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STOCKS FOR INFLATOPHOBES
Strictly speaking, the March inflation report – the CPI rose 0.6% from the month before, or at an annual rate of 7.2% – was an impossibility. The "bond vigilantes" could not have permitted such an outrage. Years ago Wall Street economists propounded the theory that bondholders, scorched once by the great inflation of the 1970s, would never allow themselves to be hurt again. At the first sign of monetary laxity they would scream, “Bonds away!” So selling, they would push up market interest rates and stop the nascent inflation cold. But now look: 10-year Treasurys yield only 1.2 percentage points more than the 3.1% that the CPI has risen in the past 12 months. The bond vigilantes of 1985 have become the bond idolators of 2005.
What do these bulls have to say for themselves? They contend that a worrying rate of inflation is impossible with so much global productive capacity in place. Wal-Mart, China, India, the Internet and the leveraged state of American finance all point, in fact, to deflation. Inflation is yesterday’s worry, they say. Bonds are the safe haven of the millennium. I say they are wrong. If monetary policy were not overstimulative, the greenback would probably not be in a bear market. Nor would the measured rate of inflation be creeping up. Nor would the unmeasured rate – think house prices – be leaping up, as well. But why be dogmatic? The future is unfathomable, forecasts are errant, and macroeconomists are notably scarce on The Forbes 400 roster. What is wanted are good investments that could benefit from a new outbreak of inflation yet would probably do well even without one. Many in the inflation-fearing camp own the Treasury’s inflation-protected securities, known as TIPS. I do not, because the inflation rate that TIPS protects against is the understated CPI. Instead, oil, tobacco and gold shares from overseas will serve you quite well.Link here.
WHEN TOKYO FELL OUT OF BED
Japan at last is making a long, agonizing climb back toward prosperity. I emphasize the word long and have advised you in the past to invest in Japan while its equities are still cheap. The perennially depressed Nikkei index has been on the upswing since 2003 but sold off sharply in the wake of recent Chinese demonstrations, presenting another buying opportunity. In the past I have recommended buying the MSCI Japan Index as the best means to track the broad Japanese market. Now there is another way for Americans to invest in a good basket of Japanese stocks: an investment vehicle called RHJ International (25, RHJI.BB) that went public in March.
Company head Timothy C. Collins, an American investor, has been a winner in the Japanese arena, and his initial public offering easily raised $1 billion. Given the cash-rich nature of so many Japanese companies, a strong case can be made that a recovering Japan is about to embark on a leveraged-buyout boom. And Collins’s group, also known as Ripplewood Holdings, is well positioned here. Ripplewood is not cheap, if you look at it like a closed-end fund. The shares now trade at a 10% premium to the net asset value of the investments plus the cash the firm raised. Since the stock is not traded in the U.S., you must pay extra to buy it in Europe. Regardless, my bet is that the share price will rise along with the Japanese recovery.Link here.
BUY GM, PREFERREDS THAT IS
General Motors’ travails are endlessly recounted in the news media these days. Deteriorating market share, clunky designs, moneylosing quarters, enormous labor costs-all contribute to the sense of dread that surrounds this onetime corporate icon. The stubborn unions are living in a time warp, bleeding the company to protect health benefits that are totally out of line with world economic realities. The sad fact is that GM has been below investment grade by most objective measures for the last three years, according to upstart rating agency Rapid Ratings. After all, it is hard to fathom how GM can remain investment grade with a $470 billion balance sheet that shows only $26 billion of equity (and a market capitalization only half that dismal figure). The news stories on GM have been so one-sided that I almost suspect Chief Executive Richard Wagoner himself is behind them, trying to budge his labor unions into a reasonable bargaining position.
While buying GM common stock is a dubious choice, the automaker’s bonds and preferreds make a lot of sense. (Here the term “preferred” encompasses not the usual variety of senior equity but minibonds that trade like shares of stock.) GM may be forced at some point to cut its common dividend, but its bond and preferred interest payments are on firmer ground. For fixed-income investors, GM does not have to generate a profit; it merely needs free cash flow greater than zero. Free cash flow is, roughly speaking, net income plus depreciation minus capital expenditures. You need look no further than the airline industry to see that a company can operate for years upon years without profitability and can avoid bankruptcy so long as cash flow stays positive. GM, still the world’s largest automaker, should be able to manage this feat despite its manifold weaknesses.Link here.
THE BEST WALL STREET EARNINGS ESTIMATORS
Wall Street punishes companies that miss consensus earnings forecasts and rewards those that exceed expectations. StarMine, a San Francisco research organization, has built up a nice business capitalizing on this fact. Since 1998 StarMine has used analyst forecast data collected by its partner Thomson First Call to analyze and rank the performance of security analysts from both big brokerage houses and stand-alone equity research shops. For a remarkable three years in a row StarMine has selected Credit Suisse First Boston’s Ivy Zelman as the sharpest earnings estimator tracking North American stocks. “The odds of that happening by luck are nil,” marvels StarMine Vice President David Lichtblau. According to StarMine, Zelman’s analytical skills in 2004 were better than those of 3,300 of her peers.
Lichtblau also tells us that analysts who are good at forecasting earnings do not necessarily excel at a second skill – making good calls on when to buy, hold or sell a stock. That is why StarMine does a separate batch of calculations to select the best stock pickers. Our list of StarMine’s ten stock-picking stars – and the companies they are up or down on now – is listed below. Go to Forbes.com for an interactive version of the best forecasters and stock pickers in each of over 50 industries.Link here.
A CONTRARIAN PREDICTS THE MARKET
As Merrill Lynch’s chief U.S. strategist, Richard Bernstein is the fellow charged with figuring out where the market is headed, and he has not always been right. No mere mortal can see through the economic murk. But Bernstein has been right often enough to merit attention. Chiefly, he spotted the upcoming tech bull market of the 1990s before most of his peers, and he later warned customers of its coming collapse, again ahead of the crowd. Bernstein compiles the recommended asset allocations of between 14 and 20 Wall Street strategists and then goes in a different direction. His average of the others’ numbers, to which he gives the fancy title “Sentiment Indicator”, is already priced into the market, he believes. And that justifies a contrarian tack.
Right now his composite of rivals says you should have 62.3% in stocks, 23.4% in bonds and 13.2% in cash – a pretty bullish call, especially since the market is down 4% this year. Bernstein, though, thinks stocks will not do as well as the indicator suggests. He would devote only 45% to equities, 45% to bonds and 10% to cash. If other firms get superoptimistic and call for owning 63% in stock, he sees that as a sell signal.
While contrarianism is a big part of his forecasting tool kit, Bernstein also depends on an array of quantitative measures that Merrill keeps under a proprietary blanket and will not reveal. In rough form, he looks at how much capital is available to business, and today that is a lot, courtesy of still-low interest rates, among other factors. A plentitude of funds is a negative sign. What vexes Bernstein is the “Greenspan put” – the public belief that the Federal Reserve will always bail the market out, as it has in recent years, with cheap credit. No wonder so much capital is in circulation, he says. Returns on capital are highest when capital is scarce, Bernstein argues. “It is hard to find unexploited opportunity”q Result: He expects a middling 5%-to-10% S&P 500 total return in 2005. Another way of arriving at this unexciting conclusion is his analysis of price/ earnings ratios. “Rich was hands down the most imaginative strategist in terms of using fundamental data,” says his predecessor, Charles Clough, who now runs an investment firm in Boston.Link here.
Warning: A virulent epidemic is sweeping the nation. How many more victims the epidemic might claim is anyone’s guess. But suffice to say that the rapid spread of this contagion is a serious national problem, which may produce several dire consequences … like falling home prices, for example. Although the disease manifests itself in a variety of ways, it often produces behavior characterized by reckless borrowing and insatiable consumption. The disease, known as “affluenza”, has infected millions of Americans already, but has reached epidemic proportions among California homeowners.
