’s move into natural gas is also a big bet on the economic viability of exploiting shale deposits which can be more expensive to extract compared to traditional wells.
For an entertaining commentary on natural gas economics, we recommend viewing a presentation made on January 7 by Contango Oil & Gas Company Chairman and CEO Kenneth Peak. Although the presentation is not a comprehensive introduction to natural gas economics, Mr. Peak provides his thoughts on the industry and talks about his company’s activities in the field.
Click on the image below or on this link to view the 23 minute presentation (registration required).
The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.
The author owns shares of Contango Oil & Gas Company.
The Economist: Will London Lose Financial Center Status?
Interesting article in a recent issue of The Economist:
AT THE start of the 1960s London’s status as a financial centre was in gentle decline, reflecting Britain’s waning importance in the global economy. Then the American government helpfully imposed Regulation Q and the Interest Equalisation Tax, two measures that encouraged investors to hold a lot of their dollars offshore. London became the centre of the so-called Euromarket, attracting more international banks than New York.
Despite its terrible weather and creaking transport infrastructure, London has continued to punch above Britain’s economic weight as a financial centre. The city built up critical mass in legal, accounting and fund-management expertise, and big American investment banks such as Goldman Sachs steadily increased their presence. London is not just Europe’s dominant financial hub (see chart). Before the credit crunch, talk that London would replace New York as the world’s financial centre was commonplace.
That claim sounds rather hollow now, thanks to a change in the political and regulatory climate. “London’s position as a financial centre is now threatened,” says Robin Bowie of Dexion Capital, which runs a listed fund-of-hedge-funds group. A special levy on bankers’ bonuses announced earlier this month has come on top of a forthcoming 50% tax rate on high earners, a charge on the worldwide earnings of expats living in Britain (also known as “non-doms”), pension rules that create marginal tax rates of over 100% and some unfriendly words from Adair Turner, the head of Britain’s financial regulator.
A poll of Bloomberg subscribers in October found that Britain had dropped behind Singapore into third place as the city most likely to be the best financial hub two years from now. A survey of executives this month by Eversheds, a law firm, found that Shanghai could overtake London within the next ten years.
Why Buffett Refuses to Write Kraft 'Blank Check' in Cadbury Bid
By Ravi Nagarajan
In September, we speculated that Warren Buffett might be less than thrilled with the terms of Kraft’s bid for Cadbury. In particular, his comments at the time indicated that he was hesitant to use Kraft’s “undervalued” stock as currency for the transaction. It appears that Mr. Buffett is growing increasingly concerned about the judgment of Kraft’s management as the “animal spirits” so often associated with expensive acquisitions intensify ahead of the January 19 deadline for Kraft to finalize the terms of the Cadbury bid.
In a press release issued by Berkshire Hathaway this morning, Kraft management is criticized for seeking a “blank check” which will allow the company to issue up to 370 million shares in order to facilitate an offer for Cadbury. The press release refers to Kraft’s proxy statement for a special meeting set for February 1 seeking approval for issuance of up to 370 million shares.
It is unusual for Warren Buffett to publicly criticize the management of companies in which Berkshire holds minority positions. Let’s look at a couple of excerpts from the press release:
The share-issuance proposal, if enacted, will give Kraft a blank check allowing it to change its offer to Cadbury – in any way it wishes – from the transaction presented to shareholders in the proxy statement. And we worry very much that, indeed, there will be an additional change from the revision announced this morning. To state the matter simply, a shareholder voting “yes” today is authorizing a huge transaction without knowing its cost or the means of payment.
The tone of the statement is revealing in that is reveals a lack of confidence in management to protect shareholder interests and profound dissatisfaction with the slightly sweetened terms of Kraft’s offer for Cadbury which were announced this morning (click on this link for coverage in the Wall Street Journal).
The press release goes on to criticize Kraft management for being so willing to issue shares at $27 (or lower) when the company repurchased shares at a higher price in 2007:
What we know with certainty, however, is that Kraft stock, at its current price of $27, is a very expensive “currency” to be used in an acquisition. In 2007, in fact, Kraft spent $3.6 billion to repurchase shares at about $33 per share, presumably because the directors and management thought the shares to be worth more.
Does the board now believe those purchases were a mistake and that Kraft’s true value is only the current price of $27 per share – and that it is therefore fine to structure a major acquisition based upon that price? Would the directors use stock as merger currency if the price were, say, $20 per share? Surely the true business value of what is given is as important as the true business value of what is received when an acquisition is being evaluated. We hope all shareholders will use this yardstick in deciding how to vote.
Here we see the familiar standard that Mr. Buffett has long used to measure whether using stock in an acquisition makes sense for the acquirer: As much business value must be received as the company is giving up in the share issue. This does not mean that Kraft cannot use “undervalued” shares to purchase another company, but the target company must be at least as “undervalued” as Kraft if stock is employed in the transaction.
While the press release keeps open the possibility that Berkshire may change its vote to “yes” if the terms of Kraft’s final offer for Cadbury (due by January 19) are acceptable, today’s press release clearly is intended to send a message to Kraft’s management and board. Perhaps the most amazing aspect of today’s drama is that Kraft CEO Irene Rosenfeld either did not consult with her biggest shareholder in advance or knew of Mr. Buffett’s opposition and went ahead regardless. In either case, Mr. Buffett’s reason to criticize management in a very public way seems very justified.
The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.
Book Review: Lessons From Andrew Ross Sorkin’s “Too Big To Fail”
By Ravi Nagarajan
Most outside observers had difficulty keeping up with the momentous events of the weekend of September 14-15, 2008 with all of the twists and turns that finally led to Lehman Brothers’ historic bankruptcy filing, Bank of America’s purchase of Merrill Lynch, and AIG’s bailout only a few days later. Ever since that tumultuous period, there has been a need for a comprehensive book covering the behind the scenes events. Andrew Ross Sorkin’s Too Big To Fail has succeeded in delivering exactly what is needed to gain a better understanding of these historic events.
If newspapers are the “first draft of history”, Andrew Ross Sorkin played a major role with his New York Times coverage of the financial crisis in 2008. Although Mr. Sorkin is only 32 years old, he has obviously been able to build up a massive network of contacts on Wall Street and in Washington. Mr. Sorkin’s coverage spans the timeframe from the failure of Bear Stearns up to the passage of the TARP legislation, but the narrative really shines when it comes to the events of a September weekend when the financial system came much closer to total collapse than anyone on the outside could have realized at the time.
Mr. Sorkin’s book has received a great deal of media attention and book reviews, but there is also a need to step back and think about the lessons that must be learned if future crises are to be avoided. The inability of Washington to come to any agreements on financial system reform was a significant failure in 2009, but one that received little attention outside the financial press. With each passing week of relative “calm”, chances grow greater than another crisis may be required to prompt reforms.
Greed and Fear
The old adage that a balance between greed and fear creates equilibrium on Wall Street seems hopelessly out of date in light of the revelations in this book. In the “text book world”, investors and other players in a market system need to be driven by the profit motive (“greed”) but decisions are tempered by a desire for safety (“fear”). For many decades on Wall Street, the partnership model in investment banking seemed to keep the level of risk aversion high enough to prevent overreaching (for a great book on the old model at Goldman Sachs, for example, see Charles D. Ellis’ The Partnership).
One can argue that many leading Wall Street players lost huge sums of money in the 2008 crash, so the absence of more “fear” in the system cannot be explained merely by a change in the ownership models of the investment banks. Indeed, an absence of adequate levels of risk aversion extended to Main Street and Washington as well. Rep. Barney Frank’s famous declaration in favor of “rolling the dice” with softer underwriting standards for mortgage lending as well as the reckless disregard of financial prudence by many subprime borrowers cannot be ignored.
False Illusions and Egos
From the outside looking in, Wall Street and Washington are populated by highly confident, assertive, and competent individuals who seem equipped to carry out their responsibilities in a capable manner. While there are many individuals who fit this description well, some of whom appear in Mr. Sorkin’s book, many others appear to suffer from the human defects that affect everyone else. At several points in the book, we can see cases where ego prevented otherwise intelligent actions from being taken.
For example, why did Lehman Brothers’ CEO Dick Fuld, shocking even his own team, attempt to abruptly change the terms of a nearly sealed deal with Korea Development Bank in early August that would have valued Lehman at a premium and likely saved the firm? Was it a matter of seeking better terms for his shareholders, a question of ego, or confidence that a government bailout would be a backstop if all else failed?
There are countless other situations in the book where the reader, with the benefit of hindsight, asks: Why?
Government Saviors?
Government players hardly come out of the story looking like heroes either, with the possible exception of Treasury Secretary Hank Paulson who had the unenviable task of coming up with solutions for the crisis without appearing to favor a bailout of his former colleagues at Goldman Sachs. Throughout Mr. Sorkin’s account of the events, it becomes quite apparent that helping Goldman was probably the last thing on Mr. Paulson’s mind.
Timothy Geithner, the current Treasury Secretary, was President of the Federal Reserve Bank of New York during the crisis. Mr. Geithner comes across as the main deal maker for the Fed while Chairman Ben Bernanke takes a much lower profile role. While there is no doubt that Mr. Geithner played a critical role, he often comes across as authoritarian in terms of his tactics. For example, at several points, he makes threats or orders bank CEOs to take action during meetings and simply leaves the room asking to be notified when a solution is in place. Whether this was necessary or not during these remarkable times is an open question, but this is not how we should want government officials to behave in normal times.
President Bush hardly appears in the narrative and seems quite detached in the few occasions where he is being briefed on the crisis. For all practical purposes, Secretary Paulson was calling the shots for the Executive branch of the Federal Government throughout this process. Sen. Barack Obama made a few appearances in the book (as well as on Secretary Paulson’s calendar) but Sen. John McCain hardly appears at all which is surprising given that he famously suspended his campaign in order to return to Washington and work on a solution for the crisis.
Financial Regulatory Reform
One of the interesting aspects of the book is the degree to which government officials pushed to “marry” commercial banks and investment banks during the height of the crisis in September. It seems like every possible permutation was considered, to the point where Mr. Geithner was referred to mockingly as “E Harmony” in a reference to the online dating site. At the same time, many in government blame the 1999 repeal of the Glass-Steagall Act, which prohibited the union of commercial and investment banks, for precipitating the crisis.
While the idea of giving investment banks access to stable deposits through commercial banks had a great deal of merit during the crisis, such mergers also created ever larger institutions, many of which are considered “too big to fail”. It seems that society must decide which is the lesser of two evils: Government regulations that seek to keep financial institutions small such that none can become “too big to fail” or heavy handed regulations that properly govern mammoth institutions that are obviously “too big to fail”.
Wall Street: Pick Your Regulatory “Poison”
Wall Street cannot have it both ways: If regulations are repealed that then allow financial institutions to grow so large that a failure would have systemic impacts, then regulations governing the conduct of these institutions is essential to avoid future crises from developing. On the other hand, if we accept regulations that prohibit mergers that will result in massive institutions, Wall Street firms should have more flexibility to conduct their ongoing affairs without as much regulatory scrutiny since the failure of any one institution will not be systemically important.
It seems preferable to have “blocking” regulations such as Glass-Steagall rather than “operational” regulations required to govern massive financial institutions that are of systemic importance. A “blocking” regulation is not as intrusive into the day to day operation of firms and is less likely to throw sand in the gears of capitalism. In contrast, the regulatory regime required to monitor massive systemically important institutions will, of necessity, be intrusive and bureaucratic.
“Too Big To Fail: The Sequel”?
There are many potential solutions that should lead to a more stable financial system going forward, but each passing week makes it less likely that reforms will be made. As the economy recovers and “business as usual” returns to Wall Street, the seeds are now being planted for the next crisis. While no doubt capable of the task, we should hope that Mr. Sorkin does not have the opportunity to write a sequel to Too Big To Fail. The consequences could be even more severe.
The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.
Inflation Debate Continues -- Should You Have a Sense of Urgency?
Whitney Tilson and Glenn Tongue summarize the inflation theses of several prominent investors in a new Washington Post article. We agree that investors should have some sense of urgency about thinking through appropriate inflation hedges even if not implementing such hedges immediately. Here is an interesting excerpt from the article:
The debate over gold, considered an excellent inflation hedge by some, is equally lively. Top investors, such as Paulson & Co.'s John Paulson and Greenlight Capital's David Einhorn, placed big bets on gold in 2009. Einhorn explained his rationale at the recent Value Investing Congress: "Gold does well when monetary and fiscal policies are poor and does poorly when they appear sensible. Prospectively, gold should do fine unless our leaders implement much greater fiscal and monetary restraint than appears likely."
At the same conference, Bill Ackman of Pershing Square Capital Management said he avoids gold because it is "a greater-fool investment." In other words, making money on the yellow metal is less a function of a rise in its fundamental value and more a function of finding someone who is willing to pay you more for it. Tiger's Robertson describes his aversion to gold similarly: "It's less a supply-demand situation and more a psychological one -- better a psychiatrist to invest in gold than me."
Famed value investor Robert Rodriguez of First Pacific Advisors is taking a one-year sabbatical. In his final fund commentary, Rodriguez pulls no punches on the government's deficit spending:
One final thought that brings me to the intensifying issue that we have written about several times before — the explosion in Treasury debt outstanding. Since September 30, 2008, Treasury debt has risen from $10 trillion to $11.9 trillion, a rate of $5 billion per day. There is no end in sight for this out of control debt growth, as reflected by federal government deficit forecasts, which we consider optimistic, that total between $7 and $9 trillion for the period 2010 to 2019. In our March 2009 Letter to Shareholders, we estimated that US Treasury debt would swell to between $14.6 trillion and $16.6 trillion by the end of 2011. If we stay on this present trend, we should reach this range which, in our opinion, is outrageous and fiscally irresponsible. This insanity is not a Democratic Party or a Republican Party "thing." Both parties are responsible, but who is ultimately more responsible than these two parties? It is we, the citizens, who keep re-electing these power-centered financially inept politicians and it will be our children and grandchildren who will have to "pay the piper." It is not right and is morally reprehensible that one generation would do this to another.
Our country is currently in this financial mess because consumers, corporations and government succumbed to the temptations of excessive spending, debt growth and risk taking. Just as any family or company can get into trouble with too much debt, so can a state or country. California is a perfect example of a state government that has been devoid of economic reality and totally irresponsible in its finances, with spending far exceeding revenue growth for years. Our federal government also exemplifies this unsound and unwise trend. Before new expenditure programs are created and laid upon preexisting ones, we should be demanding that federal, state and local governments get spending under control first. We cannot trust most politicians because they practice "bait and switch" tactics in proposing new programs. The true long-term program costs are always understated because new benefits are added subsequently that were not included in the original optimistic cost estimates — Social Security, Medicare and Medicaid are perfect examples of this process, and the proposed new health care spending program, if passed, will likely follow this same course.
