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CONTINUITY AND CONFIDENCE: GREENSPAN AND BUFFETT
You may have read that Fitch, a firm that rates the credit-worthiness of the debt of publicly traded corporations, has downgraded Berkshire-Hathaway, the investment holding company run by Warren Buffett. Berkshire-Hathaway has exceeded the return of the Standard & Poor’s 500 index in 34 of the last 40 years. This success is understandably attributed by the public to Buffett’s skill in picking companies whose shares his holding company buys. So phenomenal is Buffett’s success that economists, who are committed to the premise that nobody can consistently outperform the stock market, either ignore Buffett or else invent a new category of performance: a five-sigma man. This is someone who beats the odds by millions to one, for no known reason – just pure blind luck. Warren Buffett is living proof that the economists are wrong. This upsets them, especially when the Nobel Prize-winners are such poor investors personally.
Buffett’s success is in part due to his partner, Charles Munger. The problem is, Munger is seven years older than Buffett (“the kid”). Buffett is 74. At this year’s annual meeting of investors – paid attendance was 19,000 – Buffett began with this repartee: “I’m Warren. He’s Charlie. We work together. We really don’t have any choice, because he can hear and I can see.” Last month, Fitch, a credit-rating agency, downgraded the outlook for the triple-A rated firm to “negative”, citing Mr Buffett’s age as the main reason. “They discovered that I was mortal – though I hope to prove them wrong,” he says. An emphasis on continuity, and on fireproofing Berkshire so that, come what may, it will continue to embody the culture and characteristics that it has today, is in place. But can that be guaranteed?”
Obviously, if the economists are right, it cannot be guaranteed. A five-sigma man is hard to replace. Is he a five-sigma man? In other words, is his investment strategy a function of his own five-sigma abilities? Or is his system as such the primary source of all these gains? If it is his system, then why has anyone else not matched his performance? Why is he all alone? Fitch decided that the issue should no longer be deferred. The other credit rating services have not followed Fitch. The advantage we have as non-investors in Berkshire-Hathaway is that the outcome of investors’ sentiment regarding the firm will not affect us directly. Others have borne the risk of his death and the uncertainty of the aftermath.
We cannot say the same about Alan Greenspan. If Warren Buffett loses his five-sigma magic touch, this will harm investors in Berkshire-Hathaway. I am not convinced that Greenspan has a five-sigma magic touch, except in his ability to deal with Congress, which I think a one-sigma man could do just fine. He will be departing soon. We have no idea who will replace him. We do know this: he will not be perceived as a five-sigma man. Voters believe that governments are capable of balancing and protecting their respective national economies. Two groups adamantly deny this: Austrian School economists, who do not trust politicians as economic planners, and central bankers, who also do not trust politicians, and who have kept free of control by the very political order that grants them their legal monopoly over the monetary base. This confidence in government spills over into confidence regarding the Federal Reserve System. But this means confidence in Greenspan. What will happen to public confidence? What will happen to continuity? No one in authority is asking these questions publicly, despite the fact that his departure is only a few months away.
Faith in Buffett has paid off hugely for long-term investors in his company. Faith in Greenspan has paid off hugely for speculators who could predict the next bubble – something that Greenspan says central bankers cannot do. Buffett has a system: value investing – the Graham-Dodd system. Greenspan has a system: inflate the money supply whenever equity markets plummet. Buffett’s system is good for the economy. It moves capital to its highest known uses – and no one in history has been able to identify highest uses with the skill of Buffett. Greenspan’s system keeps capital invested in lower uses than the free market would otherwise determine. I hope Buffett stays. I am happy to see Greenspan depart. The man who replaces him may be incompetent, but that is not all bad. This would reduce men’s faith in that which should not be trusted: a government-created monopoly over money.Link here.
It was bound to happen. Cycles of fear and greed are as old as financial markets themselves. When asset prices go to excess, we always hear the same refrain, “This time it’s different.” That was the spin on tulips in the 17th century, equities in the summer of 1987, the Nikkei in 1989, fixed income markets in 1993, and, of course, Nasdaq in 2000. Chastened by the inevitable post-bubble carnage, speculators, regulators, and policy makers always promise, “Never again.” Yet memories are short, and as day follows night, so do cycles of greed and fear – and the proverbial next time. Such is the case with the wrenching unwinding that is now occurring in a broad array of so-called structured credit products. The possibility of contagion to other spread markets – namely, high-yield and emerging-market debt, as well as investment-grade corporates – cannot be ruled out. In my view, that could well open up a serious fault line in America’s asset-dependent economy.
I will leave it to the experts to walk you through the intricacies of the latest alphabet game on Wall Street – the CBO, CLO, and CSO. The latest incarnation is the synthetic CDO, or collateralized debt obligation – a “tranched” portfolio of credit default swaps (CDS) – that are, in themselves, credit derivatives. Suffice it to say, these so-called structured credit products have become the latest rage in investor circles. Sparked by downgrades in the auto sector, credit markets have come under siege in recent days. For example, the spread on the Dow-Jones Trac-X investment-grade 5-year credit default swap – a representative gauge of liquid, high-quality spreads – which widened from an uber-low 38 basis points in mid-March to 55 bp two weeks ago, stands at 70 bp today. This follows a more modest back-up in other spread markets that has occurred over the past few weeks. However, apart from the carnage in structured credit products, the recent widening of spreads has been relatively limited when compared with the dramatic compression that occurred over the preceding two years.
This underscores what I believe is a gathering sense of systemic risk in world financial markets: Despite the back-up in structured credit markets, most of the riskiest segments of fixed income markets are still priced for a minimum of risk – an especially worrisome condition in a monetary tightening cycle. My concern is that the recent sell-off in credit products may be a warning shot of considerably more pressure to come in a much broader array of fixed income markets. For an income-short, asset-dependent U.S. economy and for a U.S.-centric global economy, such risks cannot be taken lightly.
By holding short-term real interest rates at or below the zero threshold for nearly four years, the Fed has sponsored the mother of all carry trades. Return-starved investors have been more than willing to borrow for next to nothing at the short end of the yield curve and earn the spread by investing in any number of longer-duration assets. The carry trade has followed a predictable evolution across the risk spectrum – migrating over time from riskless to increasingly riskier assets. It started with Treasuries, then went to investment-grade corporates, to high-yield bonds, to emerging-market debt, and then to structured credit products. And the ever-frothy U.S. property market, in my view, is being driven by the biggest carry trade of all. Easy money and sharply elevated turnover of the housing stock go hand in hand – imparting an equally potent artificial demand for this asset class.
Alas, there is an important catch to the carry trade in residential property – debt. In an income- and saving-short climate, the American consumer has monetized the proceeds of the carry trade to fund current consumption. Courtesy of a well-developed home mortgage refinancing technology, “equity extraction” from ever-rising property values has amounted to about $710 billion over the past four years, according to data from Freddie Mac on home equity cash-outs and second mortgages. The problem, of course, is that this search for income — the consumer’s functional equivalent of the investor’s search for yield – has taken household sector debt loads up to a record of nearly 90% of GDP. Moreover, even at low market interest rates, the servicing costs of this gigantic debt load are in the upper decile of historical experience. Mainly for those reasons, I continue to believe that the American consumer will emerge as the weakest link in the macro chain in a normalized real interest rate climate.