The onset of symptoms is often accompanied by a sense of euphoric invulnerability. Unfortunately, this delusional rapture promotes additional high-risk behavior, which usually worsens the infection. Many victims succumb to the disease, but the condition is treatable. Early diagnosis can promote a highly efficacious response. Curtailing high-risk activities, for example, can reduce the infection and – sometimes – restore the infected host to an asymptotic state known as “solvency”.
But many folks – because they are oblivious to their condition – continue borrowing and spending until the disease reaches its final and most serious phase, also know as “insolvency”. We are not anticipating a widespread outbreak of insolvency. More likely, the growing awareness of the risks posed by affluenza will inspire a gradual return to low-risk behavior, like saving money and repaying debts. Sadly, such practices, while healthy for the individual, are highly toxic for the national economy and for the country’s over-inflated real estate markets. But that is a problem for another day. Let us take a quick peak at the current state of the epidemic…
(Forgive us, dear reader, for directing our financial gaze once more toward the west, specifically toward Orange County, California. It is not our fault that the county’s many quirks recommend themselves as fodder for the Rude Awakening.)Link here.
DESTROYING THE AMERICAN DREAM
Well he has done it. I did not want to believe it, but it is true. Greenspan of course has transmogrified attractive interest rates of recent years into outrageously negative real interests for so long that he has nursed into being a virtual Godzilla of real estate speculation the likes we have not seen since Og traded a club and mammoth skin for his friend’s cave. Welcome to LA’s housing nightmare. Well, what exactly did he do? Only destroy the American Dream for many. Yes, I know, I can always afford a house in Oklahoma, provided I can find a job that is one step above the Quickie Mart. (No offense to Oklahoma, as you have lots of land, or to Quickie-Mart workers for that matter as your work is more respectable than counterfeiting.) What I am talking about are places on the coasts where a lot of people have no choice but to live and work.
When Alan and his merry band of counterfeiters pursued a policy of “making the world safe for speculators” at the expense of working, middle class, and yes, even upper middle class people (100k a year is not sufficient income for a first time homebuyer in LA) he destroyed the value of their savings and returns on their labor. The new rules of the game are simply this: “He who speculates first wins.” And those who have assets to begin with are in the best position to speculate first when the conditions for speculation are risk free as opposed to those who are just getting started in life and are scrimping and saving for that 20% down payment, as in the old days.
So the rich get richer, and you can finish the sentence. When budding LA real estate tycoons in the making rapidly piece together, 3, 5, 10 residential houses at inflated prices, and then raise the rental rates, as what can happen in a difficult supply-demand situation in LA, not only does the entire cost structure of the rental market increase to the detriment of working people, but there are now fewer available homes for people who just need a place to raise their families. Result, rewarding speculators at the expense of everyone else. Great, just great.
Alan, congratulations by making the world safe for speculators and enriching the few at the expense of many, by encouraging the misallocation of capital and punishing savers, by destroying the returns of labor in relation to the returns of financial speculation. Yes, Alan, for many, you have destroyed the American Dream. Go east young man, go east young woman, but not too far. Be sure to stop somewhere in the middle!Link here.
Real-estate appraiser Karen Long is not very busy, and she thinks she knows why. Her unwillingness to fudge figures has given her a reputation. She suspects her honesty keeps away clients who do not want surprises. “If you’re not going to meet [their anticipated] value, they just walk away and find another appraisal,” says Ms. Long of State Center, Iowa. “It goes on all the time.” No one knows exactly how often appraisers tinker with reality. But reports suggest that they face enormous pressure to tweak their numbers. Some observers predict they will face even more if the real estate market cools.
In a 2003 survey of 500 appraisers by a private firm, 55% of appraisers said they had felt pressure to overstate values, according to a report by Demos, a public policy center. The National Association of Realtors has warned the U.S. Senate about the prevalence of appraisal fraud, and thousands of appraisers have signed an online petition calling for reform. Who is putting the pressure on appraisers? Appraisers blame mortgage brokers and lenders who are paid by commission. For them, just as for real estate agents, more expensive homes translate into more money.Link here.
Fools in paradise.
What do the city of Irvine, California and the Starbucks Company have in common? Maybe nothing … or maybe both of these prosperous entities owe a debt of gratitude to the consumption-crazed American economy. If not for America’s three-decades-and-counting consumption boom, for example, Starbucks might not be selling $4 lattes from 8,000 different locations. And if not for the growing tendency of Americans to assume the riskiest possible mortgages in the quest for the largest possible homes, the average home price in Irvine might not be bumping up against $800,000 – double the price of four years earlier. Unfortunately, booms that derive from debt, rather than incomes, tend to die a grisly death. …
The chart below tracks the remarkably similar trajectories of median home prices in Orange County, California, of which Irvine is an important part, and the number of Starbucks outlets worldwide. We are somewhat intrigued – and amused – that these parabolic trajectories so closely resemble one another. Perhaps no legitimate connection exists between these two trends. Or perhaps, Irvine and Starbucks share a more profound connection than is readily apparent. Both entities reflect are an aspect of America’s rampant consumption boom – a boom that may be living on borrowed time, not to mention borrowed money.Link here.
Bubble or not, high home prices can hurt.
This was supposed to be the year the housing sector, which has expanded at a record-setting pace since 1998 (except in 2000), started to cool. Instead, existing-home prices rose in March at the fastest pace in two decades, and new-home sales hit another peak in the first three months of the year. The strong housing sector has buoyed the economy and local governments, through construction payrolls, increased property tax revenue and consumer spending tied to high home equity. But it also has economic downsides. High prices are keeping buyers out of the market, making it harder for firms to attract workers in pricey markets and breeding high consumer debt and speculative buying.
Many economists warn a major swath of the market is at risk of a price correction. “Home buyers appear to be irrationally exuberant,” Jan Hatzius, economist at Goldman Sachs, said in an April report to clients, recalling Federal Reserve Chairman Alan Greenspan’s comment about stock market investors in the 1990s. Hatzius identified frenzied coastal markets, such as Los Angeles, New York, Boston, Washington, Miami and San Francisco, as especially hot. Nationally, home prices have jumped an average 50% in the past five years, doubling in California and rising about 80% in Nevada and Hawaii, according to the Office of Federal Housing Enterprise Oversight (OFHEO). In an April USA Today poll of 55 top economists, three-fourths called housing overheated, though they differed on whether they expect a gradual cool-down or a sharp drop in sales and prices. Forecasts for a soft landing expect robust job creation to offset the negative effects of the Federal Reserve’s interest-rate increases.
A few economists warn of a national housing bubble, but most say local housing and job markets vary so much that a countrywide downturn is unlikely. But price reductions in big urban markets could have a broad effect on the economy. That is why there is plenty of concern about signs of speculative buying: the fact that prices are rising faster than rents, when the two usually move more closely in tandem, and price inflation that cannot be justified by low rates or supply.
For their part, industry officials are irritated by “sky is falling"” predictions. Home builders say the current, elevated level of about 2 million housing starts a year is not enough to meet higher-than-predicted household growth, fueled by immigration. Supply is tight in some areas because it can now take years to get developments approved by zoning authorities. Further, affluent baby boomers, rather than selling homes as they near retirement, are buying second houses. Investment homes were nearly a quarter of all purchases in 2004, and vacation homes were an additional 13%, says the National Association of Realtors (NAR).
Nationally, an NAR survey shows affordability still in a healthy range. But in a number of cities, soaring prices are pushing not just lower-income workers but middle-class families to the sidelines. In California, on average, only 18% of the population could afford a median-priced home in March, according to the California Association of Realtors. Another telling sign of consumer stress is the growing use of alternative financing. Adjustable-rate mortgages (ARMs), which carry interest rates that rise in tandem with market rates after a set period, have been setting records and now account for more than a third of recent home lending, even though rates on 30-year fixed loans remain below 6% – lowest in decades. In the subprime market – higher-priced loans for consumers with impaired credit – more than 80% of purchase loans are adjustable rate. So-called 2/28 products, in which an interest rate is fixed for two years, then can rise annually or semiannually, is the main subprime-purchase loan, according to David Kogut, a senior economist at mortgage giant Fannie Mae. Based on past experience, ARMs should have only about 20% of market share, Kogut says. The rise in ARMs shows that borrowers are stretching to buy, because ARMs offer lower interest rates, and therefore lower monthly payments, in the early year or years of a mortgage.