As a beginning, no new programs should be created until others have been eliminated to offset these costs in the year of origination. We should have government prove to us first that this new budgetary balance can be achieved and maintained. Once at approximate equilibrium, we can begin to focus on debt reduction through the process of expenditures growing at less than the rate of revenue growth. Most families know that before they can regain control of their finances, they first have to control their spending. If our elected officials cannot agree to meet this principle of fiscal discipline and be held accountable to it immediately, they should be ousted from office. Most of our current elected representatives would fail this test. As is the case with any company or family that does not deal with its pre-existing debt first, and then proceeds to take on additional debt beyond its means to pay, foreclosure or possibly bankruptcy will likely result. The same goes for a country, unless it can continue issuing debt denominated in its own currency. In this case, it can expunge its debt through the process of printing money and, thus, it can create a monetary inflation that destroys the purchasing power of previously issued debt. Our lenders will not stand for this and current trends show that foreign central banks are beginning to shift their holdings from Treasury notes and bonds to much shorter term Treasury bills. This is an ominous trend. At FPA, we began this process several years ago in our fixed income management accounts.
Interesting analysis from the Pew Center On The States:
California’s financial problems are in a league of their own. But the same pressures that drove the Golden State toward fiscal disaster are wreaking havoc in a number of states, with potentially damaging consequences for the entire country.
This examination by the Pew Center on the States looks closely at nine states, in addition to California, that are particularly affected by the recession. All of California’s neighbors–Arizona, Nevada and Oregon–and fellow Sun Belt state Florida were severely hit by the bursting housing bubble, landing them on Pew’s list of states facing fiscal difficulties similar to California’s. A Midwestern cluster of states comprising Illinois, Michigan and Wisconsin emerged, too, as did the Northeastern states of New Jersey and Rhode Island.
"Beyond California: States in Fiscal Peril" makes clear that the recession severely impacted states from different geographic regions with different types of economies, tax structures and political leanings.
Updated 11/19/09—The Pew Center on the States hosted a briefing on November 13 with officials from California and Michigan following the release of "Beyond California: States in Fiscal Peril." View video clips and listen to the full audio from the event.
The Pew Center on the States compiled its list by scoring all 50 states according to six measurable factors that contributed to California’s ongoing fiscal woes, using the best available data as of July 31, 2009. The state profiles in this report go beyond the data to give a fuller picture of the recession’s deep and pervasive effects on states’ financial and economic well-being.
Robert Huebscher has posted part two of his interview with Columbia Business School professor Bruce Greenwald, author of Value Investing and Globalization.
Read part one and part two of the interview with Bruce Greenwald.
Edelheit on the Perils of Holding Cash -- U.S. Dollars, To Be Specific
Respected investment manager Aaron Edelheit of Sabre Value writes the following on his blog:
The Treasury Department and the Federal Reserve with help from Congress and the White House is making something very, very clear. They are going to devalue the American dollar through the printing of money, maintaining excessively low interest rates and out of control government spending.
If you are sitting on excess cash and that cash is in US Dollars, I feel like you have been warned. Those dollars will be worth substantially less in the future than they are now.
The Federal Reserve has communicated loud and clear they are going to keep interest rates low for an “extended time.” By keeping interest rates artificially low they are trying to recapitalize the financial system, but in the process are punishing savers who are earning little or no interest returns on their money. By keeping interest rates so low, they are actively trying to re-inflate the economy and prices, as they are worried about deflation. They are also keeping interest rates lower than other countries, thereby causing other countries currencies to increase in value.
More importantly, the Federal Reserve is doing something called “Quantitative Easing.” This made up term, means money printing. The Federal Reserve is quite simply buying the new debt that the Treasury Department is issuing. In fact, in the second quarter of this year, the Federal Reserve bought as much as half of all new Treasury Bonds issued. Think about that for a second. The government is buying half of the debt that the government issues. Does that sound absurd?
Treasury bond issuance is up 200% this year as the government posts close to a $1.5 trillion annual deficit. So, here is a dumb question. If the Federal Reserve is buying half of all new Treasury bonds, what happens when they stop? They claim they are going to stop in the first quarter of next year.
I don’t think the Federal Reserve can stop buying. The moment they stop buying interest rates will soar and bond prices will plunge, which will make our debt problem even worse. Money printing will go on for a while, and it will destroy the dollar. In a cynical way it also makes all of us feel better in the short run. We export more in the short run with a cheaper currency, our debts our lower and stocks, real estate and other real things start going up in price. And what better way to pay for all of the government debt, than to devalue that debt?
But in the long run, this is disastrous and it always ends badly. Even worse is to look at the White House and Congress. Beyond the Fed’s money printing, we have out of control spending by Congress. The projected US deficit for 2009 through 2019 is $9 Trillion. Who in the world is going to finance that debt? Where is that money going to come from?
A recent study by Peter Bernholz showed that the 12 largest hyperinflationary episodes in history all reached a tipping point when government expenditures were more than 40% of GDP. Well, the US government is over 40% this year and is projected at 40% next year.
The evidence of massive money printing is already popping up. Look at the price of precious metals, such as gold, which is soaring. Throughout history gold has been a monetary substitute and it becomes very valuable when governments become reckless with money printing and spending.
Better yet, look at the stock market or other commodities. I think we see the clearest evidence of the money the Fed is printing flowing into the markets. The stock market is quite expensive; the economy has been terrible, yet it continues to rise. I think that is why it is quite dangerous to short right now. The market may keep going up simply because there are more dollars floating around out there.
So what is my firm, Sabre Value, doing about the devaluation of the dollar?
Reed Apologizes For Creating Citigroup, Says Glass-Steagall Should Not Have Been Repealed
Bloomberg has an interesting article quoting John Reed, the man who was at the helm of commercial bank Citicorp when it merged with Sandy Weill's Travelers Group in 1998, creating the ill-fated behemoth Citigroup (C).
One of the most striking revelations in the article is Reed's admission that the repeal of Glass-Steagal should never have happened. Reed, of course, advocated for the repeal in 1999. Says Reed now, "When you're running a company, you do what you think is right for the stockholders. Right now I’m looking at this as a citizen."
Should corporate executives always look at big decisions as citizens first and as shareholders second? That might be a nice outcome for society, but it is neither possible nor is it necessary. If senior executives thought about what was right for shareholders, we might not have the kind of crisis we have had recently. The problem is that executives did not think about what was right for shareholders. Instead, they thought about what was right for their own bonus compensation in any given year. If Reed had done the right thing for Citigroup shareholders with respect to Glass-Steagall in 1999, he would have opposed the repeal. The latter has not exactly benefited Citigroup shareholders over the past ten years.
Want Proof That Market Experts Have No Clue? Watch Luis Rukeyser's Program One Week Before Crash of 1987
Note the authoritative-looking set of the Rukeyser show. Everything and everybody on the set seems so polished and proper, yet it's all just a show. It's easy to see the folly of these kinds of programs when we look at them far removed in time. Yet, almost everything we watch on business television these days is no more useful than this Rukeyser show of 1987:
In an interview with Consuelo Mack's WealthTrack, James Grant, editor of Grant's Interest Rate Observer, opines on U.S. markets, Fed policies and gold as an investment.
Jeremy Grantham: Just Deserts and Markets Being Silly Again
GMO's Jeremy Grantham provides high market outlook in a recently published quarterly letter. Excerpt:
The idea behind my forecast six months ago was that regardless of the fundamentals, there would be a sharp rally. After a very large decline and a period of somewhat blind panic, it is simply the nature of the beast. [...]
Today there has been so much more varied encouragement for a rally than existed in 1930. The higher prices preceding this crash (that were far above both trend and fair value) had lasted for many years; from 1996 through 2001 and from 2003 through mid-2008. This time, we also saw history’s greatest stimulus program, desperate bailouts, and clear promises of years of low rates. As mentioned six months ago, in the third year of the Presidential Cycle, a tiny fraction of the current level of moral hazard and easy money has done its typically great job of driving equity markets and speculation higher. In total, therefore, it should be no surprise to historians that this rally has handsomely beaten 46%, and would probably have done so whether the actual economic recovery was deemed a pleasant surprise or not. Looking at previous “last hurrahs,” it should also have been expected that any rally this time would be tilted toward risk-taking and, the more stimulus and moral hazard, the bigger the tilt. I must say, though, that I never expected such an extreme tilt to risk-taking: it’s practically a cliff! Never mess with the Fed, I guess. Although, looking at the record, these dramatic short-term resuscitations do seem to breed severe problems down the road. So, probably, we will continue to live in exciting times, which is not all bad in our business.
Simoleon Sense has a great post featuring several videos from The Economist's recent Buttonwood Gathering. Among the speakers was President Obama's economic advisor Larry Summers.
Very good interview with the CEO of Morgan Stanley, but be sure to watch the very end in which he confirms to CNBC that he told then NY Fed Chairman, and now Treasury Secretary Tim Geithner to go “$@%@% himself.”
Most value investors tend to avoid the use of leverage in their portfolios due to the old saying: “The market can stay irrational longer than you can stay solvent.” An investor can be entirely correct about his or her investment choices but the market may fail to recognize this before ruinous margin calls result in forced asset sales at depressed values. While there are many successful hedge fund managers who skillfully employ leverage and engage in short selling, most individual investors should stay far away from such strategies.
In light of this general conservatism on the part of value investors, an article suggesting the use of mortgage debt to improve investment results may seem a bit odd. In most circumstances, my view is that investors should not only avoid leverage through margin accounts but should also attempt to be free of all forms of personal debt. Excessive debt obviously played a large part in the real estate meltdown and has ruined the finances of many families. Nevertheless, opportunities now exist for intelligent use of mortgage debt for certain individuals.
When Uncle Sam Offers Subsidies … Take It
Mortgage debt has long been heavily subsidized by the Federal Government through income tax deductions for mortgage interest. However, that is only the beginning of the story when it comes to government interventions in the mortgage market today. The government now controls Fannie Mae and Freddie Mac and over the past year has implemented numerous programs to directly and indirectly subsidize mortgages. Most notably, the Federal Reserve has accumulated over $800 billion of mortgage related securities, an action that many believe prevented the mortgage market from grinding to a halt entirely.
The combined result of government actions in the mortgage market has resulted in very low interest rates on fixed rate mortgages for those who have sufficient equity in their homes. In many cases, borrowers have been able to secure fifteen year fixed rate mortgages in the low 4% range and thirty year fixed rate mortgages below 5%. The effective cost of these mortgage loans are further reduced by the interest deduction/subsidy.
Safe Leverage and Inflation Protection
Obviously, mortgage debt should only be used to the extent that it can be safely serviced without any risk of financial distress. Also, mortgage debt should not be used on properties that may have to be sold over the next five to ten years. Once these conditions are satisfied, two major advantages emerge. First, the investor has access to cheap financing for funds that can be deployed to long term value investments. At an after-tax cost of funds below 4% in many cases, it does not require heroic returns to adequately cover the expense. Furthermore, there are no margin calls associated with this form of leverage. As long as debt service payments are made, no default will occur. The investor will not be forced to liquidate holdings that are temporarily depressed to meet any margin calls. Additionally, the long term nature of the debt (fifteen to thirty years) matches the long term investment horizon that most value investors have.
The additional advantage in today’s environment is that mortgage debt provides an excellent hedge against inflation. While there is debate today regarding whether inflation will emerge, the market for commodities and foreign currencies is painting a negative picture for prospects of the US Dollar going forward. Foreigners are growing increasingly uncomfortable with holding dollar denominated assets. The Federal Government is piling up debt at unprecedented rates and the risk that politicians will attempt to monetize this debt in the future cannot be ignored.
To hedge against these concerns, many investors choose risky approaches such as speculating in commodities, shorting treasuries or participating in exchange traded funds employing an array of strategies. However, the presence of low fixed rate mortgage debt on an investor’s personal balance sheet is a natural inflation hedge. The pre-payment features of most mortgage loans also provides protection if inflation does not emerge. The borrower can always pay off the loan at any time, usually without penalty.
Value investors tend to focus on individual companies when making investment decisions and do not spend significant time on macroeconomic forecasts. While this is generally a wise approach, when a simple and low risk hedge against a growing macroeconomic risk is available, it seems intelligent to take advantage of it. While leveraging mortgage debt as an inflation hedge will not provide complete protection for most investors, it can be part of an overall strategy to mitigate the impact of potential inflation in the future.
The author of this post, Ravi Nagarajan, is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.
Bass: We are "in the midst of a once-in-a-lifetime (literally) economic shift"
Hayman Capital's latest letter to investors includes the always-illuminating macro commentary of Kyle Bass. We consider this a must-read for investors seeking an informed perspective on the state of global finance and economics.
We generally agree with those who argue that U.S. currency debasement will lead to depreciation in the U.S. dollar and accelerating inflation, making gold a good investment, at least in nominal terms. However, it is always important to consider opposing views, so here is a bearish perspective on gold, put forth by Sajid Karsan:
Not long ago, major media outlets would post daily articles reporting the price of oil and how demand is far exceeding supply. Not long before that, these same outlets were saying things like "they're not making any more land" as housing prices rose through the roof. A few years before that, the rising stock prices of technology companies were making daily headlines as the stock market had entered what was claimed to be a "new paradigm shift, where traditional methods of valuation no longer apply". Today, it's the price of gold that is the talk of the town.
Why does the topic of gold garner so much interest today from major media outlets and bloggers alike? Because so many readers are interested (thus generating traffic), and the readers are likely interested because they own gold themselves. Indeed, demand for this asset has risen to such an extent that the price of gold now flirts with its all-time high:
Does this represent an asset bubble? To answer that, we must try to determine the intrinsic value of gold. The intrinsic value of any investment is the sum of the discounted future cash flows the investment will generate. Unlike a bond or a stock, however, there is no future cash flow expected from a bar of gold. In effect, the only reason one would purchase it as an investment is because one believes someone else will be willing to pay even more for it in the future.
Paolo Pellegrini, the man who made billions for John Paulson by betting on a decline in the housing market, comments on the outlook for the economy and equities.
Nagarajan: Persistent Job Losses Paint a Grim Picture for Recovery in 2010
By Ravi Nagarajan
There is certainly no shortage of commentary on the unemployment statistics that come out every month and most value investors do not make investment decisions based on macroeconomic factors alone. In general, it is always a good time to invest when securities can be found that provide solid return potential and have a large margin of safety. But does this mean that value investors should just ignore today’s Employment Situation Summary from the Bureau of Labor Statistics (BLS)?
At the risk of looking foolish several months or a year from now, I will go out on a limb and say that “this time it’s different” when it comes to assuming that earnings will bounce back to pre-recession levels very quickly. While investing based on macroeconomic forecasts is generally not recommended, bottom up analysis of a business often requires assumptions to be made regarding earnings power. Many value investors look at five or ten year average earnings to assess long term earnings power, but if the last several years represent an aberration, this could be a recipe for overpaying for stocks.
No Green Shoots in Employment
The speed of the job losses over the past year has been unprecedented in post-war history. This chart provided by the BLS shows the one month net change in employment for the past ten years and can be adjusted to provide even more history. The rate of job losses peaked at 741,000 in January 2009 but has remained at very high levels since then. In fact, the 263,000 jobs lost in September is higher than all but two of the months of the 2001-2002 recession (October and November 2001 in the immediate aftermath of 9/11). If it was not for the extreme severity of the economic downturn that followed the financial system meltdown in late 2008, we would still consider the current environment to be a very deep recession.