All this underscores the increasingly worrisome perils that lurk on the other side of the carry trade. And the longer the Fed maintains its extraordinary accommodation, the greater the distortions to asset prices and the higher the likelihood of a disruptive endgame in the markets and the real economy. As always, the real problem with excess leverage is that there is never good knowledge as to who is most vulnerable in the event of a reversal in market conditions. Painful as they are, market corrections serve the useful purpose of revealing misalignments in both asset pricing and asset allocation of the investor base. While attention has been focused in recent days on hedge funds and other institutional investors, I am more worried about the American consumer. Usually, it is the least-experienced borrower or lender that suffers the greatest damage in a market correction. In my mind, that puts the income-short, saving-short, overly indebted, asset-dependent American consumer at the top of the watch list. As always, we will not know where the rocks are until the tide goes out.Link here.
GREENSPAN’S CATCH 22
In the late 1990s, numerous economists and strategists distinguished between the “old economy” and the “new economy”. The later were engaged in new and unproven industries in which were the pace of technological innovation was extremely rapid, and were also characterized by very high valuations (in March 2000, NASDAQ at 5000), and almost no earnings visibility. We now know what happened to the then popular buzzword “new economy”, but to be fair, there is indeed a new economy in the world. It is just different than what the visionaries had anticipated. The new economy is characterized by the rise of China, India and to some extend also Russia as global economic and geopolitical players. Out of the blue and certainly totally unexpected to the American visionaries that spent their days counting irrelevant eyeballs in order to value Internet stocks, China has overtaken the U.S. in many markets such as for steel, iron ore, copper, not to mention in the production of appliances and consumer electronics.
But more importantly the “newest economy” is characterized by seemingly endless bubbles, courtesy of the man who has done more to destroy the value of paper money than any one else in the 200 year history of capitalism: Mr. Alan Greenspan. The destruction of paper money as a store of value – the most important quality paper money should have – occurs only in one way and that is through increasing the quantity of paper money at a higher rate than real GDP growth. At times this excessive money supply growth will lead to real wages rising strongly, such as in the 1960s, or to commodity and consumer prices soaring, such as in the 1970s. But, excessive money supply growth can also lead to the most dangerous form of inflation and this is asset inflation, which at times will boost equity prices to lofty levels (Kuwait in 1980, Japan in 1989, Taiwan in 1990, NASDAQ in 2000, etc) and on other occasions boost the value of real estate into cuckoo-land (Tokyo in 1990, Hong Kong in 1997, and now in the Anglo Saxon countries).
The reason asset inflation is so dangerous is that central bankers – usually unemployable in any other capacity – not even as waiters – only pay attention to consumer price inflation. Therefore, when consumer prices do not rise much, for example because of international competition (as is now the case), they print money like water. So, with the entry of China and India into the global economy we had low consumer price increases around the world – although higher than reported – and this led Mr. Greenspan to create, after he fueled the NASDAQ investment mania with easy money, another gigantic bubble: the housing bubble! There are many ways to recognize a bubble. One of the most reliable indicators that an investment mania is underway is always very high volume. In the case of U.S. housing it is the number of home sales as a percentage of households that show how speculative the market has become.
Since 1994, housing stocks rose actually more than the NASDAQ had risen between 1994 and 2000. Now, there are several interesting development in the housing markets. In Britain home prices are no longer rising and turnover is down. In Australia, in many markets home prices are already down and in the U.S., on record home sales in March, stocks of homebuilders failed to make a new high. But there is another reason I am inclined to think that the housing boom is nearing its end: International liquidity (FRODOR) has been diminishing. FRODOR is a creation of my friend Ed Yardeni and stands according to him for “Foreign Official Dollar Reserves of central banks” and is “the sum of U.S. Treasury and U.S. Agency securities held by foreign central banks”. When FRODOR expands asset markets including stocks, commodities and real estate tend to perform well while the U.S. dollar tends to decline. Conversely, when FRODOR growth decelerates, asset markets come under pressure while the U.S. dollar strengthens. Also commodity prices and oil demand correlate very closely with the rate of change in FRODOR.
Since the takeoff in commodity prices in 2000 coincided with the takeoff in homebuilding stocks I assume that shrinking global liquidity will not only have a negative impact on industrial commodity prices, including oil, but also on other asset markets such as housing. Now, I admit that it is always possible that Mr. Greenspan will ease once again massively – if the economy weakens. But this might be one of the rare moments in financial history were “printing money” becomes totally ineffective because any easing move now would hurt the bond market – as the decline of the U.S. dollar will lead to soaring import prices, accelerating consumer price inflation and higher interest rates … hardly a favorable environment for the highly priced and highly leveraged U.S. stock and real estate markets.Link here.
TALKING VALUE INVESTING WITH TWEEDY BROWNE’S BOB WYCKOFF
The more money that flows into a mutual fund, the more fees the fund company gets. That is why it is surprising when firms close funds that are beating their benchmarks. In the case of deep value shop Tweedy Browne, the managers are shuttering their signature Tweedy Browne Global Value and Tweedy Browne American Value funds to new investors. They are doing this even though the $6.7 billion global fund is up 2.62% this year, 5.5 percentage points ahead of the MSCI EAFE index, and the $660 million American fund is down 4.61%, 41 basis points ahead of the S&P 500. Why close funds that are doing so well? In this case, Tweedy says it is making the move simply because stocks are “fully valued”. Bob Wyckoff, one of Tweedy’s five managing directors, discussed the firm’s thinking with TheStreet.com. He also let us know what it would take to open the funds to the public again.
It is getting tougher and tougher to find stocks that qualify with their rigorous valuation criteria, he says. “Since the bursting of the tech bubble, a lot of the money that was in tech and telecom has shifted into ‘old economy’, or value, stocks. The result has been that the formerly high-priced stocks got cheaper and the previously low-priced stocks became more expensive. Today there is a compression of valuation in the marketplace, which means there is not a big difference between higher priced growth and the so-called value stocks. The compression has occurred at a valuation level that is not insane, just full from our point of view.”
“[B]ack in 2000 when the bubble burst, the median P/E for the S&P was around 13. The median means that if you rank the 500 stocks and pick the one in the middle, it would have a P/E of 13 or 14. But while the median P/E was around 13, you also had some insane valuations in the tech sector – like Cisco at over 140 times earnings – which were bringing up the overall P/E of the market to between 25 and 30. That meant that half the index was pretty cheap. With the resurgence in value stocks and with the collapse of tech and telecom, we now have a median P/E that is closer to 18 times earnings. That means the deep value segment of the market has risen. And if you are like us and require a 30% to 40% discount from a cautious level of real world valuation, you just can’t find stocks to buy. So the idea flow has come to a crawl and we have become net sellers of securities. Cash is building in the funds, upwards of 20%, and we feel that in this environment it would be irresponsible to keep our funds open.”Link here.
CASH AS KING AGAIN?
Risk is becoming a nasty four letter word. Stocks are down for the year, junk bond holders are lightening up as credit spreads widen, and it is likely that GM and Ford will not be the only big issuers to see credit downgrades now that the credit cycle has turned. Hedge Funds are also struggling to see positive returns, commodities are well off their highs, and even gold and silver stock investors have recently been taken to the cleaners. Virtually every investor in almost every asset class, who has placed bets, has suddenly discovered that they are actually a losing speculator.
So, is anything offering a positive return these days? Have we all forgotten about plain old cash? Short-term interest rates are raised every six weeks – the Federal Reserve has raised the yield on cash eight times in a row! Moreover, with inflation in the CPI well entrenched at over 3% a year, there is more tightening to do. Indeed, unless there is a real market crash or the economy looks like it is dead in the water, the Gods and the odds favor the yield on cash rising. Each time interest rates are raised, the yield curve flattens more like a pancake taking all of the easy profit out of the carry trade. The markets are getting nervous, stock prices are up and down like a yoyo, and volatility is back. With over 40% of profits at S&P 500 companies tied to financing activities, rising interest rates can deflate this profit balloon. With the yield on cash increasing, price volatility in the stock and bond markets favor the down side of the market.