Potential buyers see warning signs of a speculative market but worry they run a bigger risk if they wait and prices jump still higher. “People have been saying for years now, ‘The bubble is going to burst.’ It hasn’t happened, and my friends who bought three years ago have tripled the value of their property,” says Bridger McGaw, 30, seeking a Washington, D.C., condo. McGaw has lost out on several properties, including one in a bidding war that pushed the cost $70,000 over the $319,000 listing.Link here.
Vultures smell drop in hot Florida condo market.
The vultures are circling the construction cranes and unfinished concrete-and-glass towers of Miami’s white-hot condo craze. A handful of real estate entrepreneurs are forming “vulture capital” funds to pounce on what they call an inevitable downturn in an exploding south Florida real estate market fueled by foreign buyers searching for safe havens and aging baby boomers looking to downsize and move closer to the coast.
Nowhere is the champagne fizz of the real estate mania more evident than Miami. In the city of Miami, more than 60,000 high-rise condo units are in some stage of planning or construction, officials say. The city has fewer than 400,000 people, a fraction of greater Miami’s 2.3 million population. Jack McCabe, chief executive of McCabe Research and Consulting of Deerfield Beach, Florida, said he has formed an “opportunity fund” that is nearly “eight figures” to take advantage of a swoon he sees coming next year as a result of a bulge in the south Florida condo pipeline. “We’re seeing people taking equity loans, people emptying their savings accounts. The really giddy are maxing out their credit cards to get in on this gold rush,” he said. “We think a lot of people are not going to be able to close.”
Local real estate analysts say 80% of the units in some projects are bought by speculators. About 48,000 new condos are scheduled to hit the south Florida market – Miami, Fort Lauderdale and West Palm Beach, by 2007, McCabe says. He believes a market downturn beginning next year will leave some speculators unable to close, buyers in bankruptcy or foreclosure and developers out of business. That is when the vulture capitalists will swoop. “Some of the greatest fortunes were made in down markets,” he said. “A down market sorts out the really savvy from the naive. The savvy will understand what opportunities are out there and the naive will suffer the consequences.”
The vultures may flock too early, David Dabby, president of Coral Gables-based Dabby Group and a longtime observer of the Miami market, said, recalling that the south Florida market took about six years to recover from a condo bubble in the early 1980s. “That’s a fool’s game right now,” he said. But with an estimated 1,000 new residents moving to Florida every day and land available for development running dry, particularly in south Florida, some analysts say any downturn will be less a crash than a period of flat or moderately lower prices. “South Florida will always be an excellent real estate market in the long term,” McCabe said. “We have a scarcity of land and we have constant population growth.”Link here.
Is your house an energy guzzler?
Add this to the list of life’s great mysteries: Why doesn’t everyone who buys a house have an energy rating performed immediately? Most people who bought a home recently or had one built never even considered having an energy rater evaluate the home’s energy efficiency and expected energy costs. If you are planning to buy a home this year, here are a few things you need to know.Link here.
ARE THE STORM CLOUDS ON THE HORIZON THE HARBINGERS OF DOOM?
The doomsday theme is seeping into the normally circumspect world of economics. In April, Arjun Murti, a veteran analyst at the investment bank Goldman Sachs, warned that oil could “super-spike” to $105 a barrel. And increasingly, economists are prophesying that the U.S. economy as a whole may be sailing into stormy waters. The government and consumers each year spend much more than they make, leaving the country with large and growing budget and trade deficits and personal debt load. The forces propelling and buffeting the economy are like a series of interrelated and interconnected weather systems. Could they be setting the conditions for a perfect storm – a swift series of disturbances that causes lasting damage? If so, what would it look like?Link here.
IS AMERICA GOING BROKE?
David Walker can see the future, and it scares the hell out of him. That would not be terribly unusual if he were one of the thousands of lobbyists, legislators and activists crawling all over Washington on any given day, pontificating about the urgency of their pet issues. There is a thriving industry here built on pushing policy prescriptions for every ailment, real or imagined. But Walker is not a lobbyist or an activist – he is an accountant. His title is comptroller general of the U.S., which makes him the head auditor for the most important and powerful government in the world. And he is desperately trying to get a message out to anyone who will listen: the United States of America’s public finances are a shambles. They are getting rapidly worse. And if something major is not done soon to solve the country’s intractable budget problems, the world will face an economic shakeup unlike anything ever seen before.
Seated in his wood-panelled office in downtown Washington, Walker measures his words, trying to walk the fine line between raising an alarm and fostering panic. He cringes when he hears prominent economists warning about a financial “Armageddon”, but he makes no bones about the fact the situation is dire. “I don’t like using words that are overly inflammatory,” he says, leaning forward in his chair. “At the same time, I think it is critically important that the American people, as well as their elected representatives, get a better understanding of just how serious our situation is.”
The numbers are staggering – a $43-trillion hole in America’s public finances that is getting worse every day. And the stakes are almost inconceivable for a generation of politicians and voters raised in relative prosperity, who have never known severe economic hardship. But that plush North American lifestyle to which we have all grown accustomed has been bought on credit, and the bill is rapidly nearing its due date. If the U.S. cannot find a way to pay up, the results will spill beyond national borders, spreading economic misery far and wide. In Canada, the country whose financial well-being is most tightly tied to trade with the U.S., there would not be a single region or industry left untouched by a fiscal shock south of the border.
It is the looming presence of this potential crisis that brings Walker to this office every day, through the doorway with the words “Honesty Accountability Reliability” inscribed above, in hopes that someone will listen and take up the challenge before it is too late. “The sooner we start fixing this, the better,” he says, “because right now the miracle of compounding is working against us. Debt on debt is not good. We have to first stop digging, and then figure out how we’re going to fill the hole.”Link here.
BOOKMAKERS PLACE ODDS ON GREENSPAN’S SUCCESSOR
If a longshot can prevail in the distinguished Kentucky Derby, then perhaps Donald Kohn – seen by some as the closest thing there is to an Alan Greenspan clone – can wind up as head of the U.S. Federal Reserve. Kohn is a 15-2 shot at paddypower.com, which set a line a month ago and has yet to shift the odds. “We’ll probably end up pushing Donald Kohn’s odds out a bit, try and get people to put more than a tenner on him,” Irish bookmaker Paddy Power said. The story – and the odds – are much the same at Costa Rica-based Royal Sports, where Kohn is seen neck-and-neck at 7-1 with recently departed U.S. Treasury official John Taylor. Taylor’s odds are just a hair better at paddypower.com.
The clear favorite is Fed Governor Ben Bernanke, who has been asked by President Bush to chair the White House Council of Economic Advisers. At paddypower, Bernanke’s line is 13-8; it is a nearly identical 33-20 at betroyal.com. Further down the field is former Bush aide Glenn Hubbard in second and Harvard University’s Martin Feldstein in third. Both sites have Hubbard at 2-1 and Feldstein at 4-1. Although Greenspan is not expected depart the Fed until early next year, when his seat on the central bank's board expires, bookmakers think it is none too soon to start taking bets.Link here.
THE POLITICIZATION OF THE TRADE CYCLE RAISES RISKS TO FINANCIAL MARKETS
It is hard to argue with the theoretical benefits of globalization. It is the real time application of this theory that appears to be getting the world into trouble. Macro is never pure economics. It invariably involves the powerful interplay among economic, social, and political considerations. The rising tide of protectionist sentiment around the world is an outgrowth of just such an interplay. At work, in my view, is nothing short of growing resistance to globalization – a backlash that poses a serious threat to the global economy and world financial markets.