If we are indeed at a similar point today to the economic conditions prevailing toward the end of 2001, we should not expect any quick snap back in employment. That period was followed by more than eighteen months of continued job losses, with a few months of positive results, before the employment recovery began in earnest in late 2003.
While it is true that previous post-war recessions had quicker employment recoveries, the current situation is more like the 2001-2002 recession in terms of the overall structure of the economy. In many prior recessions, manufacturing was a much larger percentage of the civilian labor force than it is today and when factories restarted production, employment quickly recovered. Services and other non manufacturing occupations are more common today as a percentage of overall employment and there are many more opportunities for outsourcing than in the past. As even President Obama has stated, many of the lost manufacturing jobs will never come back.
Consumer Spending
The fact that consumer spending accounts for nearly 70 percent of Gross Domestic Product is well known and government policies have attempted to boost such spending. The most notable attempt was the cash-for-clunkers program which now appears to have mainly succeeded in accelerating automobile purchases from September into August. With savings rates still at very low levels and unemployment rates near double digits, consumers are unlikely to trigger a recovery.
From a value investing perspective, what all of this means is that maximum skepticism must be applied to the historical earnings of any business that is exposed to discretionary consumer spending. It will be tempting to spot “bargains” by looking at 2005 to 2008 earnings and thinking that stocks are cheap based on such “normalized” numbers. However, there is simply no reason to believe that 2010 will bring about a return to the spending habits of the boom years which were fueled by ever increasing home equity balances and a bubble mentality.
It does not seem inconsistent with a value investing philosophy to be aware of this reality and to conduct bottom up fundamental analysis with a skeptical eye toward historical earnings.
The author of this post, Ravi Nagarajan, is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.
Former Federal Reserve Chairman Paul Volcker speaks with Charlie Rose in this September 29th interview. Volcker famously broke the back of inflation in the early 1980s by raising interest rates.
While Volcker has been appointed an adviser by the Obama Administration, it seems that government policy makers have essentially pushed Volcker aside. His advice, as always, is to take the bitter medicine now and heal the proverbial patient. Instead, it seems that Washington and Wall Street once again prefer a quick fix, which really is no fix at all. The next crisis, whether it's a U.S. dollar or government funding crisis, may well make the recent financial crisis seem small.
Well-known bear David Rosenberg, chief economist at Gluskin Sheff, spells out a cautious view on equities in an editorial in the Financial Times. Writes Rosenberg,
"...what if the stock market were pricing in the same 2 per cent growth rate the corporate bond market is discounting? Answer: 842 on the S&P 500. So, if you’re asking us if we think we will see a 20 per cent correction in equities, the answer is Yes. Sure, there could be another 100 points left in the S&P 500 from here to the upside in the near term, but it is seldom wise to chase an overvalued market to the top unless you are gifted enough to know when to call it quits."
James Grant's Economic Outlook: Unorthodox, But Is It Correct?
James Grant, editor of Grant's Interest Rate Observer, argues in a Wall Street Journal editorial that the economic recovery is likely to surprise — on the upside. Grant invokes historical experience in making the point that "the deeper the slump, the zippier the recovery." He cites economist Michael Darda's research, which shows that "the last time a recession ravaged the labor market as badly as this one has, the years were 1957-58 — after which, payrolls climbed by a hefty 4.5% in the first year of an ensuing 24-month expansion."
Grant also notes that "[t]his time out, the fiscal stimulus is likely to measure 10% of GDP, monetary stimulus 9.5% of GDP, for a combined pick-me-up equivalent to 19.5% of GDP." This represents unprecedented stimulus, introducing a wild card into attempts at forecasting the economy. We reckon that if the government wants to revive the economy, it can do so with the sheer determination to print and spend money. "Print and spend" may indeed be the new "tax and spend." The consequences of this behavior could be more dangerous than than slump we have gone through over the past year or so.
In Grant's words, "by driving money market interest rates to zero and by setting all-time American records in money-printing ($1.2 trillion conjured in the past 12 months), the Fed is putting the value of the dollar at risk. Its wide-open policy all but begs our foreign creditors to ask the fatal question, What is the dollar, anyway? Why, the dollar is a scrap of paper, or an electronic impulse, the value of which is anchored by the analytical acuity of the monetary bureaucracy that failed to predict the greatest financial crackup since the 1930s."
While we agree on most of Grant's points, we take issue with one assertion: Grant writes that a "1920-21 crackup [in the U.S. economy] featured a deflationary collapse — wholesale prices plunged by 37% — and, by 21st century lights, a highly unconventional set of government measures to set things right. To meet the downturn, the Fed raised, not lowered, interest rates and Congress balanced the budget — indeed, ran a surplus. Yet the depression ended. How, exactly, did it end? Falling prices opened wallets, the monetary historian Allan H. Meltzer explains." We take issue with the view that deflation aids consumer spending by helping individuals find more "bargains." On the contrary, deflation generally makes people save more, as they predict that they'll be able to buy goods more cheaply in the future. Meanwhile, an inflationary environment makes people spend today, as the prices of goods are expected to rise while the purchasing power of paper money declines.
In any case, Jim Grant is usually worth listening to, and it's no different in this case.
Stiglitz: Financial System Not Fixed One Year After Lehman Collapse (video)
Economics Nobel laureate Joseph Stiglitz heaps criticism on regulators and the Fed in an interview with Bloomberg. Stiglitz argues that financial institutions remain too powerful, so much so that necessary regulations may not be politically feasible.
At the outset of the interview, Stiglitz comments briefly on the topic of using GPD growth as the key measure of societal and economic progress. This is an interesting topic that is not adequately covered in the interview but deserves consideration by all of us. Surely, we do not measure progress or happiness on an individual level solely by increases in wealth. Whether as a society we can agree on measures that will help us develop in ways that maximize quality of life rather than solely economic output remains to be seen.
Buffett and Bogle Urge Reforms to Address “Short-Termism”
By Ravi Nagarajan
Berkshire Hathaway Chairman Warren Buffett and Vanguard Group founder John Bogle have joined with 26 other prominent individuals to call for action to reduce “short-termism” in business and investment management. In an Aspen Institute statement released today and summarized in a Wall Street Journal article, the group called for more robust action to encourage longer term thinking among investors, boards, and executives.
Systemic Problems Call for Broad Based Action
The statement asserts that the focus on short term results among shareholders is now widespread and driven by large institutions rather than individual investors. One clear result of this short term mentality is that portfolios experience higher turnover which harms the overall returns shareholders will realize. However, a more insidious consequence of short term thinking among investors involves the pressure this creates for boards and executives to ignore longer term considerations and simply focus on matters such as hitting Wall Street earnings expectations for the next quarter.
The Aspen statement strongly calls for broad based changes due to the system-wide nature of the problem:
… Short-termism is not limited to the behavior of a few investors or intermediaries; it is system-wide, with contributions by and interdependency among corporate managers, boards, investment advisers, providers of capital, and government. Thus, effective change will result from a comprehensive rather than piecemeal approach.
The statement goes on to describe changes in three areas: Market Incentives, Fiduciary Duty, and Transparency.
Market Incentives
The statement calls for changes to market incentives meant to encourage providers of capital to be more patient in their outlooks. First, capital gains taxes could be restructured in a manner that provides for lower tax rates for longer holding periods. Of course, we already have the distinction between short and long term capital gains, but the statement suggests that more differentiation could be put in place for much longer holding periods.
The statement also calls for a removal of the limitation on capital loss deductibility against ordinary income for “very long-term holdings” which are now capped at $3,000 per year. In a footnote to the statement, a suggestion is made to remove the deduction limit entirely for losses that have been held for ten years or longer.
Fiduciary Duties
The statement calls for imposing the same “fiduciary” test on brokers that has long been in place for investment advisers. Under a fiduciary standard, an adviser is required to act solely in the interests of the client without regard to the financial interests of the individual providing the advice. Brokers have often operated under a less strict standard in which they may recommend securities based on the “suitability” of the investment even if the choice is not the best one for the investor (possibly due to higher fees that might benefit the adviser).
The Administration’s proposal in the “Investor Protection Act of 2009” would enable the SEC to define “the standards of conduct for all brokers, dealers, and investment advisers, in providing investment advice about securities to retail customers or clients (and such other customers or clients as the Commission may by rule provide), shall be to act solely in the interest of the customer or client without regard to the financial or other interest of the broker, dealer or investment adviser providing the advice.” The SEC would also be required to “examine and, where appropriate, promulgate rules prohibiting sales practices, conflicts of interest, and compensation schemes for financial intermediaries (including brokers, dealers, and investment advisers) that it deems contrary to the public interest and the interests of investors.”
Improve Transparency
The statement also suggests changes to improve transparency related to investor disclosures:
The final leverage point, greater transparency in investor disclosures, can also play an important role in helping corporations maintain a long-term orientation. The advent of increasingly complex non-traditional structured and derivative arrangements has enabled some investors to influence corporate decision-making without being subject to duties to disclose the existence or nature of their positions or their plans. This lack of transparency undermines the efficacy of the disclosure regime and creates opportunities for investors to use their influence to achieve short-term gains at the expense of long-term value creation.
Long Overdue
The proposals related to improvements in transparency and strengthening the fiduciary standards for advisers are long overdue. Most individuals who rely on brokers for advice probably never realized that they were receiving advice under the “suitability” standard rather than a stronger “fiduciary” standard. While there are no doubt many brokers who elected to operate under a higher fiduciary standard all along, this standard should have been formalized as part of the code of ethics for the profession long ago.
One area of potential concern involves adding complexity to the tax code in an attempt to encourage longer term holding periods. The extremely complex United States federal tax code already differentiates between short and long term capital gains by imposing a much lower 15% rate on capital gains realized from securities held for over one year while gains on assets held for shorter periods are taxed as ordinary income at much higher rates. Adding a third tier into the mix would complicate the tax code to some extent. However, the attraction of a very low rate (maybe 5 to 10%) on “super long term” capital gains has obvious appeal for “buy and hold” investors.
The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.
Contrarian Endowment Management Helps Manhattan's Cooper Union Thrive In Recession
The Times (of London) profiles Cooper Union's endowment and its head John Michaelson.
"Men never do anything well except through necessity," wrote Machiavelli, a charter member of the Consigliere Hall of Fame. The fact that Cooper Union charges no tuition and must rely on its endowment for 70% of its expenditures has concentrated Michaelson's mind on two simple goals: "no material losses" and "a constant cashflow to meet expenses."
The other endowments mentioned in the article, which rely on endowment income for only about a third of expenditures, all follow the Yale Model of illiquidity-embracing strategies like PE, VC and hedge funds, which promise neither of Michaelson's two guiding principles. They thought they'd be compensated for this over time in the form of higher returns, in some cases correctly, and consoled themselves that their ancient institutions could handle short-term declines in endowment value with equanimity. What they did not count on was that during times of crisis, short-term declines in the endowment are correlated with things like the willingness of parents to afford high tuition, the propensity of faculty and staff to resist strongly any layoffs or strict cost control measures, and the propensity of alumni to make up any shortfalls with increased gifts. It was a political and psychological miscalculation more than an investment miscalculation. In a sense then, the dynamic faced by the sophisticated endowments of the more famous universities was more similar to Cooper Union's dynamic of discipline enforced by necessity than they realized.
The author of this post is Nadav Manham, president of Elera Advisors LLC, an investment advisory company focused on value-oriented manager selection. Mr. Manham is a Manual of Ideas contributor and editor of The Investor's Consigliere.
"Analyzing why people play golf is like exploring the intricacies of string theory – there are so many permutations lacking scientific observation that physicists or golfers can pretty darn well say anything they like and the explanation might stick. When it comes to whacking that little white ball, the possibilities are nearly endless: People play to relax, to be with friends, to get close to Mother Nature, to enhance business connections, to compete and excel. Gosh, I don’t know, the Zen explanation for why we play golf could even resemble the old saw about climbing a mountain: People golf because it’s there. Whatever the reason, it is the most frustrating, damnable game ever conceived – alternately elevating and depressing you within the span of mere minutes. I love golf. No, I hate it."
"Personally, the reason that golf draws me to its intricate web of psychological entrapment is epitomized by a simple six-inch trophy: a chartreuse ball resting on top of its ebony base, preening on a bookshelf in the family room at our desert home. Its inscription reads, “Hole in one, March 15th, 1990, 14th hole Desert Course, 155 yards.” Well and good, I suppose – the ace of my life – except it wasn’t. It was the ace of my wife. Above the inscription rests the name Sue – not Bill – Gross. It was a great shot but it wasn’t my shot, and I guess therein lies the explanation for why I continue to tee it up."
"Actually, two years ago I did tee it up in the sweltering 105° June heat of the Palm Springs desert. No one, of course, was crazy enough to be with me including my “ace” role model wife who was sipping a cool lemonade in the comfort of our air-conditioned home. Now, there is an “unwritten” rule in golf that in order to be official, a hole-in-one has to be witnessed, and that you have to play a full 18 holes. Otherwise, I suppose, you could stand on the tee with a bucket of balls and hit hundreds or thousands until one of the little guys went in – whatever. The fact is, on this particular day, I was playing only one ball, but I was alone, and – good God! – it went in! The trophy with ebony base and spanking white Titleist ball would read: “Hole in one, June 7th, 2007, 17th hole, Mountain Course, 139 yards.” Or was it? Does a falling tree make a sound in the middle of a forest if no one’s there? Is a hole-in-one a hole-in-one if no one else saw it? I say emphatically – yes! That damn ball went in and later that day Sue agreed with me (although she had a funny look in her eye – especially since she didn’t know a thing about the rules of golf). No one else though. No one else agrees with me. Not a soul. I suspect they’re jealous and, in fact, I’ve seen a few of them hitting buckets of balls at dusk from that very same tee when they think nobody’s looking. I’m watching, though, which brings up a funny question. If they sunk one, would theirs be a hole-in-one because I was a witness? Like I said – a damnable game."
"'Is a hole-in-one a hole-in-one' may not strike you as the most critical question of the hour, and I would readily agree. “Will we have a New Normal global economy (and investment market)?” would probably usurp it on even Tiger Woods’s top ten list. This “new” vs. “old” normal dichotomy was perhaps best contrasted by Barton Biggs, as I heard him on Bloomberg Radio in early 2009, when he said he was a “child of the bull market.” I thought that was a brilliant phrase, and Barton is a brilliant phrase-maker. He went on to say though, that his point was that for as long as he’s been in the business – and that’s a long time – it has paid to buy the dips, because markets, economies, profits, and assets always rebounded and went to higher levels. That is not only the way that he learned it, but that is the way, basically, that capitalism is supposed to work. Economies grow, profits grow, just like children do. I think that’s why he said he was a child of the bull market, not just because he had experienced it for so long, but also because economic growth and higher asset prices are almost invariably a natural evolution, much like the maturation of a person. That’s how people grow, and so I think Barton was saying that capitalism just grows that way too."