So who is making money these days? My wife is! I gave up trying to persuade her to buy racy investments like physical gold and silver; they are too volatile for her. She simply wanted an investment that was safe and would give her a return on her money, even if it barely kept up with inflation. So, over the last few years she has purchased I-Bonds which are sold directly by the United States Treasury www.savingsbonds.gov. I-Bonds pay a fixed interest rate plus the CPI and taxes on the interest are only due when the bonds are cashed in. There is no fee involved and you can only buy $30,000 a year. Last week, my wife showed me her investment returns since 2001 when she first began buying I-Bonds. I was quite impressed.
For those who just want to save, keep up with inflation and assume no risk, cash or I-Bonds are the best anyone can do. The reason is, since the NASDAQ had its major decline in 2000, the Federal Reserve has been determined to make sure there is no return on capital. They did this by dropping short-term interest rates to an emergency 1 percent, encouraging speculators to make risky trades, and by creating an inflated housing market. This was their way to keep the economy moving forward. Now, they are ever so slowly shifting the balance towards savers and against the risk takers. Cash is no longer trash; it’s King again.Link here.
HOUSES AND SPOUSES
There is a danger in treating ANY long-term investment as a short-term speculation. The nation’s bankruptcy and divorce courts are cluttered with folks who have attempted such foolishness. A short-term perspective is the domain of renting and dating, not home-buying and marriage. We have a suspicion that certain aspects of life should not be subjected to the harsh light of dispassionate financial examination. Nevertheless, for those readers who view life with the exacting precision of an accountant and for whom life’s many components are but a collection of assets and liabilities, we present the following examination of home-buying versus home-renting.
Home prices are rising, and rising quickly. So much so that a stockbroker friend relates, “I’ve had about six conversations over the last couple weeks in which one of my clients informed me that Florida real estate is a ‘sure thing’. These clients are sick of the stock market and are observing with the flawless vision of hindsight that Florida real estate has been a great investment.”
“So what do you tell them?” your editor asked.
“What can I tell them? They already know the answers: Stocks are unreliable. Real estate always goes up. … These opinions remind me of the moronic comments I used to hear in 1999, when a number of clients scolded me for being too cautious because ‘Nasdaq stocks always go up.’ … I don’t think I’d be a buyer at this very moment. … Maybe I’d be a renter.”
Our stockbroker friend presents a surprisingly attractive alternative. In many of the nation’s hottest property markets, the cost gap between being renting and buying has reached the widest spread in more than a decade. In other words, renting has rarely offered such a financially attractive alternative to buying. “In the past, home prices and rents tended to move in alignment,” the Wall Street Journal recently reported. “But the relationship between the cost of renting and owning has broken down as low interest rates and an array of new mortgage products have helped turn many renters into homeowners. That has helped propel home prices upward – and, in turn, has weakened the rental market, prompting landlords to cut rents or at least raise them less aggressively.”
The Journal continues: “The result, is a widening of the gap between the cost of renting and the cost of buying in some of the nation’s hottest housing markets – a gap now at its biggest since at least 1994, according to Torto Wheaton Research in Boston, and by some accounts at its biggest since the 1970s. The data suggest the economic case for renting, at least in the short term, has grown significantly in these markets.” The chart below presents a sampling of the cost of renting vs. owning for various U.S. cities.
By our calculations, if prices merely tread water for the next five years or ten years, as we assumed in our calculations, renting easily wins out over buying. But clearly, owning an appreciating house is better than renting one. Try it yourself. Just for kicks, compare the economics of buying your current home at its current market value versus renting the home at prevailing rental rates. In particular, take a look at the effect of 0% home-price-appreciation.Link here.
Greenspan builds case for limiting Fannie Mae, Freddie Mac holdings, says will not hurt housing.
Federal Reserve Chairman Alan Greenspan again pushed for limits on the multibillion-dollar mortgage holdings of Fannie Mae and Freddie Mac, saying such restrictions would not hurt the thriving housing market. Greenspan, who has been pressing Congress to limit the holdings of the two mortgage giants, warned that their debt poses a risk to U.S. financial markets. As Fannie and Freddie grow ever larger, their ability “to quickly correct a misjudgment in their complex hedging strategies becomes more difficult,” Greenspan said. “We are thus highly dependent on the risk managers at Fannie and Freddie to do everything right.”
At the end of 1990, Fannie’s and Freddie’s combined portfolios amounted to $132 billion, Greenspan said. By 2003, their combined holdings came to $1.5 trillion. “The assets required for Fannie and Freddie to achieve their mission are but a small fraction of the current level of their assets,” Greenspan said. Thus if Congress were to limit the two companies’ holdings so that they can achieve their mission, a substantial liquidation would be required over time, the Fed chief said. He said this could be done fairly smoothly, without disruptions to the housing market. “The implementation of portfolio limits should pose no significant difficulties,” Greenspan said. Unwinding some of Fannie’s and Freddie’s holdings would not raise mortgage rates for homeowners because so many big banks and other lenders compete with them in the home- loan market, he said.Link here. White House sets forth plan to limit size of Fannie, Freddie – link.
Got your Fed-speak decoder ring?
Mr. Greenspan does not make himself easy to understand, especially when he discusses risks to the financial system. Not that this stops him from sharing such thoughts, obviously. This very morning he gave a 3,200-word speech about the risks commonly known as Fannie Mae & Freddie Mac, specifically their combined $1.5 trillion mortgage portfolio. So you can imagine how easy this one was to understand. Example: “As Fannie and Freddie increase in size relative to the counterparties to their hedging transactions, the ability of these GSEs to quickly correct a misjudgment in their complex hedging strategies becomes more difficult, especially when vast reversal transactions are required to rebalance portfolio risks.” Unless you have got a Fed-Speak Decoder Ring, do not try reading syntax like this at home.
But seriously, taken as a whole this speech may be Mr. Greenspan’s “irrational exuberance” moment for what is ahead in real estate, with Fannie & Freddie being the most fragile part of the bubble. He understands what they are up to. There are plenty of other alarming real estate trends out there that the Fed Chairman could relate in plain language. In California, for example, “interest-only” loans account for 61% of the home mortgages taken out in the first two months of 2005. In 2002, the figure was 2%. Instead, he tells the world about “counterparties”, “complex hedging strategies”, and “vast reversal transactions”. I like to keep it simple in my reading and writing, but that is just me. If Mr. Greenspan’s approach is that “the more complex the expression the bigger the risk,” well, his language – and the risks he chooses to discuss – appears in a whole new light.Link here.
A glut in the market for real estate agents.
One of the few things increasing faster than house prices in California is the supply of agents licensed to sell them. More than 22,000 applicants took the state’s real estate exam in April, nearly three times as many as in April 2003, according to the Department of Real Estate. To handle the surge, the department has rented six test centers around the state to supplement the five it already has. The last time so many people wanted to sell real estate in California was in 1990. In what might be an ominous sign for the current boom, that year marked a peak in the housing market. There are 437,000 agents in California, enough to form the state’s eighth-largest city. With only 680,000 home sales a year, competition for listings can be savage.
New agents call every person they know or might have met once. They “farm” neighborhoods, which means blanketing them with brochures. They knock on strangers’ doors. They call people who are selling their homes without an agent and try to sign them up. They swoop in just as another agent is about to sign a client and steal him away. “Seventy-five percent of our membership does between zero and one transaction a year,” said Jim Myrick, president of the Santa Clara County Assn. of Realtors. A lot of the new agents have “unrealistic expectations”, said Peter Aiello, who manages 67 agents in a Cashin Company Realtors office in San Mateo. “They just see the price of houses going up. But they don’t see that there’s none to sell.”