The U.S. is leading the charge. This comes as something of a surprise in the aftermath of last fall’s intense political campaign. Most thought that the debate over outsourcing, offshoring, and job security would end on November 2. That has not been the case, in large par because a palpable undercurrent of discontent has lingered in the U.S. labor market. America remains mired in the weakest hiring cycle on record, while worker pay rates have barely kept up with inflation – all the more astonishing in an era of rapid productivity growth, which is normally thought to boost real wages. While the state of the U.S. economy may look fine on the surface from the standpoints of GDP growth and inflation, a large constituency of the American work force remains on the outside looking in. Politicians have been trained to pounce on such discontent. And there is a second important variable in the Washington equation: a U.S. trade deficit that is veering out of control.
In political circles labor market distress and a China-centric U.S. trade deficit are not viewed as happenstance. Rightly or wrongly, China is being held accountable for the unusually tough conditions bearing down on American workers. The Washington consensus has singled out China’s currency policy as the smoking gun in this accusation. As a recent 67-33 procedural vote in the Senate in favor of the so-called China Currency Bill indicates, the politics of China bashing have broad and deep bipartisan support.
This is one of these classic examples of politics driving bad economics. America’s gaping trade deficit is a direct outgrowth of an unprecedented shortfall of U.S. saving – dominated by a personal saving rate that has fallen nearly to zero and a dramatic swing in the federal government’s budget from surplus to deficit. Lacking in domestic saving, the U.S. has had to import surplus saving from abroad in order to grow – and run massive current-account and trade deficits to attract the foreign capital. Little wonder that Washington wants to pin the blame on someone else. China bashing also poses serious risks to the broader global economy. Protectionist actions aimed at restricting the growth of Chinese trade would hit the fastest growing component of world trade, thereby arresting one of the most important sources of global economic growth. Unfortunately, politicians have no patience for these macro arguments. In their minds, it is more important to pin the blame on someone else.
It was not supposed to be this way. Classical economics has long defended the benefits of globalization in the context of “two-sector models”. Tradable goods were the ever-intense arena of competition, where countries exchanged goods in accordance with the Ricardian theory of comparative advantage. But by toiling in “non-tradables”, knowledge workers would benefit from increased purchasing power arising from increasingly cheaper manufactured products imported from the developing world. In today’s parlance, this was the win-win strategy of globalization. Paul Samuelson has written eloquently of the conditions under which the introduction of a “disruptive technology” can challenge this long-cherished theory. Enter the Internet – perhaps the most disruptive technology yet to be encountered by classical economics. Courtesy of e-based cross-border connectivity, activities in the once non-tradables sector are now becoming tradable. Little wonder that opportunistic politicians have been so effective in exploiting this gathering sense of worker angst.
The post-election polarization of American politics does not suggest that reason will prevail in coping with this angst. In the past, this was always the fall-back to earlier U.S. flirtation with protectionism. In today’s increasingly acrimonious political climate, those checks and balances are sadly missing. With China bashing in the U.S. Congress likely to intensify through the summer, the risks of a disruptive global rebalancing – complete with sharp declines in currency and bond markets – are likely to rise considerably.Link here.
YUAN WATCHING LIKE WAITING FOR GODOT
Watch what they do, not what they say. It is the first commandment of watching economic policy makers. Yet China, a place with a knack for testing the rules of economics, is breaking it. In the case of Asia’s No. 2 economy, it is equally important to follow what is said as what is done. That said, here is what Li Yong, China’s deputy finance minister, had to say last week to currency traders pressuring China to let the yuan rise: “I urge them not to do such speculation – they need patience.” For anyone looking for a sign that China will not alter its 8.3 peg to the dollar anytime soon, Li’s comments in Istanbul could be it.Link here.
VEHICULAR BOND SLAUGHTER
Now that GM’s credit rating clings for its life, millions of bond investors are holding a candle for the auto titan – hoping for a miraculous recovery. If GM’s investment-grade rating sheds its mortal coil, the entire corporate bond market may suffer a near-death experience, especially that portion of the bond market that already faces life and death situations every day … the junk-bond sector. Now more than ever, therefore, junk bonds – known in polite company as “high-yield” bonds – might not be suitable for widows and orphans … or for married couples and their children … or for divorcees … or for same-sex partners … or for almost any other sort of investor who favors return OF capital over return ON capital.
Last week, an intellectually honest credit analyst at Standard & Poor’s named Scott Sprinzen, plunged the credit ratings of both GM and Ford into the ranks of junk borrowers. In so doing, he seemed to plunge many junk-bond investors into a state of extreme denial. To be sure, many GM bondholders panicked immediately upon learning of the downgrade and dumped their holdings. Likewise, many other high-yield investors reacted swiftly and decisively to the news by dumping an array of high-yield bonds. A few steps removed from the fray, however, the owners of closed-end funds that invest in high-yield securities steadfastly held their ground. They responded as if GM’s travails posed no risk whatsoever to the rest of the high-yield market.
If GM’s bonds – the newest and largest members of the junk-bond ranks – are reflecting extreme distress, should not the prices of closed-end funds that specialize in junk bonds be reflecting at least mild concern? A few of them are, but many are not. Last week’s twin-downgrade of Ford and GM was not an every-day event. To the contrary, both automakers are massive borrowers. For perspective, GM’s debt alone would account for about 15% of all U.S. high-yield bonds outstanding. In other words, junk-bond buyers might find themselves with much more junk than they wish to buy. And a dollar spent buying a bond issued by GM or Ford bonds would be a dollar NOT spent buying some other sort of junk bond. Net-net, we suspect GM and Ford will be about as welcome in the junk-bond market as a windstorm at an origami festival … and just as disruptive.
Maybe the worst is over already for the high-yield market, but we doubt it. And even if we wanted to believe it, we would not bet on that outcome with any of our own money. Hold a candle for GM’s credit rating if you wish, but don’t hold your breath.Link here.
WHERE ARE THE NEXT CAR WRECKS?
“Give me a place to stand and a lever long enough and I will move the world.” – Archimedes
History is silent on Archimedes’s understanding of financial leverage, but it might be a fair bet that anyone who could describe such diverse problems as leverage and buoyancy would grasp the concept easily. Whether Archimedes could extrapolate the shipping-based economy of his hometown of Syracuse to the modern credit-based economy, one wherein automobiles are manufactured as an excuse to make automobile loans, is more of a stretch: Like all ancients, he probably was a “show me the money” sort.
On the subject of buoyancy, stocks float on a sea of bonds. As discussed here last month, the relationship between corporate bonds and stocks is highly asymmetric. A stock can get hammered on all manner of silliness without affecting the bond, but if a corporation’s bonds are in trouble, the stock will get dragged lower until and unless a suitor for the stock emerges. Last week’s pot-clanging bid by Kirk Kerkorian for General Motors was just the sort of event that could rescue a weak stock from the issuer’s weaker bonds. So is any leveraged buyout situation.
A downside of modern executive compensation is that anyone whose paycheck is linked to the stock price has an incentive to be aggressive on behalf of the shareholders, not the bondholders. If we learned anything from the past decade’s “Executives on Trial” extravaganzas, it should have been that a compensation level, once achieved, is not abandoned without a fight. Executives who have gotten a taste of mega-riches are going to do anything to maintain those riches at the expense of whomever.
If we are to remain in a difficult market environment and in a difficult management environment – anyone want to sign their name to a Sarbanes-Oxley attestation of the financial statement?– we are likely to see more and more firms go private in one way or another. That is bad news for the bondholders. But as we saw during and after the 1980s leveraged buyout boom, it is often bad news for shareholders as well; few managers know how to run a company for the sole purpose of paying off a note. Recent jumps in credit default swap costs for firms that are going down these paths are warnings of difficulties ahead. Archimedes would have understood: Even though he probably wore a toga-like robe, the concept of lining one’s pockets at the expense of others certainly would have been familiar to him.Link here.