"Well, the surprise is that there’s been a significant break in that growth pattern, because of delevering, deglobalization, and reregulation. All of those three in combination, to us at PIMCO, means that if you are a child of the bull market, it’s time to grow up and become a chastened adult; it’s time to recognize that things have changed and that they will continue to change for the next – yes, the next 10 years and maybe even the next 20 years. We are heading into what we call the New Normal, which is a period of time in which economies grow very slowly as opposed to growing like weeds, the way children do; in which profits are relatively static; in which the government plays a significant role in terms of deficits and reregulation and control of the economy; in which the consumer stops shopping until he drops and begins, as they do in Japan (to be a little ghoulish), starts saving to the grave."
"This focus on the DDRs – delevering, deglobalization, and reregulation – may be conceptually understandable, but nevertheless still a little hard to get one’s arms around. Why would they necessarily lead to a new, slower growth normal? A little easier to grasp might be the following approach, which feeds off the same concept, but which extends it a little further by suggesting that DD and R lead to a number of broken business or economic models that may forever change the world we once knew and make even Barton Biggs a chastened adult. They are as follows:"
"American-style capitalism and the making of paper instead of things. Inherent in the “great moderation” of the past 25 years was the acceptance of a sort of reverse mercantilism. America would consume, then print paper assets and debt in order to pay for it. Developing (and many developed) countries would make things, and accept America’s securities in return. This game is over, and unless developing countries (China, Brazil) step up and generate a consumer ethic of their own, the world will grow at a slower pace."
"Private vs. public-driven growth. The invisible hand of free enterprise is being replaced by the visible fist of government, a temporarily necessary, but (if permanent) damnable condition itself in terms of future growth and profits. The once successful “shadow banking system” is being regulated and delevered. Perhaps a fabled “110-pound weakling” may be an exaggeration of where our financial system is headed, but rest assured it will not be looking like Charles Atlas anytime soon. Prepare to have sand kicked in your face, if you believe you are a 'child of the bull market!'"
"Global economic leadership. It’s premature to award the 21st century to the Chinese as opposed to the United States, but if the last six months have been any example, China is sort of lookin’ like Muhammad Ali standing over Sonny Liston in 1964 yelling, “Get up, you big ugly bear!” Not only has China spent three times the amount of money (relative to GDP) to revive its economy, but it has managed to grow at a “near normal” 8% pace vs. our “big R” recessionary numbers. Its equity market, while volatile and lightly regulated, has almost doubled in twelve months, making ours look like that ugly bear instead of a raging bull."
"United States housing and employment. Old normal housing models in the U.S. encouraged home ownership, eventually peaking at 69% of households as shown in Chart 1. Subsidized and tax-deductible mortgage interest rates as well as a “see no evil – speak no evil” regulatory response to government Agencies FNMA and FHLMC promoted a long-term housing boom and now a significant housing bust. Housing cannot lead us out of this big R recession no matter what the recent Case-Shiller home price numbers may suggest. The model has been broken if only because homeownership is declining, not rising, sinking to perhaps a New Normal level of 65% as opposed to 69% of American households."
"Similarly, the financialization of assets via the shadow banking system led to an American era of consumerism because debt was available, interest rates were low, and the livin’ became easy. Savings rates plunged from 10% to -1%, as many (if not most) assumed there was no reason to save – the second mortgage would pay for everything. Now things have perhaps irreversibly changed. Savings rates are headed up, consumer spending growth rates moving down. Get ready for the New Normal."
The author of this opinion piece is hedge fund manager Nick Gogerty.
The lack of oversight of an institution which is public/privately so important as the FED is woefully disappointing. Central Banks have been shown to be only slightly more effective at fighting inflation when separated from political controls which are often hijacked to goose short term economic performance to buy elections, independence is a good thing. No oversight is another.
However Central Bankers gone wild with limited to no oversight is on the extreme end of the pendulum, our Central bank has truly jumped the shark.
The US fed is unique as a central bank in that it has 2 policy aims, namely full employment and the control of inflation instead of solely controlling inflation. Here is a little article on such things. (warning it costs $6)
While I applaud the FED for stepping up to the liquidity crisis, a problem which it was certainly a part of creating via the ignoring of massive securitization and the amazing growth of off balance sheet banking, its current stance and lack of acknowledging blame for oversights, conflicts of interest etc, make it a loathsome institution.
In my opinion, the secrecy, lack of accountability and other issues seriously impacts its ability to function effectively going forward. This will probably only come to light when debt investors globally run out of other places to hide or realize the emperor is highly susceptible to drafts or perhaps overdrafts.
Why anyone would purchase US Treasury debt with a maturity stretching out more than 3 months is beyond me. I'll take Norwegian Krone instead.
The US has a lot of brand equity, but it looks like all hat and no cattle to me on the long end of the curve and probably for 3-10 years out. I don't think the Dollar is going to become the Pengo, but it certainly has a whiff of Charmin about it.
I say reboot the FED: Ctrl Alt Del and reposition the whole thing. Yes, I know it will cause a temporary crisis of confidence, but it is time to clean house.
I am not a fan of any organization or political agency which uses Fear as a pretext for its growth of power or ability to be unanswerable. If we started the FED during a crisis in 1913, we can certainly Reset it during one.
Bureaucracies are like babies diapers, they need to be changed from time to time and for the same reason.
Being able to gaze over Centuries of money, politics, war and economy can truly liberate one from the intellectual confines of our inward looking high frequency economy. Some of the most profound things happen at very low frequencies.
11 LP August 2009 J MARKETS AT A GLANCE Eric Sprott David Franklin Beyond the Stimulus Are you stimulated yet? We hope you are, because we’ve just witnessed the largest economic stimulus in the history of the world. Never before have so many government dollars been thrown at the economy to prevent a depression. When added together, the combined financial, monetary and fiscal stimuli in the US are more than the cost of the two World Wars and “The New Deal” combined.1 Stimulus spending worldwide has taken the form of a combination of tax cuts, transfer payments (free money) and infrastructure investments on roads, schools, railroads etc. In the US, the financial and stimulus contributions have been especially impressive in scale. According to CNN’s bailout tracker, the various US government departments have committed to stimuli worth $11 trillion dollars and have issued cheques totaling $2.8 trillion dollars thus far in 2009.2 Neil Barofsky, the Special Investigator General for the TARP program, has estimated that the total cost to the US taxpayer could be as high as $23 trillion.3 The vast majority of this stimulus has been directed at the financial sector - a complete waste of money in our opinion, supporting a segment of the economy that never deserved to be bailed out. Nonetheless, the US taxpayer has spent massive sums, committed to promises worth even more and may ultimately owe debt in the double-digit trillions when all is said and done. Nice of them to spend so generously, wouldn’t you say? Although the stimulus has been fantastic for the stock market, it has generated very little benefit for “Main Street”. To make matters worse, the effects of the stimulus packages have already started to wear off. To explain why, we must mention the American Recovery and Reinvestment Act of 2009 (ARRA), which was specifically directed at stimulating the real economy as opposed to “saving Wall Street”. ARRA calls for a total spend of $787 billion, which breaks down into $287B in tax breaks, $192B in direct aid and $308B in discretionary spending. According to Christina Romer, a White House economic advisor, 70% of this stimulus will be spent by the end of September 2010. CHART A The Moment of Truth for Stimulus Contribution to real GDP growth 4% 3% 2% 1% 0% Q1 09 -1% Q2 09 Q3 09 Q4 09 Q1 10 Q2 10 Q3 10 Q4 10 Sprott Asset Management LP Source: Moody's Economy.com, Sprott Asset Management LP Royal Bank Plaza South Tower 200 Bay Street Suite 2700, P.O Box 27 Toronto, Ontario M5J 2J1 T: 416 943 6707 F: 416 943 6497 Toll Free: 888 362 7172 www.sprott.com What impact will this stimulus have on the economy? Chart A presents results from Moody’s that is representative of several private forecasts that we have reviewed.4 The chart Inflation adjusted in 2008 dollars; the cost of World War I is $312 billion, World War II is $3.6 trillion, “The New Deal” which was legislation to aid the US during the Depression is $500 billion. These and other costs can be found at: http://www.ritholtz.com/blog/2008/11/big-bailouts-bigger-bucks/ 2 CNNMoney.com's bailout tracker. Retrieved on August 16, 2009 from: http://money.cnn.com/news/storysupplement/economy/bailouttracker 3 Kopecki, Dawn and Dodge, Catherine (July 20, 2009). U.S. Rescue May Reach $23.7 Trillion, Barofsky Says. Retrieved on August 16, 2009 from: http://www.bloomberg.com/apps/news?pid=20601087&sid=aY0tX8UysIaM 4 Zandi, Mark (June 22, 2009). U.S. Fiscal Stimulus Revisited. Retrieved on August 16, 2009 from: http://www.economy.com/dismal/article_free.asp?cid=116000&src=economy-hp-dismal-article 1 1 illustrates the ARRA’s impact on real GDP by quarter, and reveals that right now, in Q3 2009, the US is experiencing the maximum impact of the Obama stimulus package. That’s right - this is as good as it gets. The majority of the Act consists of tax cuts and transfer payments to citizens, the impact of which was felt within the first two quarters of being received.5 By the end of September 2009 this stimulus will have worn off, and along with it will vanish the greatest marginal impact of the entire stimulus package itself. According to economic forecasters like Moody’s, by 2010 the net impact of the stimulus package to real GDP will be barely over 1%. This is not good news for “Main Street”, especially considering the dramatic increase in unemployment that we’ve witnessed recently. If the effects of stimulus wear off as quickly as they were injected, we could be in for a very difficult Fall (no pun intended). To make matters worse, this scenario is not limited to the US alone - it could potentially impact any of the other large economic powers who have instituted their own massive stimulus packages, most notably China, resulting in a simultaneous global economic decline that would make 2008 look pleasant in comparison. China deserves special mention here, because on a percentage of GDP basis, they are far and away the greatest stimulator of all. While the US has made significant commitments, their $2.8 trillion capital deployment to date only represents a mere 20% of their 2008 GDP. Chinese government spending (combined with Chinese bank lending), on the other hand, is completely unprecedented in the history of banking, and far outweighs the US stimulus in scale and scope. The Chinese have deployed 4 trillion yuan in stimulus spending through to 2010.6 In concert with this stimulus, the Chinese central bank has scrapped its national lending quotas in order to jump start their economic engine. In the first half of 2009, Chinese bank lending hit a record high of 7.37 trillion yuan.7 Assuming their stimulus package is evenly split between 2009 and 2010, it equates to 8.37 trillion yuan of fiscal spending and lending by Chinese banks. For perspective, the Chinese economy generated 13 trillion yuan in the first half of 2008.8 So in effect, the Chinese have injected a stimulus equivalent to 64% of their first half 2008 GDP in the first half of 2009. Please understand us when we tell you that this is unprecedented. The Chinese government has effectively spent and lent enough in six months to buy 122 Ford Class aircraft carriers at US$8.1 billion a piece. It is akin to the US government injecting (and US banks lending) almost $4.5 trillion USD to its citizens and businesses before July 2009…an ungodly sum that would impact every asset class under the sun. Is it any wonder then that the Shanghai stock exchange has more than doubled from trough to peak since its November lows? What is perhaps even more surprising, however, is the fact that the Chinese stimulus has had a seemingly lackluster impact on the Chinese economy. Despite its massive size, the stimulus program has only generated a 7.9% increase in their 2009 GDP. For perspective, this represents a mere 1 trillion yuan return on a 9.37 trillion yuan stimulus - not a good return on investment. So if the money hasn’t generated GDP growth, where did it go? It’s gone everywhere. Their government-induced liquidity flood has “soaked” virtually every speculative asset class in China. Copper, nickel, steel, Chinese equities, Chinese real estate - they’ve all appreciated in spite of the obvious and acknowledged weakness in the global The Congressional Budget Office (CBO) reviewed the impact of the 2001 and 2008 tax rebates under the Bush Administration which would concur with economic model estimates that impact is felt very quickly. This can be found at: http://www.cbo.gov/ftpdocs/96xx/doc9617/06-10-2008Stimulus.pdf 6 (November 11, 2008). World markets buoyed by massive Chinese stimulus plan. Retrieved on August 17, 2009 from: http://news.xinhuanet.com/english/2008-11/11/content_10341108.htm 7 Wang, Aileen (August 11, 2009). INSTANT VIEW 5 - China's July lending and money growth slows. Retrieved on August 17, 2009 from: http://www.forbes.com/feeds/afx/2009/08/11/afx6763394.html 8 (July 17, 2009) China's GDP up 10.4 percent in first half of year. Retrieved on August 17, 2009 from: http://english1.people.com.cn/90001/90776/90884/6452204.html 5 Sprott Asset Management LP Royal Bank Plaza South Tower 200 Bay Street Suite 2700, P.O Box 27 Toronto, Ontario M5J 2J1 T: 416 943 6707 F: 416 943 6497 Toll Free: 888 362 7172 www.sprott.com 2 economy. It’s been great in the short-term - but this money was LENT OUT remember, and must eventually be paid back. It is not a sustainable long-term growth model, and in the words of Wu Xiaoling, a previous deputy governor of the Chinese central bank, “will sow bad seeds for [China’s] economic adjustment.”9 It is our view that the world’s combined government stimuli have completely distorted the global economy in the short term, and have encouraged a false sense of hope in the stock market. While the market has rallied, the real economy continues to struggle, and is notably worse in many areas. Rates of employment, corporate revenues, US housing prices and retail sales all continue to decline in the face of ‘shock and awe economics’. In our assessment of recent economic data, there are only two possible explanations for the recent market rally. Either investors are discounting an incredible economic recovery that is just around the corner (hard to believe), or the extra liquidity injected into the economy has found its way into the stock market. We’re leaning towards the latter alternative. So what happens next? Will the Keynesian miracle take hold? Will the recovery be strong enough to pay back the increased debt load that was needed to jolt the economy back to life? It seems unlikely. On July 29th two Chinese banks announced that they would limit loans in the second half of 2009. Since the announcement, Chinese stocks have reversed into a considerable down trend. This is reflected in the chart of CSI 300 stock index, which tracks the performance of the largest and most liquid stocks traded on the Shanghai and Shenzhen stock exchanges (see CHART B). Now that the excess stimulus liquidity has been removed, all asset classes that previously benefited will begin to fall. The CSI 300 suggests this process is well underway. CHART B The CSI 300 Stock Index 4000 Chinese Banks Cut Lending 3500 3000 Market Breaks 2500 2000 3/1/2009 6/7/2009 7/5/2009 3/15/2009 3/29/2009 4/12/2009 4/26/2009 5/10/2009 5/24/2009 6/21/2009 7/19/2009 8/2/2009 8/16/2009 8/30/2009 9/13/2009 Source: Bloomberg, Sprott Asset Management LP Sprott Asset Management LP Royal Bank Plaza South Tower 200 Bay Street Suite 2700, P.O Box 27 Toronto, Ontario M5J 2J1 T: 416 943 6707 F: 416 943 6497 Toll Free: 888 362 7172 www.sprott.com The Federal Reserve has embarked on its own monetary injections, called quantitative easing, by buying $1.745 trillion dollars worth of debt issued by Fannie Mae, Freddie Mac and treasury bills issued by US government. On August 12, 2009 the Federal Reserve provided guidance on their plans to ease the program. Interestingly enough, they extended the completion date from September to October 2009 in order to keep the option of boosting purchases later this Fall. If the Chinese experience is an early lesson, removing the stimulus liquidity from the market could be a dangerous proposition. We have already proven there are not enough buyers of US debt to support the budget deficit this year (please see “The Solution…is the Problem”), and we suspect that much of the US monetary stimulus used to purchase debt issued by Fannie and Freddie has actually made its way into the new US Treasury auctions - thereby supporting the record US budget deficit in 2009. This two step debt monetization process is a complicated topic that we will address in a future MAAG. In the world of government stimulus, the size and speed of the injections are critical to their impact. Once the taps are turned on full bore, any reduction to the stimulus will have almost the same negative impact as removing it entirely. We are now seeing this reduction on three fronts: the Federal Reserve threatening to close the window on its 'quantitative easing’ program; the tax cuts and transfers already paid out to US citizens; and the Chinese banks 7 Garnaut, John (August 12, 2009). China pulls back on bank-credit throttle. Retrieved on August 16, 2009 from: http://business.smh.com.au/business/china-pulls-back-on-bankcredit-throttle-20090811-egzv.html 9/27/2009 3 now reining in their excessive lending. In trader terms - we will soon have no "dry powder" left to burn. In their 2008 annual report, the Bank for International Settlements (BIS) recently reviewed previous banking crises and suggested that a sustainable recovery would require the banking system to take losses, dispose of non-performing assets, eliminate excess capacity and rebuild capital bases. The BIS concludes that “these conditions are not being met and any stimulus will therefore only lead to a temporary pick up in growth followed by protracted stagnation.”10 We agree wholeheartedly, and have seen nothing yet to suggest that the real problems plaguing the world’s banking system are being addressed. In our view, the threat of a double dip recession remains real. When the stimulus effects wear off there will be nothing left to replace the artificial demand they have induced. Investors should be prepared for what awaits us beyond the stimulus. Sprott Asset Management LP The opinions, estimates and projections (“information”) contained within this report are solely those of Sprott Asset Management LP (“SAM LP”) and are subject to change without notice. SAM LP makes every effort to ensure that the information has been derived from sources believed to be reliable and accurate. However, SAM LP assumes no responsibility for any losses or damages, whether direct or indirect, which arise out of the use of this information. SAM LP is not under any obligation to update or keep current the information contained herein. The information should not be regarded by recipients as a substitute for the exercise of their own judgment. Please contact your own personal advisor on your particular circumstances. Views expressed regarding a particular company, security, industry or market sector should not be considered an indication of trading intent of any investment funds managed by Sprott Asset Management LP. These views are not to be considered as investment advice nor should they be considered a recommendation to buy or sell. The information contained herein does not constitute an offer or solicitation by anyone in the United States or in any other jurisdiction in which such an offer or solicitation is not authorized or to any person to whom it is unlawful to make such an offer or solicitation. Prospective investors who are not resident in Canada should contact their financial advisor to determine whether securities of the Funds may be lawfully sold in their jurisdiction. Royal Bank Plaza South Tower 200 Bay Street Suite 2700, P.O Box 27 Toronto, Ontario M5J 2J1 T: 416 943 6707 F: 416 943 6497 Toll Free: 888 362 7172 www.sprott.com 10 Bank for International Settlements, Annual Report 2008/09 (June 29, 2009). Retrieved on August 16, 2009 from: http://www.bis.org/publ/arpdf/ar2009e6.pdf 4
This chart shows the share of U.S. income earned by the top 1/100th of one percent of the U.S. population (annual data from 1913 to 2007). Looks like we have a little ways to go before returning to the inequality levels of the 1950s and '60s (no need to go back to the '70s, though).