Some new agents have already made a U-turn. Duard Slattery, a former engineer at FMC/United Defense in San Jose, switched to real estate in 2003, joining Coldwell Banker in Los Altos. “In a year and a half, I wasn’t able to get any listings,” he said. He recently got another tech job. The allure of real estate is so powerful that stories like Slattery’s are not much of a deterrent. Neither is the industry’s uncertain future. On one side, the agents are pressed by the rise of Internet firms that skimp on traditional service but charge much lower commissions. On the other side are their own customers, whose houses are frequently in such demand that the owners can insist on a reduced commission. Yet the new agents keep coming. Six years ago, people gave up good jobs for the excitement – and stock options – of Internet start-ups. Now some are leaving good jobs with tech companies because they find more thrills in real estate.Link here.
World Empire Towers
Mr. Leon Cohen has proposed building the world’s tallest condo – 110 stories towering over Miami like a colossal perforated bomb that forgot to explode. We salute Mr. Cohen for his boldness. We admire his audacity. We applaud his can-do spirit. We give a knowing wink at his clever name for the place – Empire World Towers. Or was it, World Empire Towers? To tell you the truth, in all the excitement, we cannot remember. But as much as we admire Mr. Cohen, we would sell his stock if he had any.
Architectural pride cometh before a fall. The “prideful monsters” of Fourth Century Egyptian pharaohs signaled the decline of the Old Kingdom, says Frank Johnson in The Spectator. Hausmann’s reconstruction of Paris presaged the doom of the Second Empire. And just before the Crash of ‘29, came the building boom in Manhattan; the Chrysler Building’s official opening took place just seven months after the stock market began its decline. The Empire State Building was already under construction, too.
James Grant, in his book, The Trouble with Prosperity, tells the story of another developer, Louis Adler, from whose block Mr. Cohen could be a chip. “In the spring of 1930 … Adler made history by becoming the first individual to buy up an entire Wall Street block …” His plan was to build on it – a tall building, of as many as 105 stories; in the next 75 years, the nation’s prices shot up 20 times, but the nation’s dreamy developers added only a few stories. There is, of course, a time to be bullish. But 1930, only a few months after the crash on Wall Street, was not it. Is 2005? We do not know. Mr. Adler’s building was never built – although his vision for lower Manhattan was largely realized … many years later. Whether Mr. Cohen’s building will be built or not, we cannot say. But announcements of very tall building projects give a fin de bubble air to the nation’s real estate market.
The tallest buildings in the world are no longer being built in America – they are being put up in China. The world’s three highest skyscrapers are under construction in China - the tallest one, in Shanghai, will rise to 1,509 feet, 260 feet higher than the Empire State Building. Surely, this is a sign of impending doom in China, too. At some point, Asian industries will shift to supplying goods and services to their own people, who have money and few consumer goods – rather than to Americans, who have no money and too many consumer goods already. When and how the shift will come about we do not know. Most likely there will be plenty of Adlers, Cohens, Wongs and Yangs who wished they had put up smaller buildings.Link here (scroll down to piece by Bill Bonner).
AFTER ALL, SOME OF THOSE GUYS ARE NOBEL PRIZE WINNERS…
Columnist William F. Buckley once quipped that he would rather be governed by the first 2,000 names in the Boston phone book than by the 2,000 members of the Harvard faculty. That is amusing, but for a moment let’s be serious about a faculty like Harvard’s: How, for example, do these academics invest for their retirement? Surely they have the disposable income and brainpower to outperform the market, not to mention the Average Joe investor. Well, it just ain’t so for at least half of this esteemed faculty, according to the university itself. An LA Times story this month reported that “an estimated 50%” of Harvard’s faculty place “all of their retirement savings” in low-interest money market accounts, less by choice than from indifference, due simply to “failing to specify how they want their funds invested.”
Maybe the 50% in question must be faculty from the Music and Sociology programs, since none of the business school or economics professors would be that dull-witted? After all, some of those guys are Nobel Prize winners. Think again, dear reader. “In interviews and e-mails” said the LA Times article, “five of the 11 Nobel winners in economics during this decade and a handful of others since 1990 said they failed to regularly manage their retirement savings. One even says he missed the mark in how he invested his prize winnings.” Among these Nobel laureates is the 77-year old father of “modern portfolio theory”, a school of thought that advocated notions such as buy & hold, the random walk, and the efficient market hypothesis; it denied that price movements are patterned and said successful market timing was impossible.
Obviously these particular gentlemen do not practice what they preach about what “rational” investors do in reliably “efficient” markets. The thing speaks for itself.Link here.
HOW JAPAN FINANCED GLOBAL REFLATION
In 2003 and the first quarter of 2004, Japan carried out a remarkable experiment in monetary policy – remarkable in the impact it had on the global economy and equally remarkable in that it went almost entirely unnoticed in the financial press. Over those 15 months, monetary authorities in Japan created ¥35 trillion. To put that into perspective, ¥35 trillion is approximately 1% of the world’s annual economic output. It is roughly the size of Japan’s annual tax revenue base or nearly as large as the loan book of UFJ, one of Japan’s four largest banks. ¥35 trillion amounts to the equivalent of $2,500 for every person in Japan and, in fact, would amount to $50 per person if distributed equally among the entire population of the planet. In short, it was money creation on a scale never before attempted during peacetime. ¥35 trillion could have made the difference between global reflation and global deflation. How odd that it went unnoticed.Link here.
THE “NUCLEAR OPTION” … OR A “FOOD FIGHT”?
This may be the week when the ugly climate in Washington, D.C. turns uglier, as the so-called nuclear option plays out in the Senate. Obviously it is easy to be cynical about both this sorry episode and the phrase the politicians have embraced to describe it: The grave word, “nuclear”, simply reveals how much bombastic self-importance they attach to what they do. Politicians get paid to negotiate compromises that solve problems. When they fail to do so, the result is not a catastrophe but a “food fight” – and last time I checked, nobody in a food fight ever died from radiation exposure. (Ask yourself who could do more to muck up the works in America by going on strike for a month: all the politicians or all the plumbers … or all the electricians … or, for that matter, all the garbage collectors.)
Still, if the office holders in the Senate cannot solve their disagreement over a few judicial appointments, what follows might even be big enough to push a story as important as the Michael Jackson trial from the top of the headlines. My weakness for sarcasm having been fully indulged, I would like to point out that national politics very often reflects the national mood. And I need not explain what U.S. politics in the past couple of years have reflected about this country’s mood. Bob Prechter had it just right in his October, 2003 Elliott Wave Theorist when he said, “Politics will become far more polarized, splintered and radical.”
In that same issue, Bob also forecast that “the U.S. will increase restrictions on immigration,” and “the U.S. will require internal travel papers.” Here again – if you have followed the headlines of recent weeks and months – no explanation is necessary.Link here.
RETAIL LOOKS SHOPWORN
With first-quarter earnings from most retailers on the books, investors have turned skittish. Earnings growth has slowed, consumer spending is shaky, and a variety of chains expressed reservations about the future. As usual, prognosticators are working with a variety of conflicting data in evaluating the sector’s prospects. But the S&P Retail Index has dropped steadily so far this year, down 9%, representing a continuous lowering of expectations on Wall Street. Meanwhile, Thomson First Call estimated that earnings growth for retailers has slowed to around 8% in the first quarter, down from 20% for the fourth quarter of 2004 and down 62% in the year-ago period.
Most analysts agree that consumers hit a soft patch during the quarter that was mostly attributable to high gas prices and bad weather. The situation bears a striking resemblance to the slowdown that hampered the stock market last summer. Back then, some observers proclaimed that consumers finally had reached the end of their spending rope, only to be proven wrong when a healthy holiday followed the president’s re-election. A year later, the situation could be more dire. “We expected some weakness here, but the depth of some of the reductions in forward guidance for the June and September quarters are a little surprising,” said Andy Graves, a retail analyst with Pacific Growth Equities.Link here.