TRANSFORMATIONAL TECHNOLOGY STOCKS PROVIDE IDEAL DIVERSIFICATION
Venture capitalists are some of the savviest investors in the world. They buy into early-stage companies, usually high tech, before the rest of the world knows about them. When they win, they win big: they can make hundreds of times their money on a single investment. Although VCs are aggressive investors, they are also careful. They perform extensive due diligence. They focus on savvy management, strong business plans, and really valuable technology with proprietary barriers to entry. There is a niche opportunity where you can do better than a venture capitalist. These are small public companies that VCs originally backed when they were still private. They went public, but they got into trouble somewhere along the way.
These companies can be better for at least two reasons, sometimes three. First, they are publicly traded, which means you can buy and sell them any time. (It is still best to plan on holding these for years, not months – but sometimes you may unexpectedly need the money.) Second, thanks to Sarbanes-Oxley, you can rely on information in companies’ SEC filings, which is far more extensive than what VCs typically get to work with. Third, these companies are often less expensive than when they were private. Having had their wings clipped by a bad event or two, they are no longer such high fliers. Their market capitalizations are lower. However, the potential is often still quite exciting.
Here is the key: Many times, the stumble was not due to bad management but rather something external to the company. In particular, I look for the little undervalued public companies I call “transformational technologies stocks”: those capable of changing the world in some area. They do not merely offer a marginal improvement to the status quo … they have the potential to overturn a whole industry.
Transformational technology stocks have three stages of life, kind of like a butterfly. During the first, or “caterpillar” stage, they wander around, but do not seem to make a whole lot of financial progress. They burn through a whole lot of money, and rarely manufacture or sell anything. During the second or “cocoon” stage, the company is starting to succeed. It is “cocooned” from the broader market. Its revenues grow rapidly, as it begins to sell products and moves to overturn an established industry. In cocoon stage, price movements do not have a lot to do with the broader market. During this stage, transformational technology investing is an ideal diversification from other types of investing. It offers a kind of diversification that is unique. Finally, during “butterfly stage”, the company is discovered. It becomes front-page news in the mass media and moves from outsider to mainstream. Butterfly stage is the ideal point to sell.Link here.
THE END OF PENSIONS
The decline of pensions is likely well past the tipping point already. No so long ago, the defined benefit pension – guaranteed retirement income – was a prevalent aspect of the U.S. financial scene. But no more. In 1980, 38% of Americans had a defined benefit pension as their primary retirement plan. By 1997, just 21% of Americans had such plans, according to the Pension Benefits Council. That percentage is certainly lower now, and more and more plans have been passed off to the PBGC, a federal agency that insures pensions, but which does not necessarily pay the benefits retirees expected.
The ratio of active to inactive workers in existing defined benefit pension plans has fallen to roughly 1-to-1, down from more than 3.5-to-1 in 1980, according to the PBGC. This retirement math is starker than that faced by the Social Security system. The PBGC now pays the pensions of more than 1 million retirees. While many more workers now have retirement savings plans such as 401(k)s, relatively few have sufficient assets to fund their retirements in a way that will maintain all or most of their pre-retirement incomes.Link here.
THE NEWEST TREND IN HIGH CULTURE
The newest trend to make its way on display in galleries across the nation uses real human cadavers as their subject. We call this development “ARTopsy”, and it really will leave you breathless. A May 9 Associated Press article grants us admission to a Cleveland, Ohio based “Corpse Exhibit”, one of the many stops along the way in the “Body Worlds” cross-country tour. Viewers get a first hand look at “a collection of bodies and organs once used to instruct medical students,” now manipulated into poses and postures, backlit and set into place as any sculpture would be. One figure is “propped up like a department store mannequin, nonchalantly holding his preserved skin on a clothes hanger while a nearby corpse rides a bicycle.” Others are less choreographed, mere “musculoskeletal systems” preserved in perfect form, offering a three-dimensional version to some anatomy textbook drawing.
The controversy surrounding this new trend in high culture spans across the entire debatable spectrum: Is it art, science, obscenity? Is it educational, eccentric, unethical? Every criticism, concern, question, and commendation has been raised, then raised again. But the fact of the matter is, a handful of oddball outcasts does not the crowd of “Corpse Art” make. As the AP piece reveals, the grand headcount from all 27 cities where the show has so far run is 16 million visitors, from children to corporate business-workers to college students alike. Not only that, the extreme “popularity” of the “Body Worlds” show has “produced copycat” productions in Los Angeles, San Francisco, and Chicago known as “The Universe Within”.
Now, chances are, nobody reading this is over 165 years old. But if you were, you would know ARTopsy was alive and well long before now. In the AP article, a university professor wepoints to the late 1800s in the United States as Charles Darwinwts theory of evolution was challenging beliefs and traveling freak shows claimed corpses and fetuses in their exhibits were evidence of the ‘missing link’ between humans and animals.” In fact, Charles Darwin first went public with his theories in the 1840s, the period when “freak shows” became popular in America. Yet that decade goes down in our book for a lot more, namely:
The 1840s to late 1850s saw major bank closings, a double depression in stocks, a radical break in the fabric of American patriotism that ultimately erupted in the Civil War of 1861 to 1865 – all culminating in what historians refer to as “the era of gloom” AND what we refer to as a clear downtrend in mass social mood; the general malaise of collective psychology ultimately finds itself imprinted on the canvas, the records, and the cinema which embodies the culture. And, as one “horror scholar” points out in the May 9, 2005 AP article: “People are being torn apart daily, but the only places to bear witness seem to be exhibits like ‘Body Worlds’ and splatter movies.” We could not have said it better ourselves.Elliott Wave International May 10 lead article.
THE WALL STREET FANDANGO
What is Wall Street’s purpose? “To allocate capital efficiently,” a traditional economist might say. But economists are merely victims of their own silly theories. A communist economist would snarl and spit. Wall Street’s function is merely to aid the capitalist as a lackey aids a knight – he would say – to help the greedy bastard onto the backs of the working class. One might just as well ask the question: Why are there giraffes? To which we can only honestly answer: because they have not been exterminated yet. All animals – including humans – exist only because they have not yet become extinct. Wall Street exists because it has not yet disappeared.
We doubt that this sort of reductionism is very useful, except that it provides a solid footing upon which to begin our climb. We want to get up out of the mist … up to the heights, where the air is clear and we might actually see something. For the problem that most investors face is that they do not see Wall Street for what it really is … but as a sort of mirage, which changes shape depending upon what theory you use to look at it.
“Where you stand depends on where you sit.” If you sit on the board of GM or another major cash-hungry corporation, your stand on Wall Street is fairly obvious: it is a worthy and necessary ally. If you sit in an office of Goldman Sachs or Merrill Lynch, or in any other office of the financial industry, you are sure to view your Wall Street as generous and benevolent employer. And if you are the typical investor, you are likely to look upon your Wall Street stockbroker as though he were the family doctor; he provides a necessary and helpful service. Like a doctor, he is a phone call away, ready to fly to your aid and comfort. He even wears a tie and drives a nice car. He is a professional. He is there to help.
You are not wrong; he provides a valuable service. But before you send a thank you note, you should realize one thing: your stockbroker is probably a quack. Medicine is a science, of sorts. Progress is cumulative. But the financial industry is not the same as the medical industry. Both claim positive results. As to medical science, we have no reason to doubt it; we have seen some of its wonders first hand. But the claims of the financial industry are mostly a swindle.
The cost of the Wall Street casino must be paid. Brokers, analysts, deal-makers, financiers, fund managers, account managers – all the financial intermediaries who make up the Wall Street industry – draw salaries and pensions as long as they draw breath. That money must come out of investors’ pockets, so that over the long run, the average investor’s real return must be lower than the actual return from the investments themselves … and many, including most of the little guys, will actually lose money. Still, they take a leap of faith – for they believe every word of Wall Street’s hustle – and then, every time, they come crashing down on the pavement as if they had jumped out of a 23rd-story window. It must be depressing to investors. But it is the greatest show on earth for spectators.