New York Times Editorial: Warren Buffett on the Dangers of Deficits and Money Printing
Warren Buffett, chairman of Berkshire Hathaway, opines in today's New York Times on the dangers of the Administration's fiscal policies as well as the Fed's money printing.
To make his point, Buffett draws a parallel between "greenback emissions" and "greenhouse emissions" -- the former are bad for the economy while the latter are bad for the environment. Buffett may not realize that his argument on the dangers of money printing will be undermined in the eyes of some by this comparison, as there are still those who refuse to acknowledge the greenhouse effect. Or perhaps this was intentional on Buffett's part. The message? We ignore greenhouse emissions and greenback emissions at our own peril. Here are Buffett's words:
IN nature, every action has consequences, a phenomenon called the butterfly effect. These consequences, moreover, are not necessarily proportional. For example, doubling the carbon dioxide we belch into the atmosphere may far more than double the subsequent problems for society. Realizing this, the world properly worries about greenhouse emissions.
The butterfly effect reaches into the financial world as well. Here, the United States is spewing a potentially damaging substance into our economy — greenback emissions.
[...]
The United States economy is now out of the emergency room and appears to be on a slow path to recovery. But enormous dosages of monetary medicine continue to be administered and, before long, we will need to deal with their side effects. For now, most of those effects are invisible and could indeed remain latent for a long time. Still, their threat may be as ominous as that posed by the financial crisis itself.
To understand this threat, we need to look at where we stand historically. If we leave aside the war-impacted years of 1942 to 1946, the largest annual deficit the United States has incurred since 1920 was 6 percent of gross domestic product. This fiscal year, though, the deficit will rise to about 13 percent of G.D.P., more than twice the non-wartime record. In dollars, that equates to a staggering $1.8 trillion. Fiscally, we are in uncharted territory.
Because of this gigantic deficit, our country’s “net debt” (that is, the amount held publicly) is mushrooming. During this fiscal year, it will increase more than one percentage point per month, climbing to about 56 percent of G.D.P. from 41 percent. Admittedly, other countries, like Japan and Italy, have far higher ratios and no one can know the precise level of net debt to G.D.P. at which the United States will lose its reputation for financial integrity. But a few more years like this one and we will find out.
[...]
Legislators will correctly perceive that either raising taxes or cutting expenditures will threaten their re-election. To avoid this fate, they can opt for high rates of inflation, which never require a recorded vote and cannot be attributed to a specific action that any elected official takes. In fact, John Maynard Keynes long ago laid out a road map for political survival amid an economic disaster of just this sort: “By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.... The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”
[...]
Unchecked carbon emissions will likely cause icebergs to melt. Unchecked greenback emissions will certainly cause the purchasing power of currency to melt. The dollar’s destiny lies with Congress.
11 LP July 2009 J MARKETS AT A GLANCE Eric Sprott David Franklin It’s the real economy, stupid We are now in the early stages of a depression. The economic indicators we follow to track real economic activity are all signaling a slowdown of massive proportions. You wouldn’t know it reading the mainstream papers of course – they all focus on the relative decline in the slowdown’s intensity. Reading about the slowdown ‘slowing down’ is not the same as growth however, and does not warrant excitement in our opinion. Our title this month paraphrases one of Bill Clinton’s presidential campaign messages from 1992. As one of the three key themes in Clinton’s campaign, “The economy, stupid” was printed on a sign in his headquarters in Little Rock to help campaign workers stay on message. This month we’re keeping it simple by focusing on the real economy and its implications for the stock market. Here is the real economy summarized in numbers: Industrial Capacity Collapse: US industry used only 68.3% of available capacity in May 2009, according to a monthly report from the Federal Reserve.1 That represents almost one third of all US industrial capacity sitting idle. Prior to the current recession, the lowest rate recorded since the Fed started this series of records in 1967 was 70.9% in December 1982. 2 CHART A depicts worldwide industrial production in a comparison between April 2008 and June 1929. 3 Very similar trajectories. CHART A Sprott Asset Management LP Royal Bank Plaza South Tower 200 Bay Street Suite 2700, P.O Box 27 Toronto, Ontario M5J 2J1 T: 416 943 6707 F: 416 943 6497 Toll Free: 888 362 7172 www.sprott.com Federal Reserve Statistical Release, Industrial Production and Capacity Utilization – G.17 (June 16, 2009). Retrieved on July 10, 2009 from: http://www.federalreserve.gov/releases/G17/Current/default.htm Gallagher, Thomas (June 16, 2009). Industrial Capacity Use Hits Record Low. Retrieved on July 10, 2009 from: http://www.joc.com/node/411908 3 Eichengreen, Barry and O’Rourke (June 4, 2009) A Tale of Two Depressions. Retrieved on July 10, 2009 from: http://www.voxeu.org/index.php?q=node/3421 2 1 1 Government Tax Revenue Declining: 32 of the 46 states whose fiscal year ended midnight July 1, 2009, did not have budgets signed by their Governors. States are grappling with deficits totaling a collective $121 billion, and all states but Vermont require that their budgets be balanced. Personal income tax, which accounts for more than a third of state revenues, dropped by 26% in the first four months of 2009, according to the Albany, New York – based Rockefeller Institute of Government. 4 The US government has spent $2.67 trillion thus far in fiscal 2009, but has only collected $1.59 trillion. The US government collected $685.5 billion in individual income taxes so far this year, a 22% drop from the $877.8 billion the government took in during the first nine months of 2008. US corporate income taxes plunged 57% to $101.9 billion in 2009, down from $236.5 billion in the first nine months of fiscal year 2008.5 Retail Sales Slump: The International Council of Shopping Centers (ICSC)/Goldman Sachs same-store sales tally for June was down 5.1% from June 2008, worse than the latest forecast for a 4.5% decline. Privately held luxury department store Neiman Marcus Group Inc. posted a 20.8% drop in same-store sales. Abercrombie & Fitch Co.'s same-store sales fell 32%, even more than the 26.6% decline Wall Street had projected. 6 Unemployment Catastrophe: The June 2009 jobless rate reached 9.5%, the highest since 1983. 4 million Americans have been looking for work for more than 26 weeks, representing 29% of the unemployed – the most since records began in 1948. During the last 30 years, Americans who lost their jobs took an average 15.8 weeks to find new positions. In June 2009, the average duration of unemployment was 24.5 weeks, the longest since records began in 1948. The number of people collecting unemployment benefits reached a record 6.88 million in the week ended June 27, 2009. Approximately six people are seeking work for every job opening, the most since the government began keeping such records in 2000. A year ago, the ratio was a little more than two-to-one.7 Sprott Asset Management LP Royal Bank Plaza South Tower 200 Bay Street Suite 2700, P.O Box 27 Toronto, Ontario M5J 2J1 T: 416 943 6707 F: 416 943 6497 Toll Free: 888 362 7172 www.sprott.com 4 Randall, Kate (July 1, 2009). US states budget crisis fuel massive spending cuts. Retrieved on July 10, 2009 from: http://www.wsws.org/articles/2009/jul2009/budg-j01.shtml 5 Clifford, Catherine (July 13, 2009). Uncle Sam is $1 trillion in the hole. Retrieved on July 13, 2009 from: http://money.cnn.com/2009/07/13/news/economy/treasury_budget/?postversion=2009071315 6 D'Innocenzio, Anne (July 10, 2009). Weak retail sales in June raise worries. Retrieved on July 11, 2009 from:http://www.google.com/hostednews/ap/article/ALeqM5jEUOBuLQexhEw6Sbb1sU7mSLR6iAD99B0MO01 7 Miller, Rich (July 10, 2009). Obama’s Jobless Safety Net Torn by Rebecca Alvarez (Update1). Retrieved on July 11, 2009 from: http://www.bloomberg.com/apps/news?pid=20601109&sid=atnjG1uvDprY 2 US Housing Market Failure: The annual pace of new home sales is now 342,000, a whopping 32.8% below the rate in May 2008. At the current sales pace, there is 10.2 months worth of inventory overhang sitting on the market, dragging down prices and encouraging potential buyers to wait it out as prices deflate.8 New home sales are down 73% from the all time high of 1,283,000 new homes sold in 2005 (mild recession?). See Chart B.9 CHART B Rail Car Loadings Suffering: For the first 26 weeks of 2009, US railroads reported cumulative volume of 6,806,892 carloads, down 19.2% from 2008.10 An excellent quote included in the June report from the Association of American Railroads stated: “Whenever Americans grow something, eat something, mine something, make something, turn on a light, or get dressed, freight railroads are probably involved somewhere along the line. Unfortunately, right now there’s not enough mining, manufacturing and buying going on. So railroads, like most other business sectors, are suffering because of it.”11 Carloads are down 22.5% from the all time high set in the first 26 weeks of 2006.12 Sprott Asset Management LP Royal Bank Plaza South Tower 200 Bay Street Suite 2700, P.O Box 27 Toronto, Ontario M5J 2J1 T: 416 943 6707 F: 416 943 6497 Toll Free: 888 362 7172 www.sprott.com 8 New Home Sales Stagnate. April Revisions Mitigate May Decline. Retrieved on July 10, 2009 from: http://www.mortgagenewsdaily.com/06242009_new_home_sales_stagnate_april_revisions_mitigate_may_decline.asp 9 US Census Bureau – New Residential Sales. Retrieved on July 13, 2009 from: http://www.census.gov/const/soldann.pdf 10 American Association of Railroads (July 9, 2009). Rail Freight Traffic Remains Down During Holiday Week. Retrieved July 10, 2009 from: http://www.aar.org/NewsAndEvents/PressReleases/2009/07_WTR/070909_Traffic.aspx 11 American Association of Railroads (July 2, 2009). Rail Freight Traffic Down in June. Retrieved on July 10, 2009 from: http://www.aar.org/NewsAndEvents/PressReleases/2009/07_WTR/070209_Traffic.aspx 12 American Association of Railroads (July 6, 2006). Led by Coal and Intermodal, U.S. Rail Traffic Up in June. Retrieved on July 14, 2009 from: http://www.aar.org/NewsAndEvents/PressReleases/2006/07/Led%20by%20Coal%20and%20Intermodal%20U,-d-,S,-d,%20Rail%20Traffic%20Up%20in%20June.aspx 3 Dow Jones Industrial Average: Chart C below plots a return comparison of the Dow Jones Industrial Average between 1929 and 2007. Another frightening comparison to 1929.13 CHART C The big question now is what effect all this bad data will ultimately have on the stock market. Stock valuation can often be wonderfully complex – but it ultimately rests on two main foundations: earnings and investor sentiment. The ‘earnings’ component is concrete; it is a stream of profits that companies expect to generate in the future for their shareholders. The ‘investor sentiment’ component, however, is not concrete. It dictates what investors are willing to pay to buy corporate earnings, and can fluctuate widely depending on perceptions of future growth. The relationship between these two components is vital in gauging market direction. The price-earnings (P/E) ratio is the classic investment fraction that combines these two factors into a usable metric. It deserves mention here because its analysis helps to illustrate the point we are trying to make. In Chart D, we provide data by Robert Shiller that plots the real, inflation-adjusted P/E ratio of the S&P 500 stock index from January 1900 to June 2009.14 As the chart illustrates, as at the end of June 2009, the S&P 500 traded at an inflation adjusted P/E ratio of 16.08, implying that investors were willing to pay an average of 16 times earnings for a share in the S&P 500 index.15 Sixteen times earnings is well below the all time, inflation-adjusted high of December 1999 (44 times), but also well above the lows of 1932 (5.57) and 1982 (6.64). As it turns out, 16 times is almost exactly at the 109-year monthly average P/E ratio – so stocks are trading at their long-term average P/E level in the current environment. Sprott Asset Management LP Royal Bank Plaza South Tower 200 Bay Street Suite 2700, P.O Box 27 Toronto, Ontario M5J 2J1 T: 416 943 6707 F: 416 943 6497 Toll Free: 888 362 7172 www.sprott.com 13 Lundeen, Mark J. (July 3, 2009). Bear Markets and Horror Movies. Retrieved on July 10, 2009 from: http://www.gold-eagle.com/editorials_08/lundeen070509.html 14 Shiller, Robert J (2005) Irrational Exuberance [Princeton University Press 2000, Broadway Books 2001, 2nd ed., 2005]. Data set downloaded on July 3, 2009 from: http://www.econ.yale.edu/~shiller/data.htm 15 Bloomberg reports the P/E for the S&P 500 Index in June 2009 as 14.58. The discrepancy to Shiller’s data is for several reasons: a) Shiller reports using June 10 closing data b) Shiller uses a rolling average value for Real Earnings when calculating the P/E ratio c) Shiller uses extrapolation for estimates of the CPI data when calculating real earnings for June 2009. Despite these minor variances, we found this publicly available data set to be the most complete comprehensive historical review of P/E ratios. 4 CHART D Historical Real Price Earnings Ratio S&P 500 1900 to June 2009 50 December 1999 44.20 40 April 1929 27.57 30 Real P/E Ratio 20 10 June 1932 5.57 July 1982 6.64 June 2009 16.08 0 1900 1920 1940 1960 1980 2000 Year Source: Robert Shiller, Sprott Asset Management LP If this is average – how low is low if investors turn their backs on stocks? There’s the real economy which generates the earnings, and then there’s the investor sentiment/perception which dictates the multiple they are willing to pay for those earnings. We already know that the real economy is in severe decline. What happens if investor sentiment changes? We assess three scenarios below: 1. Earnings stay constant; P/E ratios hit cycle lows: We assume a scenario where investors are nervous, people need to sell stocks to pay for lost wages, or for retirement, but the companies continue to perform as of June 2009. Assuming a P/E of 6, which is close to the all time low, and using an earnings value of $63.04 for the S&P 500 Index, we derive an S&P 500 Index value of 378.16 Earnings get halved; P/E stays constant: Earnings have been half of their current value three times over the last 30 years – so it is entirely within the realm of possibility that they could be halved once again. In the late 1970’s, early 1980’s and early 1990’s the S&P 500 Index generated half the earnings per share that it did this year in 2009 dollars. Using today’s P/E multiple of 16.08 results in an S&P 500 value of 506. Earnings get halved; P/E ratios hit cycle lows: double trouble. If we combine these cases where earnings are cut in half from today and the P/E ratio drops to a cycle low, it implies an S&P 500 Index value of 189 (depression territory). 