IS THE COMMODITIES BULL MARKET OF THE “JIM MORRISON” OR THE “JERRY GARCIA” VARIETY?
Is the bull market in commodities a financial “Jim Morrison?” Is it a sensation that flames out as suddenly as it first burst onto the scene? Or is the bull market in commodities more likely to be a “Jerry Garcia” – a slightly mellower and longer-lasting phenomenon? A “Garcia” bull market – like the Grateful Dead lead singer, himself – would still offer plenty of mind-altering ups, but might also spend a little time in rehab along the way. So if the bull market in commodities is more “Jerry” than “Lizard King”, courageous investors might want to consider adding a few resource stocks to their portfolios.
In 1998, James Rogers launched the Rogers International Commodity Index. During the next few years, as its value more than tripled, the index became something of an investment sensation (despite the fact that Rogers, as far as we know, did not engage in any Morrison-style excesses). Not only did the Rogers Index triple since 1998, but it did so while the S&P 500 produced a cumulative return of only 4%. Most resource stock indices had been producing similarly astonishing results … until recently. Since the middle of March, the Rogers Index has slipped more than 10%, while the Goldman Sachs Natural Resource Index has dropped a similar amount.
In the context of the last six years, the recent sell-off does not seem like much. But in the context of the last six months, the sell-off feels like the beginning of the end. Accordingly, CNBC’s daily broadcasts have not lacked for experts proclaiming the death of $50 oil and celebrating the seeming death of the entire commodity bull market. The bull market in commodities may, indeed, be dead – but we are not yet prepared to RSVP to the wake. Rather, we eagerly await its revival.
Over the last couple of days, as we examined one beaten- down resource stock after another, we were struck by two conflicting observations. First, most of the stock price charts we viewed looked horrible. Second, most of the valuation measures we examined looked downright gorgeous. We encountered stock after stock that had tumbled 20% to 30% from its March highs, and that now traded for five or six times earnings. A few offered hefty dividend yields to boot. And so we wondered, should the prudent investor be dumping resource stocks selling for 6 times earnings to put their money to work elsewhere, presumably in some sort of “consumer staple” stock selling for 19 times earnings or a “tech stock” selling for 29 times earnings or an Internet stock selling for 99 times earnings? We suspect not.
We readily admit that most of the stock price charts of resource companies look like “death” right now. So maybe May 18, 2005 is not the optimal date to establish new positions in resource stocks. On the other hand, the PE ratios of resource stocks are as low as they have been at any time in the last three years. So maybe May 18 is not the worst day to buy a stock or two. The commodity bull market might be in rehab, but we suspect it will be touring again very soon.Link here.
DISCOVERING OPPORTUNITIES IN INDIA
India is a land of great opportunity. The country experienced a record GDP growth rate of 8.5% last year. And its BSE index is up 40% since 2000, while the Nasdaq has gone nowhere in the same time period. And when I heard about an Investing in India Conference in New York two weeks ago, I immediately booked my ticket on Amtrak. India presents the perfect option for an investor scouting for cheap, unknown stocks and undiscovered prospects. Many foreign investors are unaware of the steady transformations taking place in the Indian financial markets. They still view it as the land of crippling poverty and political instability.
The Bombay Stock Exchange is over 120 years old, and is Asia’s largest. It boasts a T+2 trading system, which is one of the most sophisticated in the world. Even the Nasdaq does not have a T+2 system! There is plenty of value in India, and for the investor who is willing to explore, there is a sea of stocks in undiscovered sectors. Take the consumer sector. India adds the population of Canada every year to its middle class. And that means there will be 432 million people in 2007 spending money on everything from cars, to medicine, to oil, and to houses.
Not only will these people consume, but they will also earn and produce wealth. By 2050, the largest English-speaking nation in the world will not be America. It will be India. This spew of well-trained, highly educated, English-speaking professionals that India is churning our year after year is highly productive. So much so that every dollar paid to India for outsourcing services creates, in turn, $1.46. And it is not just outsourcing that makes up the India story. It is a complex web of sectors and sub sectors ripe with potential, waiting to be discovered.
At the Investing in India Conference in New York, I met one of India’s most prominent value investors, Ajit Dayal. Dayal spoke to me on his strategy of value investing – something that applies to every asset class and stock market in the world. He also told me about what he thinks of Indian small caps, politics, exports, infrastructure and much more. He told me that disciplined investing in cheap stocks is the recipe for success. A former Vanguard fund manager and the founder of private equity funds, Dayal’s philosophy on investing is solid. He draws upon classic investment wisdom that is tempered with caution. Dayal is a far cry from many of the reckless money managers we see today. And he was kind enough to speak to me about everything from his investment technique to small caps to cement.
Dayal explained to me the potential pitfalls an investor should avoid in the coming months. At the Investing in India Conference in New York, many speakers were bullish on India. But many, I felt, added a heavy dose of irrational exuberance to their presentations. An error often made by investors who are too embroiled in their ideas – in this case, India. But not Ajit Dayal…Link here.
Set your sights on Asia’s sleeping elephant.
Many people think China is THE growth story in Asia. And sure, China has a lot going for it. But don’t look now, because the high-flying dragon might be overtaken by a “sleepy” elephant – India. Today, we will look at an Indian stock that is on the launch pad. It is a leading automaker in what will soon be the world’s most populous nation … it is exporting to 70 countries and adding more customers … it grew sales by 29% and earnings by 50% in the most recent quarter … and yet it is selling for relative peanuts. But before I show you why this car manufacturer is shifting into higher gear, let us look at why you should invest in non-U.S. companies … and why India is the place to put your money to work.Link here.
THE RISE OF RED CAPITLAISM
In 1999, when I was in China, the then prime minister, Zhu Rongji, spoke at the Harvard Business School. During the question-and-answer period, a smart aleck asked, “Are you going to devalue the Chinese currency?” Since 1984, the Chinese currency, the renminbi, has been pegged to the U.S. dollar, and there had been a lot of speculation in the press that the Chinese would be making their currency convertible – the sine qua non for China to become a truly great economy.
Rumors persisted that before the government made the currency convertible, it would devalue it. The premier assured the questioner that devaluation would not occur, and then invited the skeptics in the room to buy “puts” on the renminbi. Buying puts – the right to sell or go short – is a sophisticated way to profit from the collapse of a stock or currency. It was an extraordinary remark from the mouth of any politician, never mind a leader of the Chinese Communist Party. Zhu put the Harvard wise guy in his place while proving to a sophisticated audience of businesspeople that the premier of China knew a thing or two about playing the currency market.
That kind of financial sophistication permeates the Chinese bureaucracy as well as the business community. Some of the best capitalists in the world live and work in Communist China. Not so long ago, the government denounced entrepreneurs as “exploiters” and banned them from the Chinese Communist Party. But in 2001, then president Jiang Zemin praised business leaders for pushing ahead with modernization; now, a political party created to represent the interests of peasants and workers includes millionaire entrepreneurs. And therein lies the problem: How does a market economy champing at the bit function under a Leninist regime?
The central government has been learning how to benefit from the markets by trial and error. But Chinese bureaucrats are fast learners, supported by talented young economists, bankers, and financiers faced with the challenge of dealing with an unprecedented rate of growth in an increasingly globalized marketplace. For decades, the best and the brightest in China have aspired to careers in the Party and the government rather than in the private sector. These people now run China, so it should be no surprise that China has some of the most capable politicians in the world. Worldwide economic growth – indeed the stability of the world – depends on how well the leadership in Beijing manages its economy. Despite the challenges, it seems to be doing fine. For no matter how long China’s leaders persist in calling themselves Communists, they seem quite intent on creating the world’s dominant capitalist economy.