Not only is investing not a science, it is not even an art. It is more like holding up liquors stores or seducing the rector’s wife. Sometimes you get away with it. Sometimes you do not. But you are generally better off if you don’t. For there is nothing like success to set up failure. As soon as you get the idea that you are such a smooth operator that you can pull off a job like that; you will be planning the next one when the cops pull up.
The root of the problem is the nature of investing itself – at least, the public form of it as practiced by most investors and as tempted by Wall Street. The idea of it is that a man can get rich without actually working or coming up with an insight or an invention by careful study or dumb luck. All he has to do is put his money “in the market” by handing it over to Wall Street, and poof! – by some magic never fully described it comes back to him tenfold. The whole edifice of Wall Street is built on a lie: that you can get something for nothing. What you actually get, of course, is nothing for something. But it takes you so long to figure it out that by the time you have realized you have been had.
You can make money on Wall Street as a simple investor. But for that you will have to do a lot more than just be “in the market”. You will have to treat your investments as though you were driving a nail through a 2 x 4. You will have look upon it not as a public investment, but as a private one. You will have to look at the company, not the stock. You will have to do a lot of serious research and thinking, or pay attention to someone who does. In short, you will have to earn it.Link here (scroll down to piece by Bill Bonner).
LET THEM EAT INDEXES!
History buffs will recognize the roots of this phrase. Marie Antoinette, wife of King Louis XVI, is supposed to have said “Let them eat cake” when informed in 1789 that the Parisian masses had run out of bread. There is no reliable evidence that the ill-fated queen ever said this, but it has made good propaganda since 1789. The sign of the insensitivity of the successful to the suffering masses is some version of “Let them eat cake.” In our day, the public no longer worries about bread, except as a source of unwanted carbohydrates. The free market had made us all so rich that our concern is with too much bread and too much cake. Twinkies celebrated its 75th birthday recently – cost-conscious Americans’ favorite substitute for cake. Our waistlines reveal that ours is a world very different from Marie Antoinette’s.
Economists speak of the wealth effect. When people think they are doing well – jobs, investments – they tend to save less. They assume that good times will take care of retirement portfolio growth. A rising market will let them retire in comfort. The self-discipline of thrift today can be deferred. Besides, thrift is so uncomfortable. This same attitude afflicts corporate America. In a story published in Business Week (August 5, 2002), the authors commented on what they called the pension pinch. Because of the downturn of the market after November, 2000, corporate America was facing a new reality. Its pension funds were not being automatically funded by stock market indexes. Stocks – in which a record 60% of fund assets were invested in early 2000 – have gone down in the bear market, as have interest rates. The result: Funds’ assets have plunged at the same time that the present value of their liabilities have soared. The pincer movement has wiped out surpluses racked up during the long-running bull market, and then some. Which companies are facing the biggest problems? Old-line companies that are unionized.
The article was published in mid-2002, close to the bottom of the stock market. The S&P 500 was around 900. It rose, then fell back to 800 the following March. Today, it is around 1200. So, despite the bad news regarding the pension funds’ condition, investors in mid-2003 decided to ignore the information. They rushed back into the stock market. They assumed that GM could solve its pension problem. We now know that this assessment was premature. GM and Ford investors have taken major hits, both in stocks and bonds. But the stock market’s current rebound indicates that these wake-up calls have made no impression on investors and fund managers. Investors did not wake up in 2002. They have not awakened in 2005. They assume that they can continue to rely on the wealth effect for their retirement portfolios.
Everyone plays the manipulation game. Consider Standard & Poor’s, the rating company that just downgraded General Motors and Ford. Some market watchers prefer the S&P 500 to the Dow Jones Industrial Average. Both the Dow and the S&P 500 are subject to statistical jiggering. Companies that do poorly are removed from both indexes. Both add companies that seem to be doing well. Let us return to 2002, when bad news was visible in the stock indexes, and readers were a little more alert to reality. An article appeared on the Slate Web site, “The Poor Standard of Standard & Poor’s” (Aug. 1, 2002). The author discussed in detail the way that the S&P 500 is subject to revisions: “The index is one of the more unlikely villains of the bubble. Despite perceptions, the index is not a passive investment vehicle. Instead, S&P is constantly choosing new stocks and booting old ones. And in the past few years, S&P’s modus operandi – which receives surprisingly little scrutiny – led it, essentially, to recommend that investors buy highly speculative companies at or near their tops.”
The index managers added high-tech companies in 1999, which was close to the top. Index funds that follow the S&P 500, and which are the darlings of the buy-and-hold investment strategy school, bought these stocks at the top. “According to a 2000 study by Salomon Smith Barney,” says the Slate article, “stocks selected for inclusion outperformed the S&P 500 by 7.7 percent in the period between the announcement and the inclusion. The net effect: S&P 500 mutual funds – that is, you – effectively bought these new stocks at artificially inflated prices.” The indexes drop poorly performing stocks after they have shrunk. This is called “sell low”. They add stocks after a long period of rising prices. This is called “buy high”. This “buy high, sell low” strategy guides the stock index funds. But it does more than guide index funds. It guides the investment community generally, due to the widespread use of the S&P 500 as a benchmark for professional investors.
Stories like those that I have cited appear from time to time, but investors take little notice. It seems easier to trust the experts … until the bills come due. When the bills do come due, the experts will say, “We knew it all along.” And when index fund investors complain, the experts will say, “Let them eat indexes.”Link here.
What other kind of fraud is there? Picture this – millions of American retirees and those getting ready to retire in the next two decades marching on Washington, demanding a government handout. It will happen. American corporations have hundreds of billions of dollars in pension liability. This is money that has been put aside to pay for Joe Six-Pack’s retirement from General Motors, Ford, etc. It is also for current retirees, who are enjoying the fruits of their labor and the fruits of union contracts negotiated when the U.S. Industrial machine was at its peak in the 50s, 60s and 70s. Back then, the American post-war generation had no competition for global trade. We made it, people bought it. End of story.
Pension plans are really quite simple. In principle, money is set aside from the employer in a special fund. This fund is then invested in the markets to generate a return. This return, along with the principal, is paid out as an annuity after the employee retires. So, as long as the market is not crashing and there are enough investable funds to begin with, everybody is happy. During the nineties, many large corporations were running pension surpluses because the stock market was doing gangbusters. Companies were obliged to put in money into these funds at a prescribed rate – which was directly related to the expected rate of return on the funds. Much as investors must do when determining how much to pay into private retirement funds, companies would try to estimate the return on the cash they put in and adjust their contributions accordingly.
The obvious chance for chicanery here is for companies to play with the expected rate of return. They cannot play with it too much, because there are limitations as to the rate they can use. For the most part, they are supposed to use the rate of return from the 30-year U.S. Treasury Bond. Well, what if you could somehow tweak the rate higher? Either you could understate your liability, or you could effectively run a deficit. More on this in a moment. Enter the Bear and lower interest rates. It is now 2003. The markets have fallen, and fallen hard for three years. Interest rates have plummeted. The effects are devastating.
As we all know, the 30-year Treasury Bond has seen its lowest rates ever in the past few months. This means that U.S. corporations have had to put even more money into these plans to make them compliant. Well, what if you could raise the rate of return with the stroke of a pen? The answer: the amount of your liability would actually decrease … which means Corporate America would be perpetrating a massive fraud on retirees. After all, the money has to be paid at some point. The government has now decided to allow companies to use the rate of return from corporate bonds to calculate the needs and returns from pension plans. What is a few hundred basis points’ difference?