2. Sprott Asset Management LP 3. Royal Bank Plaza South Tower 200 Bay Street Suite 2700, P.O Box 27 Toronto, Ontario M5J 2J1 T: 416 943 6707 F: 416 943 6497 Toll Free: 888 362 7172 www.sprott.com What about inflation? All three of the above scenarios are calculated using 2009 dollars. Doing so adjusts for the effects of inflationary periods over the last 109 years and allows for the historical comparisons we have discussed. As we mentioned, a stock price is based on pricing the future stream of a company’s profits. Over the long-term, inflation erodes the value of those earnings and with it the multiple that investors are willing to pay for them - ultimately lowering the value of stocks. 16 Bloomberg S&P 500 earnings per share for June 2009 not included in Shiller dataset. 5 CHART E S&P 500 Real Price Earnings Ratio 35 30 25 Real P/E Ratio June 1929 April 2008 20 15 10 5 0 1 3 6 9 12 15 18 21 24 27 30 33 36 39 42 45 48 51 Months Into Crisis Source: Robert Shiller, Sprott Asset Management LP Chart E plots the real P/E ratio of the S&P 500 Index fifty months out from 1929 and compares it to the recent real P/E ratio performance from April 2008 to June 2009. We find the similarity between the 2008 economic collapse and the 1929 economic collapse disturbing. Don’t get sucked in… the real economy is still struggling and the market has yet to reflect this. In 1932, the Dow Jones Industrial Average bottomed 90% below the September 1929 peak. The S&P 500 Index peaked in October 2007 at 1,576, and from our brief analysis above we can easily calculate a drop in the S&P 500 of as much as 88% from that peak using our ‘double trouble’ scenario. At the very least, under all of our scenarios it appears that the S&P 500 Index will test the March 2009 low of 666. Judging by the continued declines we are seeing in the real economy, we expect that test to happen sooner rather than later. In our view, the only thing propping this market up is investor sentiment. Earnings have not improved. Keep it simple, stupid - investing is and has always been about the real economy, and this market is ignoring the hard data. You can invest in sentiment if you want to, but as we have said before, we prefer to invest in real things. Sprott Asset Management LP Royal Bank Plaza South Tower 200 Bay Street Suite 2700, P.O Box 27 Toronto, Ontario M5J 2J1 T: 416 943 6707 F: 416 943 6497 Toll Free: 888 362 7172 www.sprott.com 6 Sprott Asset Management LP Royal Bank Plaza South Tower 200 Bay Street Suite 2700, P.O Box 27 Toronto, Ontario M5J 2J1 T: 416 943 6707 F: 416 943 6497 Toll Free: 888 362 7172 www.sprott.com The opinions, estimates and projections (“information”) contained within this report are solely those of Sprott Asset Management LP (“SAM LP”) and are subject to change without notice. SAM LP makes every effort to ensure that the information has been derived from sources believed to be reliable and accurate. However, SAM LP assumes no responsibility for any losses or damages, whether direct or indirect, which arise out of the use of this information. SAM LP is not under any obligation to update or keep current the information contained herein. The information should not be regarded by recipients as a substitute for the exercise of their own judgment. Please contact your own personal advisor on your particular circumstances. Views expressed regarding a particular company, security, industry or market sector should not be considered an indication of trading intent of any investment funds managed by Sprott Asset Management LP. These views are not to be considered as investment advice nor should they be considered a recommendation to buy or sell. The information contained herein does not constitute an offer or solicitation by anyone in the United States or in any other jurisdiction in which such an offer or solicitation is not authorized or to any person to whom it is unlawful to make such an offer or solicitation. Prospective investors who are not resident in Canada should contact their financial advisor to determine whether securities of the Funds may be lawfully sold in their jurisdiction. 7
MidAmerican’s David Sokol on Housing Market: No “Green Shoots” Yet
By Ravi Nagarajan
It appears that MidAmerican Energy Chairman David Sokol has taken on a higher media profile in recent weeks. MidAmerican is a subsidiary of Berkshire Hathaway and David Sokol has often been mentioned as a front runner to take over the CEO position at Berkshire in the future. Could this media exposure signal something about Berkshire succession plans?
It is probably best to avoid reading into Sokol’s recent media exposure in terms of Berkshire succession plans. It would be entirely out of character for Warren Buffett to float trial balloons regarding management succession. However, Sokol’s recent statements on the economy and housing should carry some weight given the fact that MidAmerican owns Home Services of America which is the second largest real estate brokerage in the United States. Let’s take a brief look at Sokol’s recent comments on housing and the economy.
No Green Shoots Yet
Pronouncements of “green shoots” appearing in the economy have been common over the past two months since the stock market hit multi year lows in early March. This optimism is obviously a factor in the broad market recovery. But is the optimism justified, particularly in housing? Sokol does not seem to think so:
“We’re not seeing the green shoots,” said Sokol, head of MidAmerican Energy Holdings Co., which owns HomeServices of America Inc. “We don’t see improvement.”
Homes in the process of foreclosure are creating a “shadow backlog” of unsold properties that will continue to hang over the market, Sokol, 52, said in a speech yesterday at the Ira W. Sohn Investment Research Conference in New York.
While official statistics show a 10- to 12-month supply of unsold homes, “we believe the backlog of homes for sale is twice that.”
It appears that Sokol is pointing out one of the worries that has often been cited by those with a bearish view on housing. Given the large number of properties in foreclosure or near foreclosure, a flood of new inventory may be waiting on the sidelines and could appear in the coming months. This could snuff out any price improvement and lead to further declines.
Counterproductive Government Actions
In recent interviews, Sokol appears to be much more critical of government policy than either Warren Buffett or Charlie Munger. This has been particularly true on the “cap and trade” policy that will impact MidAmerican’s public utilities and was a subject of a recent article related to MidAmerican’s partnership with BYD. It appears that Sokol is equally unimpressed with government action in the housing arena:
Sokol suggested government efforts to ease the crisis are actually drawing out the recovery. “We really need to let the economics work through the system,” he said.
Many people who want or need to sell their homes haven’t put them on the market yet because the outlook for sales has been poor, he said. “It will be mid-2011 before we see the market in balance,” with no more than a six-month backlog, he said.
If Sokol’s predictions prove to be accurate, the economy is in for a much longer recession than the market consensus appears to reflect. If depressed housing conditions persist for another two years prior to staging a recovery, it is difficult to see how a consumer led recovery will be possible. With consumer spending representing around 70% of GDP, confidence is unlikely to return and any recovery will need to be led by other components of GDP if a recovery is to occur prior to 2011.
Bloomberg Video
Here is a video from Bloomberg with a report on Sokol’s recent comments that may be of interest to readers:
Whether Sokol’s predictions are accurate remains to be seen but his words should at least be carefully considered by those making investments that assume that a quick economic recovery will begin in the second half of this year. If we are two years from a housing bottom, it is highly unlikely that any sustained economic recovery will begin this year.
I am a believer in Warren Buffett’s advice to not allow macroeconomic factors to be the predominant criteria for investment in well selected businesses. Generally I make investments based on criteria specific to a business or industry rather than the overall economy. However, it is still interesting to follow macro trends and the divergence of macro trends from “consensus” market expectations.
Ravi Nagarajan is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.
Will Fed Marginalize Regional Bank Presidents To Monetize Debt?
A Wall Street Journal article dated May 23rd contains an interesting nugget about the potential marginalization of regional bank presidents who are members of the Federal Open Market Committee. Some FOMC members, including Richard Fisher of the Dallas Federal Reserve Bank, have criticized Fed Chairman Ben Bernanke's policy of "monetizing the debt," i.e., using electronically printed money to buy Treasury bonds, thereby essentially converting government obligations into dollars in circulation.
Such a policy has obvious inflationary consequences, something Fed officials have been loath to acknowledge. As the above-referenced article explains, there has apparently been some consideration of attempting to exclude officials such as Fisher from membership in the FOMC. Writes the Wall Street Journal's Mary O'Grady:
Voices like Mr. Fisher's can be a problem for the politicians, which may be why recently there have been rumblings in Washington about revoking the automatic FOMC membership that comes with being a regional bank president. Does Mr. Fisher have any thoughts about that?
This is nothing new, he points out, briefly reviewing the history of the political struggle over monetary policy in the U.S. "The reason why the banks were put in the mix by [President Woodrow] Wilson in 1913, the reason it was structured the way it was structured, was so that you could offset the political power of Washington and the money center in New York with the regional banks. They represented Main Street.
"Now we have this great populist fervor and the banks are arguing for Main Street, largely. I have heard these arguments before and studied the history. I am not losing a lot of sleep over it," he says with a defiant Texas twang that I had not previously detected. "I don't think that it'd be the best signal to send to the market right now that you want to totally politicize the process."
When we read stories like this one, it seems only logical that investors have started dumping Treasuries.
Michael Milken Hosts Conference on Distressed Debt
The Milken Institute hosted a conference on credit markets on April 27-29. View a 71-minute video of a discussion hosted by former "junk bond king" Michael Milken. The Milken Institute described the event as follows:
Moderator Michael Milken convened this timely panel before a packed house, exploring the current crisis in the credit markets and a host of possible solutions to solve it.
David Malpass of Encima Global opened with a basic rundown of the importance of credit as the underpinning of any healthy economy, stressing the importance of proper valuations and accurate ratings. Without well-functioning credit markets and proper credit allocation, he warned, expansion will be limited.
According to James Walker of Fir Tree Partners, the core of the crisis came from off-balance-sheet securitizations in mortgages; cars and credit cards; and securitization of securitization (i.e., CDOs). This securitization phenomenon was driven over the past 15 years by a combination of financial institutions, investment management firms and rating agencies with little skin in the game operating under misaligned incentives to generate fees rather than execute accurate, well-considered analysis. Through this process, Walker said, these asset managers essentially became "asset gatherers," and the world became a global casino with governments acting as the house and taxpayers taking the losses.
Milken turned the discussion to the question of ratings, pointing out that almost 17,000 instruments received AAA ratings in 2007, while today we only have four U.S. companies holding that distinction. He noted that much of the exuberance in ratings was driven by analysts' over-reliance on historical asset appreciation, pointing out that schools typically teach students backward-looking regression analysis as a way of charting the future. The flaw in this model is that raters really need a realistic grasp of future dynamics to understand where things are headed. "The past can't pay you interest," Milken remarked.
Echoing points raised by Milken and the other panelists, Stephen Nesbitt of Cliffwater noted that many institutional investors were hurt because they looked to the past and trusted the ratings firms to provide realistic evaluations of risk. Over the past 35 years, credit has been a bad deal for these investors, Nesbitt said, pointing out that Treasuries actually would have provided a better return. He cautioned that just because an instrument has a high rating or good spread doesn't mean it's attractive. Milken summarized these points by noting the importance of looking at "facts rather than perception."
To round out the discussion, Milken challenged the panelists to focus on solutions. Walker said the key lies in the equitization of debt, otherwise known as deleveraging. Currently there is just too much debt out there at the institutional, corporate and consumer level. To remedy this, Walker proposed banks build tangible common equity and deleverage through asset sales. Corporations must swap debt for equity, pursue secondary equity offerings and enter bankruptcy if necessary. Finally, Walker argued that consumers need to similarly raise their savings rate, restructure debt and enter bankruptcy if needed.
Stephen Tananbaum of GoldenTree offered his thoughts, focusing primarily on the corporate side since he feels it’s easier to change the balance sheet for corporations than consumers, at least in the near term. He spoke of his experience in working with distressed firms, noting that companies are generally receptive when approached with a reasonable offer. He also made the point that the market may be willing to value debt equity at a higher price.