Unlike Russia, which had a feudal society before its Communist revolution in 1917, China, which opted for a Communist economy in 1949, has had a vibrant merchant class throughout much of its history. They also have the habits of ready-made capitalists: The Chinese save and invest upwards of 40% of their income (Americans save barely 2%), and they have an incredible work ethic. The conversion from Communism to the world’s most dominant capitalistic economy will not be instantaneous or smooth. In the meantime, China will have to settle for being the world champion in commodity consumption.
The Chinese currency, the renminbi, has been extremely undervalued – by 15% or more, some experts contend. Even if its currency doubled in value against the U.S. dollar, China would still be competitive. The renminbi is one of the few currencies in the world whose value does not fluctuate, pegged 8.3 to the U.S. dollar. Historically, China’s leaders have been afraid to let their currency float, presuming that its citizens would move money out of the country and the renminbi would collapse. A higher rate of exchange would also slow foreign investment and exports, another threat to the economy. The Chinese leadership still uses that argument as a means of refusing to revalue the renminbi. It would have had merit 20 years ago, but China is a much more attractive investment opportunity now. Let the currency go down, I say. If people want to dump the renminbi, go for it. I would be a buyer whether it declines or rises, and I doubt that I would be alone.
China is a creditor nation. The U.S. became a debtor nation again in 1987 and has been the world’s largest debtor nation since. The international debts of the U.S. are more than $8 trillion and growing, at the rate of $1 trillion every 21 months. For years, we have been financing our standard of living with other people’s money, and one of our biggest bankers is China. That dependency makes the renminbi a perfect candidate for a world currency – once its leaders allow it to be freely convertible and tradable on the world market. Ironically, when the Chinese pegged their currency to the dollar in 1994 the U.S. applauded it as a smart move. Now that we are begging them to unpeg it, they are bound to express their independence by letting the renminbi float in their own good time. I suspect that the renminbi will be floating quite freely by the time the Olympic torch is lit in Beijing in 2008.Link here.
REAL HISTORY VS. THE MYTH OF STABILITY
When financial bubbles that grow especially large finally go bust, periods of especially easy credit usually follow. In turn, easy credit creates growth spikes that move too rapidly, and suddenly the economy will begin to fall as quickly as it had climbed. Eventually, somebody finally understands what is going on well enough to coin phrases like “Boom and Bust Cycle” – these episodes characterize much of economic history in the U.S. and elsewhere, notwithstanding the myth of “stability” propagated by central bankers in recent decades. Japan has yet to recover from a bust cycle that began in 1990; just this week the government there said “deflation deepened” in the previous quarter, even though the Bank of Japan has kept interest rates near zero for years.
Of course, the Boom & Bust Cycle can move at a room-spinning pace; it is hard to follow which sector of the economy is up or down from one month to the next. Consider, for example, today’s release of the Consumer Price Index (CPI) for April. The conventional wisdom expected widespread price increases, yet the core CPI was 0.0% - as in, “zero”. The overall CPI rose 0.5%, with nearly all of that gain due to higher energy costs in April. Yet during this month the price of a barrel of oil has fallen from about $57 down to $48; again, the turns and trends can be dizzying.
Interest rates are usually at the center of the boom & bust. The swings from easy credit and then to higher rates help explain nearly every major financial crisis of the past 50 years, even if that truth was not one of the chapters in your history textbook.Link here.
SOME THOUGHTS ON FINANCIAL STUFF: ART, SILVER AND THE IMF
Since shifting into college teaching in the less developed world, my priorities have shifted to – among other things – sussing out emerging markets and investments off the beaten track. You are aware by now of my increasing interest in the commodities market. The bull market for stuff that you can drop on your feet appears to be in full swing. However, one sector of that market has not managed so far to attract a bunch of attention. It may be the right time to chat a little about it. I am rambling about art investment, in particular art funds. For quite a while, investment in fine art seemed to have been reserved for the extraordinarily affluent. About a year ago, Picasso’s “Garcon a la Pipe”sold for $ 104 million, setting a new record at an art auction for an individual piece of art. This sort of money indicates that the art market is heating up again. To attract the interest of folks who do not have that sort of money available, various financial honchos have set up art funds. These art funds are run more or less along the lines of hedge funds, private equity funds and mutual funds.
In case you wonder what yours truly reckons about this sort of thing, I am inclined to be a little sceptical. The reasons for my being reserved? First, the art market is characterised by high transaction costs and low transparency. That is already reason enough for me to keep a healthy distance. Second, to quote my favorite financial column, which is Buttonwood on the website of The Economist: “… this market … is virtually unhedgable”. By the way, there is a reason why I am fond of reading Buttonwood. The author tends to display a healthy contrarian attitude and lived in some exotic places. She seems to tick a little like me.
There is another reason why my enthusiasm for this sort of thing deserves to be characterised as underwhelming. Investors’ money in these funds is frequently locked up for about 10 years, which means art funds with that sort of time frame do not offer shiploads of flexibility, so to speak. It is comparatively easy to have cash available when loads of folks have cash available. But it is more important to have cash available when heaps of folks are broke. In that situation you can buy bargains.
After rambling a little about an investment theme that does not give me a buzz, let us continue with an investment theme that does give me a buzz. You are aware that I’m getting more and more interested in investments in junior mining companies. One of the countries that tends to offer an attractive environment for mining is my current home turf, Mexico. Mexico deserves to be called one of the top notch countries in the world for exploring and mining silver. Mexico actually enjoys a 500 year history in mining. My current home turf currently produces about one hundred million ounces of silver every year. In a nutshell, Mexico still looks like fertile ground for investing in silver exploration.
Even though I do not tend to read the Wall Street Journal, a while ago I stumbled across an article in the Journal that is worth chatting about. The article deals primarily with the IMF and its economic prescriptions for Latin America. According to that article, the IMF reckons that Latin America needs to strenghten financial regulation (including insulating central banks from political pressure) to improve economic growth. Joseph Stiglitz, who won the Nobel Prize in economics and was the World Bank’s chief economist in the late 1990’s retorts to these IMF proposals: “What a whitewash … the IMF was part of the problem”.
When I read Joseph’s remarks I was wondering along the lines “what problem”. Eventually I found the answer in Fortune, which I usually do not read either. According to what I read there, more than 50% of the less developed countries borrowing from the IMF between 1965 and 1995 were no better off than when they started with the IMF. About 30% were worse off. Most of these countries were more indebted. All this makes me wonder now whether the world really needs an outfit with that sort of underwhelming track record.Link here.
WHY YOU WILL FEEL HEDGE FUNDS’ PAIN
It is a perverse fact of life in the market for financial instruments that the well-intentioned quest for safety very often leads to the worst sort of dangers. Almost 20 years ago, the great crash of 1987 came about in large part as a result of stock market participants’ purchase of a kind of portfolio insurance that paradoxically caused the very type of volatility it was intended to prevent. About seven years ago, the Long Term Capital Management hedge-fund crisis sprang from a wrongheaded theory by prize-winning economists that tons of money could be made with little risk by betting that the sovereign debt of various European countries would converge.
And now we learn that one or more major hedge funds may have suffered substantial losses this month – and potentially ignited a “contagion” – as a result of blown-up trades related to U.S. automakers in esoteric risk-avoidance instruments called collateralized debt obligations and credit-default swaps. The trouble this time is unlikely to be as deeply pervasive as the first two, in which a passion for risk-aversion by well-capitalized institutional investors heaped billions of dollars of losses on the public. But because these instruments have never been stressed in a real-time crisis, it is hard to know exactly how they will act. We may discover that they could ultimately batter the public just as soundly.