Companies love this idea, since contributions to pension plans can decimate earnings reported to investors. The government loves it, since this means delaying the inevitable pension crisis in America, and it also means more contributions for their re-election efforts. Still, at the end of the day, only the retiree really cares … but as long as the checks come in every month, he is willing to coast along. Why should you and I care? Because all of these pension plans are guaranteed to some degree by the PBGC, The Pension Benefit Guarantee Corporation. This is not some private insurance company, but one funded by you and me. It operates much like the FDIC – insuring the pensions based on the assumption that it can handle a crisis here or there if only one or two plans go belly-up – but heaven forbid that we have a massive failure. So … what will happen if the Fed’s current effort at reflating does not result in higher rates? Once again, the American taxpayer will be called to step up to the plate, simply to guarantee higher paper profits for companies that need the numbers to send the market higher, so the taxpayer can feel better about the future.Link here.
THE SEER CEMETERY
The dollar’s rally continues, and is now on the verge of making a 6-month high against the euro. Since bottoming at 1.3665 on Dec 30, 2004, the euro/USD rate has made a steady recovery and now looks like breaking below 1.2700 for the first time since early November. To our regular readers, this should come as no surprise. Throughout November and December, we pushed the idea that the dollar was oversold and was probably due for a bounce. With articles titled “Comical Dollar Bearishness” and “The Dollar Bounce” we explained how sentiment against the dollar had become so negative, a classic snap-back rally should be expected. And so it came to pass.
But will it continue? Our guess is that it will. And the reason is simple: as the pain of the rally intensifies, all those short positions must get liquidated, reinforcing the bounce. It is an idea echoed by Dennis Garman, who writes, “We are reminded of one of Judy Collins’s great songs, The Moon’s A Harsh Mistress, at this point, for the market is a very harsh mistress indeed, extracting payment in full for transgressions.” Except Gartman’s analysis is directed toward Warren Buffett and his colossal bet against the dollar. Gartman thinks the market will eventually force Buffett out of the position, and push the dollar higher still.
Gartman is one of our favorite analysts, but in this instance, we disagree with him. Gartman is confusing Buffett for a trader. But he is not a trader, he is betting on a long-term, fundamentally driven trend and he is not the type to be frightened by a 10% rally against his position. Besides, Buffett’s bet has already made a fortune. In the fourth quarter of 2004, his foreign currency positions earned $1.63 billion versus a $310 million loss in the first quarter of this year. Any way, Buffett said he would prefer that his currency positions LOSE money!
Buffet first mentioned trade deficits, his new favorite subject, in his 1987 Berkshire Hathaway shareholder’s letter. The topic got five paragraphs in the 2003 letter, two full pages in 2004, and three paragraphs back in the 1987 letter. Buffett waited 15 years before he invested in foreign currencies. It is fair to say a three-month rally in the dollar is not going to shake him from the trade. The rest of the dollar shorts may not have such patience, and that is why, for now, we buy dollars.Link here.
LIQUIDITY BLACK HOLES
Gotta love the hedge funds, making bets on events based on probabilities, or what seem like improbabilities. How about this bet … long GM bonds as a contrarian play (before the downgrade) and short GM stock to hedge (before the stock soared)? It probably looks foolproof in a statistical model. And then volatility happens. You get caught on the wrong side of the trade … both times. First, investor Kirk Kerkorian, who already owns 3.9% of GM stock, offers to more than double his stake in GM and then buy an additional 28 million shares at $31. The stock soars 18% in one day to close at $32.80. Not a good time to be short. The very next day Standard and Poors downgrades GM bonds to junk status. Not a good time to be long. The rumor – and it is just a rumor of course – is that at least one hedge fund, London-based GLG was long GM bonds and short GM stock prior to last week’s events.
The real danger to markets in a situation like this is a loss of liquidity. Volatility itself is no bad thing. As Avinash Persaud writes in the introduction to his book Liquidity Black Holes, “Volatility is a normal and necessary function of markets. Markets should adjust quickly to new information and, if the information is shocking enough, the adjustment will be volatile.” Traders live for these kinds of events. Fat tails … rare events. But sometimes they spiral quickly out of control. “Our concern … is where episodes of high volatility reflect not a market adjustment to a more stable position, but a market disruption: where price changes no longer help to clear a market, but help destabilise it,” Persaud continues. “A liquidity black hole is where price falls do not bring out more buyers, but generate even more sellers, who chase the market lower, bringing out yet more sellers.”
“Thus,” Persaud concludes, “in portfolio and banking markets, the system seizes up. No one player is willing – or indeed able – to prevent the formation of a liquidity black hole once confidence has evaporated and a downward cycle has begun.” Has it begun? Wait and see.Link here.
Echoes of 1998
When GM bonds skidded last week, a few hedge fund managers ended up with tire tracks across their backs … and some nasty injuries. According to the hyperactive Wall Street rumor mill, several large hedge funds are reeling from an ill-timed “capital-structure arbitrage” play: Buy General Motors bonds and simultaneously sell short the stock. Suffice to say that neither side of this arbitrage behaved as anticipated, which caused a few big hedge funds to suffer great, big losses. If a few big hedge funds are in trouble, are a lot of us little investors also in trouble? Maybe so, but we have already been living in a state of perpetual peril for many years, thanks partly to the growing influence of hedge funds in the global financial markets. In other words, the GM debacle may have triggered a financial “red alert”, but “orange alerts” have become a near-permanent condition. Although the growing influence of hedge funds within the financial markets creates unnerving volatility, it also creates unique opportunity.
Most likely, the GM debacle is something more than a non-event, but something less than a disastrous event. For perspective, let’s consider a worst-case scenario. A few weeks before the infamous “blow-up” of the Long Term Capital Management (LTCM) hedge fund in 1998, the S&P 500 Index traded near 1,200. Shortly after the LTCM crisis hit, the S&P tumbled to 923, or more than 20% below its then-recent high. Similarly, on March 7th of this year, the S&P 500 traded a few points above the 1,200 level. If past were prologue, therefore, a second LTCM-style crisis could plunge the S&P below 1,000. Very few investors would enjoy that ride. We would not rule out the possibility of a repeat, but we would assign a low probability to that outcome. Of greater concern is the growth of the hedge fund industry itself.
Van Hedge Fund Advisors estimates that there are about 8,500 hedge funds with about $900 billion in assets – twice as many as existed 5 years ago. The parabolic growth of hedge funds over the last few years has introduced new – and often exotic strains of both risk and opportunity into the global financial market organism. Hedge funds have become an outsized influence in the financial markets. In many respects they ARE the financial market. Last year, for example, hedge funds accounted for about 82% of the trading volume in the U.S. distressed debt markets and 70% of U.S. trading in exchange-traded funds. The funds also account for more than one quarter of all the volume on the NYSE. In short, they are everywhere. In the early days of hedge funds, the pioneers tried to take advantage of stock market inefficiencies. But today, hedge funds often CREATE the inefficiencies because they often flock to similar strategies and trades. From time to time, therefore, certain pockets of the financial markets become cluttered with hedge fund managers jockeying for a competitive edge. In those moments, certain market sectors or asset classes can become irrational, volatile and frustrating to individual investors who utilize fundamentals-based investment strategies. Our advice: don’t get mad, get ready.
The LTCM disaster of 1998 illustrated the infinite capacity of “smart guys” to do dumb things. (Having Nobel Prize winner on the payroll – as did LTCM – may be helpful for structuring hedge-fund-destroying arbitrage trades, but it is not an absolute prerequisite). If, therefore, a few brainiacs in Greenwich, Connecticut can cause a serious financial crisis, just imagine what 8,500 brainiacs could do. In short, hedge fund managers, as a group, are no so different from most other groups of investors. As individuals, the managers may be brilliant – or not – but as a mob, they can be complete idiots. And when they are idiots, they can create opportunities for us individuals.Link here.
The Man Group plc (London: EMG) oversees $43 billion of hedge fund investments for various institutional clients worldwide. As the largest publicly traded hedge fund operator, Man’s share price trend might offer clues about both the health of the hedge fund industry and the approximate health of the stock market. Lately, Man’s share price has been falling (chart here), which is probably not a favorable omen.