Milken seized on this last point, noting that in good times, a firm's value will likely go up when it takes on debt. In the current environment, however, enterprise value may actually go up when equity is swapped for debt.
Commercial Real Estate: Delinquencies About to Surpass Peak of Previous Recession
click on image to enlarge (source: Deutsche Bank, Wall Street Journal)
The Wall Street Journal has made available a report by Deutsche Bank on the outlook for commercial real estate. The presentation is an eye-opener, as it presents a lot of data on the coming depression in commercial real estate prices.
IMF Says Bad Asset Writedowns Could Reach $4 Trillion
In a new Global Financial Stability Report, released today, the International Monetary Fund sends a stark warning to economic and political leaders, asserting that more will have to be done to shore up the financial system.
The IMF estimates that "writedowns could reach a total of around $4 trillion, about two thirds of which would be incurred by banks." Writes the IMF, "Without a thorough cleansing of banks’ balance sheets of impaired assets, accompanied by restructuring and, where needed, recapitalization, risks remain that banks’ problems will continue to exert downward pressure on economic activity."
While the IMF acknowledges that "there has been some improvement in interbank markets over the last few months," the report also states that "funding strains persist and banks’ access to longer-term funding as maturities come due is diminished."
Of course, when reading the IMF's report, it should be remembered that the IMF is hardly a disinterested bystander. Rather, the mission of the IMF is to support global economic growth and financial stability. By warning that losses could reach into the trillions, the IMF is essentially giving cover to politicians eager to increase the size of their bailouts of the financial system.
Related resource: statistical appendix to the IMF report, containing many interesting charts and figures.
Buffett: California real estate "has flattened out with good volume recently"
In an interview with CNN Money, Berkshire Hathaway chairman Warren Buffett provides interesting insight into Wells Fargo and the banking business in general. He also states that,
California residential real estate is not deteriorating. It hasn't moved up. But it has flattened out with good volume recently. So my guess is that the option ARMs will work out about as they guessed.
On Wells Fargo, Buffett comments,
Those guys have gone their own way. That doesn't mean that everything they've done has been right. But they've never felt compelled to do anything because other banks were doing it, and that's how banks get in trouble, when they say, "Everybody else is doing it, why shouldn't I?"
Wells just has a whole different attitude. That's why Kovacevich calls them retail stores. He doesn't even like the word banking. I mean, he is looking to have a maximum enduring relationship with many, many millions of people. Tens of millions. And at the base of it involves getting money in very cheap. When you do that that's a helluva start in the business. The difference between getting your money at 1-1/2 % and 2-1/2% on a trillion-dollar asset base is $10 billion a year. It's hard to overemphasize that. He thinks more like Sam Walton than he thinks like J.P. Morgan.
On book value as a metric of valuing banks, Buffett asserts,
You don't make money on tangible common equity. You make money on the funds that people give you and the difference between the cost of those funds and what you lend them out on. And that's where people get all mixed up incidentally on things like the TARP. They say, 'Well, where'd the 5 billion go or where'd the 10 billion go that was put in?' That isn't what you make money on. You make money on that deposit base of $800 billion that they've [Wells Fargo] got now.
Buffett then provides his favorite metric for valuing banks:
It's earnings on assets, as long as they're being achieved in a conservative way. But you can't say earnings on assets, because you'll get some guy who's taking all kinds of risks and will look terrific for a while. And you can have off-balance sheet stuff that contributes to earnings but doesn't show up in the assets denominator. So it has to be an intelligent view of the quality of the earnings on assets as well as the quantity of the earnings on assets. But if you're doing it in a sound way, that's what I look at.
Once again, it appears Buffett is way ahead of pundits who are declaring the banking business all but dead. Whenever there is carnage in an industry, most observers and investors have a hard time imagining that things will ever change -- even if the industry will be needed for a long time to come. This is what makes for market bottoms. It also produces attractive long-term investment opportunities for those with the imagination and patience to envision what will be rather than what is.
Irving Kahn, Walter Schloss and Seth Glickenhaus Offer Their Unique Perspective
Noted investors Irving Kahn, Walter Schloss and Seth Glickenhaus have managed money since the Great Depression. They recently shared their perspective on today's markets in the Wall Street Journal. Reshma Kapadia starts off by taking us into the office of centenarian Kahn:
Irving Kahn sits at his cluttered desk, peering at his computer screen through thick, dark glasses. The Dow inched up 38 points today, a small move in light of its 332-point drop earlier in the week. But Kahn has made a career of betting on beaten-down stocks, and he's hard at work poring over annual reports and studying balance sheets looking for companies that have lots of cash, not much debt and good long-term growth prospects. General Electric has a solid business and looks pretty good at these prices, he muses. General Motors? Not so much.
Like a lot of us, Kahn has seen good times and bad, bull markets and bear markets, recessions and recoveries. But he's also seen something most of us haven't: the Great Depression. Kahn, who still shows up at work every day and puts in a good six hours, worked as a stock analyst and brokerage clerk on Wall Street in the 1930s. He's 103 years old.
That's right — 103. As pundits half their age dominate the airwaves with prognostications on whether the next Great Depression is just around the corner, a small group of overlooked folks who not just lived through it but worked through it — on Wall Street — are still here. What's more, they're still at it, running their own sizable portfolios and, in a few cases, managing money for clients. Despite innumerable bull and bear markets, 17 presidents, and countless economic policies, they've remained remarkably true to their investing philosophy. They've also remained remarkably true to their methods: Forget BlackBerrys; most of them hardly touch their desktop computers. And you won't find CNBC blaring in their offices throughout the day; that's more noise than news to these gentlemen. Instead, you'll find stacks of reading material (these guys actually read a firm's annual report before investing) and a lot of old-fashioned...what do you call it? Oh, right. Math.
This cohort has perspective most of us lack: They know what the Depression looked like and how it felt. They saw bread lines on the street and despair in the faces of friends and strangers. Some lost money in the stock market, while others made enough to make it through the Depression rather comfortably. A few began their 80-year careers working for a legendary investor whose investing principles are still taught in business schools. And their take on today's markets might surprise you.
Federal Reserve Vice Chairman Donald Kohn and New York Fed Bank President William Dudley are quoted as saying yesterday that they have virtually no worries about inflation. Writes Bloomberg,
Vice Chairman Donald Kohn, speaking yesterday in Nashville, Tennessee, said the Fed has loaned to "sound" borrowers and plans to disclose more about such credit. New York Fed Bank President William Dudley, speaking at the same conference, said he's "not worried at all that" a doubling in the central bank’s balance sheet to $2.19 trillion will spur inflation.
These are strong words from Fed officials, as "sound" may not be the first word a disinterested observer would choose to describe institutions that have recently been in need of Fed loans. And while it's nice to know that Dudley is "not worried at all," we wonder if he was at all worried about the housing market back in 2006.
One thing seems clear: When public officials sense a need to speak unequivocally on an issue that at best warrants equivocation, you know there is reason for concern. Usually, we hear this kind of talk from countries vulnerable to attacks on their currency or from desperate borrowers in need of putting on a good face to maintain the confidence of their lenders.
Bloomberg goes on to say,
The increased credit has provoked concerns prices will surge. Central bank officials are "dramatically underplaying the risks and liability side of the balance sheet," former St. Louis Fed President William Poole said in an interview at the conference.
"We are very vulnerable to an inflation explosion," said Poole, a senior economic adviser to Merk Investments LLC in Palo Alto, California.
When given a choice to believe a former government official who clearly knows the subject at hand, or a current government official with a vested interest in the success of current policy, we are inclined to choose the former. Certainly, when you have someone of Poole's stature making an unequivocal statement as to our vulnerability to accelerating inflation, one might expect Fed officials to address the concern a bit less glibly than to say they are "not worried at all."
Ironically, it was Kohn himself, perhaps speaking during a moment of unscripted freedom, who said earlier this month that "the trick will be unwinding this balance sheet in a timely way to avoid inflation."
Disclosure: Affiliates of this blog are short 30-year Treasury Bond futures in anticipation of rising yields and falling prices.
At the recent G20 summit in London, political leaders agreed to create $250 billion of special drawing rights (SDRs), which will be exchangeable into a basket of currencies rather than just the U.S. dollar.
With the dollar continuing to enjoy the position of world's de facto reserve currency, any major issuance of paper money that can be used globally and redeemed into multiple currencies represents at least partly a challenge to the U.S. dollar. However, the prevailing view still seems to be that SDRs cannot threaten the dollar's leadership position, at least not when "only" $250 billion of SDRs are issued. A ten-fold increase in the value of SDRs would probably threaten the monetary supremacy of the U.S. globally, but this is unlikely to occur any time soon.
There are rising signs that China is growing worried over its dollar reserves. According to Reuters,
Some experts think China wants to redenominate some of its huge dollar holdings into SDRs without selling dollars on the open market – which would risk a crash in the US currency and a fall in the value of its reserves. But they say the US and the other countries whose currencies make up the SDR are unlikely to agree.
Nick Gogerty of Designing Better Futures makes some interesting points on credit default swap (CDS) spreads on government debt.
We understand why all sorts of CDS spreads would have blown out in the current financial crisis, but the U.S. government is one entity we're not worried about. With Uncle Ben able to print as much paper as it takes to satisfy the nominal claims on the U.S. Treasury, we don't see how an actual default is in the cards. If there were CDSs that referenced the U.S. government's ability to pay off its obligations in real dollars, however, we would be all over those instruments.
Fed's Kohn: "the trick will be unwinding this balance sheet in a timely way to avoid inflation"
According to Bloomberg, "Bernanke, Kohn Pledge Fed to Withdraw Credit When Crisis Ends." This is undoubtedly easier said than done. Given the expediency of recent Fed and Congressional action, we doubt there will be sufficient political will to endanger any future recovery by withdrawing credit early enough to prevent inflation.
David Rosenberg, who recently left Merrill Lynch after gaining respect for predicting the recent downturn in the economy and financial markets, has put out a new piece providing a grim outlook.
Former Federal Reserve Chairman Alan Greenspan writes in the Financial Timesthat "some financial institutions have become too big to fail as their failure would raise systemic concerns." He goes on to say,
"This status gives them a highly market-distorting special competitive advantage in pricing their debt and equities. The solution is to have graduated regulatory capital requirements to discourage them from becoming too big and to offset their competitive advantage."
Lest you believe that Greenspan has shed his Ayn Rand clothes as a result of the failure of our hitherto laissez faire financial system, consider Greenspan's conclusion:
"In any event, we need not rush to reform. Private markets are now imposing far greater restraint than would any of the current sets of regulatory proposals."
Wonderful. Let's leave it up to the private market to fix the mess that the private market created! George Soros calls this blind faith in unregulated commerce "market fundamentalism." The word choice is deliberate. When it comes to religion, faith is a positive force, providing healing and sustenance. Religious fundamentalism, however, is something altogether different. The analogy applies quite well to the free market.
Which brings us to our final point: Here we are debating the latest policy advice of a man whose policies as Chairman of the Federal Reserve arguably pushed us to the edge of collapse. This is symptomatic of what is still happening in many business circles: The same actors who got us into the current mess are now arguing that we should listen to them on how to get us out. Let us restate this: They are not arguing we should listen to them; they are assuming it. And we are, for the most part, buying into this notion.
Well, here is some advice for Mr. Greenspan and his ilk: Write an honest assessment of what you did wrong, what the conflicts of interest or misjudgments were that caused you to do wrong, and what you have learned from your mistakes. Then -- and only then -- will we start listening to your policy prescriptions.
One of our favorite non-fiction authors, Roger Lowenstein, recently wrote an interesting article for New York Times Magazine. Here is an excerpt:
Is there such a thing left as a safe investment? Stocks have been massacred, real estate all but wiped out. Each was promoted in its day — as was gold — as safe and secure, appropriate for widows and orphans.
If there is a truly last bastion of safety, it would be, of course, the U.S. Treasury bond, that venerable instrument with the full faith and credit of the United States behind it. Perhaps it is esteemed so highly because we think of it not as an “investment” per se but as an article of faith in Washington and, by extension, the entire country. It is our tax dollars, after all, that stand behind it — the accumulated output of our citizens. And ever since the Wall Street meltdown, as investors have fled from any security carrying a whiff of danger, Treasuries have been in hot demand.
So it is an eye-opener, and rather depressing, to report that even Treasuries bear risk, in particular, the risk that flows from crowd psychology. Last month, in his annual letter to shareholders (of which I am one), Warren Buffett wrote: “When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary.”
Pretty strong words for an investment that has outperformed stocks over the past 25 years and is widely referred to as “riskless.” Yet according to Buffett and other investors of a cautious bent, “risk free” Treasuries of longer maturities are anything but. None other than China’s prime minister, Wen Jiabao, expressed worry about the safety of China’s big stake in U.S. bonds.
Not since World War II has the government borrowed anything close to what it is borrowing now. Because of the economic slowdown, the stimulus package and various financial-relief measures, pundits estimate this year’s federal deficit at $1.75 trillion. To put the figures in (alarming) perspective, over the past half century and regardless of the party in power, federal tax receipts have usually provided 80 to 90 percent of the money needed to fill the budget; thus, the government has had to borrow only the remaining fraction. But this year, it will need to borrow 45 percent, virtually half, of what it is projected to spend. This means that the U.S. government is looking much like a homeowner at the tail end of the boom: too hooked on spending (even if, hopefully, for a worthy cause) to stay within its means.
When you buy a Treasury security, you are actually lending the government money for a set period of time — from 30 days to 30 years — at a fixed rate of interest. Few people worry that Uncle Sam will go the way of a defaulting subprime borrower because the government, unlike other debtors, can always print the money it needs.
But as James Bianco, who runs an eponymous bond-research firm, explains, investors in fixed-income securities face two types of risk. One is credit risk — the risk of default. The other is what bond geeks refer to as “duration” risk. This is the risk that, even if the bonds are paid in full, the promised rate of interest will turn out to be worth less over time.
Inflation destroys bond values. It’s not a big deal over one or two years, but if you hold a long-term bond and inflation takes off, the present value of the security will plummet. Bonds also lose value as interest rates go up. If rates on 30-year U.S. bonds, recently 3 percent, were to rise to, say, 6 percent, the value of bonds issued at the lower rate would fall nearly in half. (The reason is largely intuitive: if the market rate is 6 percent, nobody would be interested in a 3 percent bond, and its price would fall.)
Today's rally makes March the biggest up-month since 1987, according to Bloomberg. Who would have thought only a few weeks ago that we would be nearing the 8,000 mark on the Dow as of today? We certainly didn't think so, but neither did we prophesy otherwise. We were enticed by the undervaluation of individual companies, and so we were buyers of several companies that had fallen to irrational valuation levels.
We still see plenty of bargains out there, but we have no clue which way the market will go. Neither does Buffett -- who readily admits this -- and neither do market prognosticators who claim to know. What we do know is that there are plenty of ways for investors to profit in this volatile market, but in order to do so, one needs to have a set of investment principles and stick with them.
We invite you to try our "Margin of Safety"-inspired monthly newsletter, Downside Protection Report. Read the latest issue now with your 30-day free trial.