Why should you care? It is tempting to view hedge funds harshly for any misjudgments they may have made. After all, in the popular imagination they are cowboys on the risk-taking fringe, only out for themselves. Yet the reality is quite different. The hedge funds at the root of the problem may actually have been working on your behalf – and at any rate they were tripped up by pretty conservative trades that went terribly wrong. What happened last week that imperiled a number of hedge funds’ carefully constructed credit-spread compression strategies was the very unusual span of two days in which Los Angeles financier Kirk Kerkorian first announced a significant bid for General Motors stock at a premium, and then debt-rating agency Standard & Poor’s downgraded GM bonds to junk status. As you might recall, GM shares went straight up and then its bonds went straight down – blowing up a trade that was leveraged to the hilt. In the space of a few hours, an unknown amount of highly leveraged hedge-fund money that probably totaled well into billions of dollars went poof!
No hedge fund has admitted yet that it was on the wrong side of this trade, but it will eventually come out. And the reason that it can have a “contagion” effect is that the funds at risk will undoubtedly face a large number of redemption requests from their members – and failure of a fund could have a combustible impact on its counterparties and prime brokers, which are big investment banks. If we see big up days in the market followed by big down days, you can be sure that funds are using every uptick to unload inventory to meet their obligation and avoid bankruptcy. At times like this, the Federal Reserve and other central banks have learned to flood the system with money to avoid big disruptions. So from now until the end of the month, or quarter, there may be an interesting battle between the private forces of fear and the public forces of balance. Stay tuned: It could be your money.Link here.
The topic de jour.
Hedge funds have become the topic de jour. Is there another Long-Term Capital Management out there waiting to implode? Such notions are generally dismissed out of hand. Conventional thinking has it that individual funds and their lenders have implemented controls on the amount of leverage used, as well as employing sophisticated safeguards and risk management systems. Certainly, there is great confidence all the way to the top of the Federal Reserve that today’s major money center banks and Wall Street firms are keenly focused on risk management and have the most sophisticated risk monitoring systems ever available. There is a perception that great strides have been made since LTCM. The financial system is resilient; the economy is resilient; bullishness is resilient; the markets indicate otherwise.
I have no insight as to individual fund leveraging or vulnerability. However, from a systemic risk point of view we can make some important inferences. Investment (not positions) in hedge funds has almost tripled since LTCM, with total global derivative positions outstanding up a similar amount. The leveraged speculating community became the marginal buyer/price setter in most markets, surely including equities, corporate debt, MBS, CDS, and junk. And there are aspects of hedge fund investing that encourage atypical risk-taking and aggressive trading across markets. I would argue that the key issue is not individual fund vulnerability – although there are surely many funds suffering these days. The most important issue is systemic fragility.
I relentlessly write about market speculative blow-offs. The dynamics involved are as fascinating as they are nebulous and analytically challenging. But from our study of market history we do appreciate that it takes years (decades?) for major systemic bubbles to flourish and to create the backdrop for the final climax of excess. Such spectacular market developments require a protracted inflationary period to engender market psychology susceptible to a (aberrational) manic convulsion. It takes, as well, years for the financial system infrastructure to expand and evolve to the point of being capable of furnishing the necessary onslaught of finance, both for leveraged speculation and spending throughout the real economy. And, importantly, it takes survival through a series of mini (appearing that way only in hindsight) bursting bubbles, downturns and “close calls”. Bubbles that permeate the entire Credit system are uncommon, and can only be nurtured by repeated intervention and safeguarding by the monetary authorities (“moral hazard”).
While I have no way of knowing if there is another LTCM-like hedge fund collapse that risks markets “seizing up”, I do understand very clearly that the LTCM and other system bailouts by the Fed have played a seminal role in nurturing today’s precarious Credit Bubble Blow-off. When we these days analyze and ponder the heightened stress enveloping the leveraged speculator community, it is most important to think in terms of the ramifications for speculative dynamics – more specifically its influence on Credit system blow off dynamics. Are we witnessing a bout of speculator tumult at The Fringe that will be resolved over time, or is this a much more serious breach at The Core that will mark the beginning of the end?
We have witnessed over this long boom cycle the transformation of much of Credit creation into marketable securities and instruments. The nature of the entire Credit system evolved to support the emergence of a historic speculative Bubble, accommodated by the easiest monetary environment in history. And today, with the newfound media focus on hedge funds, it is imperative to put things in proper context. The massive inflation of the leveraged speculating community over the past few years was a critical facet of the blow off phase of this historic Credit Bubble. And 2004’s wild speculation in Credit default swaps – GM and Ford in particular – was indicative of the manic terminal phase of hedge fund/proprietary trading excess.
The blowup of the huge GM/Ford risk speculation was the pin that pierced the leveraged speculator Bubble (as much as I expected it to be higher interest rates). There is no doubt at this point that the leveraged speculators are losing money and will have to pare back risk. What is more, soon redemptions will commence which will only add additional pressure to liquidate. The downside of the cycle will see reduced Credit Availability, faltering liquidity, risk aversion, faltering asset markets and rather dramatically different spending habits. While it would be tempting this evening to conjecture as to what hedge fund trades are going sour and what firms could suffer, I want to stick with a topic near and dear to my analytical heart: Why must booms end and, more specifically, why did the “roaring twenties” end in disaster? The analysis seems to become clearer in my mind every week.
I cannot look at today’s financial environment and rant about system illiquidity. But I can look to the U.S. Bubble economy and warn that the Financial Sphere is going to have an increasingly onerous task in both providing sufficient finance and intermediating risk. And lower mortgage rates and higher home prices might very well sustain the credit bubble blow off for a little while longer. Yet prolonging the mortgage finance bubble is terrible news. In the end, it is the risk of today and tomorrow’s home loans (inflated prices, stretched buyers, and ill-conceived mortgage terms) that will prove the most damaging to the system. All eyes on mortgage spreads. The mortgage credit bubble makes the GM risk bubble look awfully teeny-weeny.Link here (scroll down to bottom article on page).
A SPINOFF STUDY
The money to be made in investing can often come simply from knowing where to look for bargains. Fortune swims not in the busy waterways, but in the quiet shallows, where people are not usually looking for it. Examples include small-capitalization stocks, obscure or illiquid securities and uniquesituations – such as spinoffs, divestitures, merger securities, rights offerings, restructurings and a host of other lesser known and underfollowed situations.
Though these special situations, as they are often called, are not usually thought of when one thinks of value investing, the fact is that these activities have traditionally been the province of some of the greatest value investors. These were the kind of rich veins that the young Warren Buffett routinely mined. During his time running the Buffett Partnership (1957-69), before Berkshire Hathaway, there were some years in which special situations made up more than half of his profits.
Of course, Buffett was not the only one dining off the tasty menu in the bistro of special situations. In 1985, a man named Joel Greenblatt started the private investment partnership Gotham Capital. Greenblatt made it his bread and butter to work in the special situations arena. He writes about his experiences in his book, You Can Be a Stock Market Genius, which, despite its moronic title, is a serious treatment of investing and contains a lot of good advice. Much of the book consists of case studies in which Greenblatt shows you how various spinoffs unfolded - Host Marriott from Marriott Intl., STRATTEC Security from Briggs & Stratton, American Express from Lehman Brothers, Liberty Media from Tele-Communications (this last one netted investors ten times their initial investment in less than two years) and many others. Each of these experiences teaches us something about investing, in particular about the nature of special situations.