200 years ago, the Man Group devoted itself to trading agricultural commodities. But the Group sloughed off that business in 2000 to focus on the oh-so-sexy business of running hedge funds. However, Man does not run just any old sort of hedge fund, it operates the so-called fund of funds that charge multiple layers of “management fees” and “performance fees”. A plain-vanilla hedge fund charges an annual fee equal to 1% of the assets under management plus 20% of the profits. But a fund of funds might subject clients to fees as high as 3% of the assets plus 30% of the profits. So far, such lavish fee structures do not seem to trouble Man’s clients. Business has been booming. Why then has Man’s stock been performing so dismally of late? Does it “know” something that we do not? Maybe the stock knows that a few big hedge funds are in a lot of trouble. Is it a coincidence, for example, that Man shares have dropped about 20% since GM’s latest woes began surfacing in mid-March?
Or maybe Man shares are sensing that the entire universe of 8,500 hedge funds is in a little bit of trouble, due to the fact that the number of funds is growing while the average performance results are shrinking. Hedge funds, on average, are down about 2% in 2005, compared to a drop of about 4% for the S&P 500. This uninspiring performance continues a multi-year trend of yawn-inducing results. “Over the past four years,” the Wall Street Journal relates, “the average hedge fund gained 6.4% annually, compared with an average annual gain of less than 2% for the S&P 500.”
Now that a sustained period of low returns has arrived, Man’s clients may become a little less eager to pay bull- market-style fees. In which case, today’s super-sized hedge fund industry might begin to downsize. Sadly, investment results among hedge funds are unlikely to improve soon, according to J.P. Morgan analyst, Jan Loeys. The spectacular growth of the hedge fund industry is making it more difficult for funds to replicate the client-pleasing results of past years. Imagine a backyard Easter egg hunt attended by a dozen kids from the neighborhood. All the kids would finish the hunt with some goodies in their bags and smiles on their faces. But if the identical Easter egg hunt were attended by 8,500 kids, you would be drying a lot of tears.
But why should we care? What does it matter to us individual investors if the world loses a few hedge funds? On the other hand, Man’s share price trend might contain a timely message for all of us. It might be saying that the stock market is more likely to be a “sell” than a “buy” over the coming months. The “toppy” price chart of the Chicago Mercantile Exchange (NYSE:CME) seems to be sending the same message. The “MERC” is the derivatives exchange that trades many of the nation’s most actively traded financial futures contracts. It is to financial futures what the NYSE is to stocks. And in this age of hedge funds, futures and stocks share a very intimate relationship. Neither could flourish for long without the other. Therefore, it is no accident, we think, that Man’s share price and CME are both sliding south. Unless and until either stock resumes its ascent, we would be hesitant to “bet big” on U.S. stocks.Link here.
DO ECONOMISTS DESERVE THIS MUCH GENEROSITY?
“Economists Scale Back Forecasts for Growth” was the headline of the Wall Street Journal story about the May Forecasting Survey, as if these economists could do anything but recognize the obvious: GDP growth has slowed down in the second quarter. In fact, “Scale Back” is a pretty generous description of what these economists are doing. As 2005 began, they forecast that GDP growth would accelerate in the second quarter. The trend is going the other way.
The same can be said for: 1.) Stocks – The investing public, economists and virtually all of Wall Street were aggressively bullish as the year began. Yet the major indexes are down in 2005, and have fallen six to eight percent since March. 2.) Gold – Some mainstream forecasters said that in 2005, gold would see its largest rally in 35 years. Yet in the past five months, the trend has been mostly southward. 3.) Commodities – Demand for raw materials in China and elsewhere was supposed to send commodity prices to the moon; but after a strong rally in the CRB commodity index during February & March, the decline that followed has erased most of the gains. 4.) U.S. Dollar – Universal bearishness toward the dollar prevailed as 2005, yet today the Dollar Index stands at a seven-month high. ‘Nuff said.
All of the above (and more) answers the question about how the conventional wisdom in doing. If you have not heard it being asked, at least you know why.Link here.
“IT’S ME! IT’S ME!” DON’T PANIC, STAY CALM
If you picked up the phone and heard a strangled voice crying, “It’s me! It’s me! I’ve been in a car accident,” who would you think it was? Your son, daughter, husband, wife? Would it even cross your mind that this call might be a hoax? Suppose another voice came on the line, identifying himself as an insurance company employee, telling you that your family member had hit a luxury car and caused $50,000 in damages but that the owner was willing to accept $30,000 in cash within the next two hours and would not pursue the matter legally. Would you somehow find the cash to pay up? In the United States, not likely. In Japan, much more likely indeed.
That is according to a page one story in the Wall Street Journal. This insurance swindle has been so successful in Japan that it reaped more than $180 million last year and has earned its own name: the oreore (pronounced oray-oray) sagi, or the “It’s me! It’s me!” swindle. The phone scam works particularly well in Japan for two reasons: 1) most Japanese do not want bad news made public through law suits, and 2) many Japanese keep large amounts of cash around, because it has not paid lately to invest in stocks or property.
No one wants to be played for a fool, but emotions can override the most rational behavior, just as what happens to the victims in the “It’s me! It’s me!” swindle. Screening out emotions is one reason why Elliott wave analysis [or any strict technical or fundamental analysis] can help you to make good decisions. And explanations with charts that show you possible alternatives allow you to make your own decisions.Link here.
THE PRIMARY PRECONDITION OF DEFLATION
Think 30 years is a long time to pay off a home mortgage? Try 40 years. And although only 1% of all mortgages is strung out that long, Fannie Mae is now going to create the “action”. Dow-Jones newswires reports that a Fannie Mae executive told a mortgage-banking conference last week that Fannie Mae would be making the 40-year mortgage a standard product. Why would anybody want a 40-year mortgage? Because they want to get the monthly payment down to afford the house of their dreams. Most people do not stay in a home even 10 years. But what is the downside? We all know the answer to that: over the long term of this mortgage, homeowners end up paying much more interest.
And what is another downside in the big picture? Bob Prechter wrote about the extension of credit being a precursor to deflation back in 2000 in his business best seller, Conquer the Crash (You Can Survive and Prosper in a Deflationary Depression). Deflation requires a precondition: a major societal buildup in the extension of credit (and its flip side, the assumption of debt). Austrian economists Ludwig von Mises and Friedrich Hayek warned of the consequences of credit expansion, as have a handful of other economists, who today are mostly ignored. Bank credit and Elliott wave expert Hamilton Bolton, in a 1957 letter, noted: that all major depressions in the U.S., from 1830 on, were set off by a deflation of excess credit; none was ever quite like the last, so that the public was always fooled; credit is credit, whether non-self-liquidating or self-liquidating, but deflation of non-self-liquidating credit usually produces the greater slumps.
Self-liquidating credit is a loan that is paid back, with interest, in a moderately short time from production. Production facilitated by the loan – for business start-up or expansion, for example – generates the financial return that makes repayment possible. The full transaction adds value to the economy. Non-self-liquidating credit is a loan that is not tied to production and tends to stay in the system. When financial institutions lend for consumer purchases such as cars, boats or homes, or for speculations such as the purchase of stock certificates, no production effort is tied to the loan. Interest payments on such loans stress some other source of income.
Contrary to nearly ubiquitous belief, such lending is almost always counterproductive; it adds costs to the economy, not value. If someone needs a cheap car to get to work, then a loan to buy it adds value to the economy; if someone wants a new SUV to consume, then a loan to buy it does not add value to the economy. Advocates claim that such loans “stimulate production”, but they ignore the cost of the required debt service, which burdens production. They also ignore the subtle deterioration in the quality of spending choices due to the shift of buying power from people who have demonstrated a superior ability to invest or produce (creditors) to those who have demonstrated primarily a superior ability to consume (debtors).
Near the end of a major expansion, few creditors expect default, which is why they lend freely to weak borrowers. Few borrowers expect their fortunes to change, which is why they borrow freely. Deflation involves a substantial amount of involuntary debt liquidation, because almost no one expects deflation before it starts.Link here.
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