A Bloomberg article argues that Ben Graham, the father of value investing, "would find most U.S. stocks expensive even after the Standard & Poor’s 500 Index dropped 56 percent in 17 months."
The banking dilemma seems eternal, like the monetary dilemma, the tax dilemma, and the marital dilemma. The essence of the banking dilemma, however, is that the depositors' money is not in the vault awaiting the depositors' decision to withdraw it. Instead it is out on loan or invested in the money market or in mortgage-backed securities.
Some of the money is in the vault or on deposit with the Federal Reserve – these funds are called bank reserves – but only a few cents of every dollar. Depending on the specific management, depositors, and financial markets, the average bank may be prepared to accommodate a sudden demand for repayment by a sizable minority of its depositors. Almost no bank in modern times, however, has been able to accommodate a sudden demand for repayment by a majority of its depositors.
Murray N. Rothbard, the economist and libertarian philosopher, has a forcible view on the institutions of fractional-reserve banking: it is "a giant Ponzi scheme in which a few people can redeem their deposits only because most depositors do not follow suit."
Some features of the modern banking dilemma are new, notably the socialization of credit risk during the Reagan years. It was decided that no money-center bank would be allowed to fail and that no depositor, even a sophisticated one, would be allowed to lose his money in a failure, if it could possibly be helped. But other problems are cyclical and still others are chronic. Reading up on the subject, one becomes fatalistic about it.
In gaslight days, before the "too-big-to-fail" doctrine and other modern banking improvements, national banks were bound to hold reserves amounting to 25% of demand deposits. By our standards, this was a lavish margin of safety, even if, as Rothbard notes, capital reserves were often tied up in government bonds. ("[B]anks were induced to monetize the public debt," he has written, "state governments were encouraged to go into debt and government and bank inflation were intimately linked.")
Reserve requirements were reduced to 18% with the advent of the Federal Reserve System in 1913 and stand at 12% today [1990]. Loans as a percentage of assets are higher today than they used to be, however. And off-balance-sheet liabilities – such as standby letters of credit, interest-rate swap commitments, and futures-markets trading – are higher, too.
The rise in the risks attached to banking prompts numerous questions about the nature of lending and the credit cycle. How has the regulatory and monetary climate of the 1980s affected bank lending? If, as seems obvious, it has inflated it, what will be the consequences of it?
The Manual of Ideas estimates that Tobin's Q was 0.33 as of the market close on March 4th. The ratio now hovers near the lows reached during the Great Depression, sending a strong message for U.S. equity investors
In a forthcoming quarterly report, The Manual of Ideas publishes a detailed analysis of Tobin's Q and puts the current ratio in historical context, with data going back to 1900. The new report, to be published on March 16th, will include data from the Fed's yet-to-be-published Z.1 statistical release.
The Vanguard Group founder Jack Bogle is always worth listening to, and so we found his comments on the economy quite notable. He is not in the camp of those who expect an economic turnaround by the end of the year or even next year. Watch Bogle discuss the outlook.
The Nobel Prize-winning economist is out with a thought-provoking editorial in the New York Times:
Comrade Greenspan wants us to seize the economy’s commanding heights.
O.K., not exactly. What Alan Greenspan, the former Federal Reserve chairman — and a staunch defender of free markets — actually said was, “It may be necessary to temporarily nationalize some banks in order to facilitate a swift and orderly restructuring.” I agree.
The case for nationalization rests on three observations.
First, some major banks are dangerously close to the edge — in fact, they would have failed already if investors didn’t expect the government to rescue them if necessary.
Second, banks must be rescued. The collapse of Lehman Brothers almost destroyed the world financial system, and we can’t risk letting much bigger institutions like Citigroup or Bank of America implode.
Third, while banks must be rescued, the U.S. government can’t afford, fiscally or politically, to bestow huge gifts on bank shareholders.
Let’s be concrete here. There’s a reasonable chance — not a certainty — that Citi and BofA, together, will lose hundreds of billions over the next few years. And their capital, the excess of their assets over their liabilities, isn’t remotely large enough to cover those potential losses.
In an interview with Bloomberg on February 11, Jim Rogers says the U.S. should do what it was telling Japan to do when the Japanese bubble burst twenty years ago. Rogers argues that Japan did not listen to the U.S. advice, instead propping up "zombie" banks and ushering in the so-called "lost decade."
Rogers believes the U.S. is now doing the opposite of what it had advised Japan to do. The implication is that the U.S. may end up along the same path as Japan, i.e., no recovery for a decade or longer. Needless to say, Rogers is not very complimentary toward Treasury Secretary Tim Geithner.
Business Spectator's Isabelle Oderberg recently interviewed economist Dr Lacy Hunt of Hoisington Investment Management (link courtesy of Dah Hui Lau). Hunt is quite outspoken on the deflation of the debt bubble. Excerpt:
Isabelle Oderberg: How did we get ourselves into debt deflation?
LH: Well it's been a long time in the making. The debt to GDP ratio took out the highs of the 1930s and 2003. At that point in time total debt was just a little bit more than $3 of debt for every dollar of GDP. Today it is just under $3.60 of debt for every dollar of GDP and we are going to see that ratio move higher, in part because normal GDP in the United States is now falling and the difficulty of repaying this debt is going to be very difficult, because the loans are denominated in dollars and the assets that were borrowed against are dropping in value. The income generating capacity of these assets are also dropping and the US economy is in something called a debt deflation. A very rare situation. It only occurs every 3 to 8 or 9 decades. The last time that we experienced it was the 1930s in the United States. We experienced it in the 1870s and 1880s and Japan experienced a debt deflation post 1988 but it has happened historically. It is very rare and the two main things that identify it are setting a new peak in the debt to GDP ratio and also a lot of borrowing that is improperly financed and where there is little likelihood that the borrower can repay the principal and the interest of the loan.
IO: What scenario are we going to see now?
LH: These debt deflationary periods tend to last. They're very pernicious, they're very persistent and they tend to last a long time. Really, the only thing that brought the United States out of the post 1929 debt deflation was our participation in World War II. The debt deflation that ensued after the panic of 1873 lasted another 20 to 23 years and the Japanese, they had debt deflation which started 1989 and is still running for all practical purposes today. They last for a very long time.
IO: According to your quarterly review and outlook, we're now essentially in a 15-year process. Does that mean that it's going to take 15 to 20 years for this situation to actually stabilise or normalise?
LH: Well, there are other intervening events that could occur. If we would have very significant technological breakthroughs that might shorten the process, but one of the things that suggest it's long running is you can look at what happened to interest rates and stock prices after these prior debt manias. Post-1928 you had a negative risk premium for 20 years. Negative risk premium meaning the total return on treasury bonds exceeded the total return on the S&P 500. Post-1872 you had another 20 year period of a negative risk premium and we've seen a negative risk premium post-1988 in Japan. The low in interest rates after those previous debt bubbles occurred about 14 or 15 years later, for example the low post 1928 occurred in 1941 on the yearly average basis at 1.95 per cent. Once we went into World War II, then there were some very minuscule increases 20 years after 1928 interest rates were up slightly, but not very much from the lows that were reached in 1941 and that was also a characteristic of the Japanese situation and our situation in the US post 1872.
IO: So if we're in any way mirroring the '31 to '33 situation, is the S&P at risk currently of a bear market rally?
LH: Well, one of the things that has happened in these debt deflations is you get a number of false dawns. People believe that the normal business cycle is going to take control and you're going to get a cyclical recovery and the model that soon prevails is that you get three to 10 years of expansion. You have one year, maybe a year and a half of a recession or nasty economic conditions, but after a year and a half at most, the economy then has another expansion for 3 to 10 years.
When we have these very rare debt bubbles occurring at these long irregular intervals, the normal business cycle model doesn't really apply. We do get some false dawns. Some intermittent cyclical recoveries but the unwinding of the debt process proves to be very very long and difficult. One of the reasons for that is that borrowers don't know anything about paying back loans in harder times, which is what's now beginning to occur and as a consequence there is a major behavioural shift or there has been historically in which consumers decide to live inside of their means as opposed to living outside of their means and normally the saving rate goes up for a long time.
After the experience of the 1930s the savings rate in the United States rose irregularly into the early 1980s and it's been in a decline since then irregularly to extremely low levels, virtually the same low levels that we reached in the 1930s and if history is a guide and there are not many data points we're now beginning to see an upturn in the saving rates that will last for a very long time.
George Soros On What Went Wrong, What Needs To Be Done
George Soros provides insight into the financial crisis in a new editorial in the Financial Times. Soros tracks the cascading of the crisis from the fateful bankruptcy of Lehman Brothers. He shows clearly how difficult the situation has become and argues against the use of credit default swaps. Highlights:
...Lehman, AIG and other financial institutions were destroyed by bear raids in which the shorting of stocks and buying of CDS amplified and reinforced each other. Unlimited shorting was made possible by the 2007 abolition of the uptick rule (which hindered bear raids by allowing short-selling only when prices were rising). The unlimited selling of bonds was facilitated by the CDS market. Together, the two made a lethal combination.
What about credit default swaps? Here I take a more radical view than most people. The prevailing view is that they ought to be traded on regulated exchanges. I believe they are toxic and should be used only by prescription. They could be used to insure actual bonds but – in light of their asymmetric character – not to speculate against countries or companies.
The bursting of bubbles causes credit contraction, the forced liquidation of assets, deflation and wealth destruction that may reach catastrophic proportions. In a deflationary environment, the weight of accumulated debt can sink the banking system and push the economy into depression. That is what needs to be prevented at all costs.
To prevent the US economy from sliding into a depression, Mr Obama must implement a radical and comprehensive set of policies. Alongside the well-advanced fiscal stimulus package, these should include a system-wide and compulsory recapitalisation of the banking system and a thorough overhaul of the mortgage system – reducing the cost of mortgages and foreclosures.
...the international financial system must be reformed. Far from providing a level playing field, the current system favours the countries in control of the international financial institutions, notably the US, to the detriment of nations at the periphery. The periphery countries have been subject to the market discipline dictated by the Washington consensus but the US was exempt from it.
How unfair the system is has been revealed by a crisis that originated in the US yet is doing more damage to the periphery. Assistance is needed to protect the financial systems of periphery countries, including trade finance, something that will require large contingency funds available at little notice for brief periods of time. Periphery governments will also need long-term financing to enable them to engage in counter-cyclical fiscal policies.
Roger Lowenstein is the author of five books covering financial markets. His latest book, 
In an interview with The Financial Times, Jeremy Grantham discusses a study on various financial bubbles that his firm has recently completed. Mr. Grantham found 34 examples of bubbles that fit his definition as a “forty year event” statistically. Of these 34 bubbles, 32 have moved back to trends prior to the bubble forming. The two bubbles currently outstanding are the U.K. and Australian housing bubbles which Mr. Grantham believes are driven by low rates on floating rate mortgages.
National Underwriter P&C magazine recently reported that 
H. Kevin Byun, managing partner of Denali Investors, provides some enlightening commentary in his just-released Q1 letter to investors. Byun argues that the equity market is behaving as irrationally on the upside today as it did on the downside in late 2008 and early 2009. He attributes some of the recently exuberant action to so-called "Mr. Magoo pretenders" who suffered big losses in 2008 and may still be chasing their high watermarks. In a quest to recoup losses and get paid, Messieurs Magoo appear content to gamble with their investors' capital, risking disaster yet again. Byun also discusses his concerns surrounding the recent rise of protectionism.
Perhaps no other government policymaker has suffered as much reputational damage due to the housing collapse as former Federal Reserve Chairman Alan Greenspan. Mr. Greenspan has defended his record in recent months and 
Those who have followed the career of Berkshire Hathaway Vice Chairman Charlie Munger know that he has a long history of using parables to educate the public regarding business, economic, and political issues. By far, the best compilation of Mr. Munger’s thoughts on business and life can be found in 
During the hurricane season, the news media often reports forecasted losses even before a storm makes landfall. The same was not true during the epic blizzards that impacted the Mid-Atlantic states earlier this month. While there were a number of reports regarding damage to individual structures, few estimates were made regarding aggregate damages.
Kansas City Federal Reserve President 
The Financial Times has published a five part video interview with Paul Volcker who is the head of President Obama’s Economic Recovery Advisory Board. Mr. Volcker discusses his proposed “Volcker Rule” which would limit the proprietary trading activities of commercial banks. For institutions such as Goldman Sachs that may wish to avoid the ban on proprietary trading, Mr. Volcker suggests that they will have to do so without the benefits of a commercial banking license:
One interesting proposal was recently presented by Paul Calello and Wilson Ervin in a 
While reviewing the Bureau of Economic Analysis (BEA) 
"The International Monetary Fund is forecasting positive growth in 2010; yet, it warns the pace of growth will be too sluggish to prevent further increases in unemployment across the global economy. What is the outlook for the global economy in 2010?"
In the late 1990s, pension funds decided that it would be a good idea to purchase stocks near the peak of the technology bubble. Strike one. In the mid 2000s, the idea was to join the private equity and hedge fund wave sweeping over Wall Street just in time for the 2008 financial crisis. Strike two. Now, The Wall Street Journal reports that public pension funds have decided to 
The Associated Press 
Interesting article in a recent issue of The Economist:
Famed value investor Robert Rodriguez of First Pacific Advisors is taking a one-year sabbatical. In his final fund commentary, Rodriguez pulls no punches on the government's deficit spending:
Respected investment manager Aaron Edelheit of Sabre Value writes the following on his blog:
Bloomberg has an 
GMO's Jeremy Grantham provides high market outlook in a recently published 
By Ravi Nagarajan
We generally agree with those who argue that U.S. currency debasement will lead to depreciation in the U.S. dollar and accelerating inflation, making gold a good investment, at least in nominal terms. However, it is always important to consider opposing views, so here is a bearish perspective on gold, put forth by 
Former Federal Reserve Chairman Paul Volcker speaks with Charlie Rose in 
Well-known bear David Rosenberg, chief economist at Gluskin Sheff, 
The Times (of London) 
PIMCO's Bill Gross writes in his 
Warren Buffett, chairman of Berkshire Hathaway, opines in today's 
Federal Reserve Vice Chairman Donald Kohn and New York Fed Bank President William Dudley are 
Former Federal Reserve Chairman Alan Greenspan writes in the 
One of our favorite non-fiction authors, Roger Lowenstein, recently wrote an interesting article for New York Times Magazine. Here is an excerpt:
The Vanguard Group founder Jack Bogle is always worth listening to, and so we found his comments on the economy quite notable. He is not in the camp of those who expect an economic turnaround by the end of the year or even next year. 
The Nobel Prize-winning economist is out with a thought-provoking editorial in the New York Times:
In an interview with Bloomberg on February 11, Jim Rogers says the U.S. should do what it was telling Japan to do when the Japanese bubble burst twenty years ago. Rogers argues that Japan did not listen to the U.S. advice, instead propping up "zombie" banks and ushering in the so-called "lost decade."
Business Spectator's Isabelle Oderberg 
George Soros