Greenblatt enjoyed tremendous success at Gotham Capital. Every dollar invested in the partnership when it was started in 1985 returned $51.97 by the end of 1994, for an annualized return of 50%. In January 1995, all capital was returned to the outside limited partners. While Greenblatt invested in a host of special situations, spinoffs were his favorite play. Why were spinoffs so appealing to Greenblatt and his merry band at Gotham? A little research shows that they had found a crack in the sidewalk of Wall Street, which market-beating investments often slipped through. Greenblatt points to a Penn State study published in 1993 that found spinoffs beat their industry peers and outperformed the S&P 500 Index by about 10% per year in their first three years of existence. That is a large margin of outperformance, but is no anomaly. …Link here (scroll down to piece by Chris Mayer).
AFTER SCANDALS, NEW LEGAL STARS RISE ON WALL STREET
Looked across the room at Babbo recently and figured that the man and woman splitting an expensive bottle of wine worked on Wall Street? Good assumption. Did you further guess that they were investment bankers? You may need to expand your portfolio of stereotypes. They just may have been the new face of Wall Street, the newly empowered – and often newly rich – compliance lawyer. They are often the only people standing between their investment firms and a lethal blow from the government, and their status is assured and growing.
Just as corporate raiders represented the Wall Street of the 1980’s (think of Gordon Gekko) and mutual fund managers were the icons of the 90’s, the lawyers who keep companies in compliance with increasingly tough regulatory laws have become a new prototype of the financial district. They may lack the flash and glamour of earlier models, but this is the compliance lawyer’s moment in the sun. From 2001 to 2003, when the securities industry lost more than 8% of its work force, those toiling in the ranks of corporate oversight grew 30%, according to the Securities Industry Association, a New York-based trade organization that analyzed federal labor data. It is too early to tell whether hiring these lawyers will stem the tide of corruption scandals on Wall Street that have marred the industry and shaken investors’ trust in recent years, or whether they will be largely window dressing. The lawyers are being hired in greater numbers and being paid better, but scandals continue to erupt, and it is not clear that their advice is uniformly heeded.Link here.
“CONUNDRUM” REVISITED: CHEAP BORROWING PERSISTS
Three months after Federal Reserve Chairman Alan Greenspan described peculiarly low long-term U.S. borrowing costs as a “conundrum”, 10-year rates are now even lower and there is little more clarity as to why. Most experts agree it is hard to justify such low rates given a robust U.S. economy and rising Fed interest rates. While the persistence of such cheap borrowing is likely to buoy the economy by underwriting robust spending, many fear the long-term effects of supercharging already red-hot house prices and keeping savings-shy households in the shops. Cheap credit poses an inflation risk, at a time when consumer prices have been growing at an annual 6.2% rate in the past three months, and also aggravates the record trade deficit by fueling import demand.
And by neutralizing the impact of rising Fed interest rates, up 2 percentage points to 3 percent in 10 months, subdued long-term rates remain a policy headache. Analysts expect the Fed to raise its benchmark overnight rate to about 4% by the end of the year, but despite rising inflation and above trend growth, the 10-year Treasury notes are trading at only 4.1%. “It’s still clearly a conundrum,” said Paul Mortimer-Lee, Global Head of Market Economics at BNP-Paribas. “We really shouldn’t be seeing 10-year rates around 4 percent for an economy that’s going to grow about 5.5 percent in nominal terms,” he said. “You should be getting more reward for locking up your cash for long periods.”
Now at 4.1%, 10-year T-bond yields are lower than just before Greenspan’s “conundrum” speech on Feb. 17, half a percentage point below subsequent peaks in March and 70 basis points below when the Fed first started raising rates in June. Many experts reckon Greenspan’s “conundrum”, a word he has since said he regretted using, mirrors the “irrational exuberance” phrase he used to describe rising equity prices late in 1996. Then, it took almost 4 years for equities to peak in what is widely considered to have been a bubble. Whether bond markets are experiencing something similar is unclear.Link here.
VALUE INVESTING … BY A NOSE
Because a 50-1 long shot named Giacomo won this year’s Kentucky Derby, a few lucky trifecta punters cashed in on a $133,184 payday. Meanwhile, the hordes of bettors who plunked down money on the favorites walked away with nothing but regrets. Betting on favorites rarely produces satisfactory results, whether at Churchill Downs or on Wall Street. Out on the racetrack, the old-time handicappers know it is best to “copper the public”, or to bet against the favorites. In the stock market, a few savvy investors have produced brilliant results by doing exactly the same thing: betting against the favorites, while betting on the underdogs.
In August 2000, Fortune magazine published a list of its favorite stocks, entitled “10 Stocks to Last the Decade”. Pity the investors who heeded Fortune’s advice … “[These stocks] were the glory stocks of the fin-de-siecle bubble,” recalls Louis Lowenstein, professor of Law and Economic Studies at Columbia University, “and their high price-earnings ratios – only one under 50 – reflected the faddishness of the age. Fortune, swallowing the popular perceptions whole, said they were ten stocks to let you ‘retire when ready.’” On the contrary, owning these stocks probably pushed retirement back several years for many of Fortune’s readers. Collectively, these stocks lost more than 80% of their value within two years. Even as the decade approaches the halfway mark, Fortune’s “Top 10” is still producing abysmal results.
But there were some investors who did not own any of these names. In fact, Lowenstein, in his paper (titled “Searching for Rational Investors in a Perfect Storm”) found ten of them. Lowenstein found that all of them steered clear of the names on Fortune’s ignominious list, with one small exception. Lowenstein tested this group of funds for the years 1999-2003, which he felt were among the most volatile in recent history. During these five years, the S&P 500 actually showed negative average annual returns of 0.57%. Well, they performed brilliantly. The boring old value disciples beat the market handily over that span – earning an average annual return of 10%. “A five-sigma event,” Lowenstein calls the achievement, “a statistical marvel that pure chance cannot explain.” More interesting, is how they did it:
1.) Own a limited number of stocks, 2.) maintain a low portfolio turnover, and 3.) Relate to stocks as part interests in a business. Each of the funds that Lowenstein examined applies its investment philosophy in different ways, but they all seem to embrace the idea that successful investing relies upon a long-term commitment to a few, well-chosen stocks. These three main tactics all seem pretty straightforward and intuitive. Yet, very few investors bother to pursue a similar approach. Bill Ruane at Sequoia Fund once estimated that only 5% of all professionally managed money follows the basic principles of value investing. Instead, most investors – professional and non-professional alike – prefer to bet on the favorites, and that is a strategy that almost always raises the odds against success.Link here.
THE GREAT INFLATION ILLUSION: A HISTORIC PERSPECTIVE
After the 2000 to 2002 decline, I embarked on a journey to study as much as I could about history and systemic risk in the world of money. In the process I learned that most of us, novice and professional alike, know very little about the history of our markets and thus are blindly following the conventional wisdom of “the experts”. If we knew history and could get past our own natural biases, I believe we could dramatically increase our probabilities for financial success. With the Dow falling from 10,984 on March 7 to 10,087 on April 15 of this year, this has become much more than an academic discussion. While it is easy to lose the overall direction of the markets in day-to-day moves, its general direction in the next few years is of crucial importance to all.
Most of our current circumstance can be traced to inflation (and possibly deflation) as reflected in the supply of money. In discussing inflation we do well to first start with a simple definition. Webster’s defines inflation as follows: “An increase in the volume of money or credit relative to available goods resulting in a substantial and continuing rise in the general price level.” Deflation on the other hand would reveal the opposite. It is: “A contraction in the volume of money or credit that results in the decline of the general price level.”
So I ask you, “can you or I create money … legally?” If you answered “no”, then congratulations, you just passed economics and law 101. The answer, we both know, is that we, as individuals, are not capable of doing this. So where is all this money coming from? Since I was a child, the amount of money in the U.S. has grown significantly. According to the Federal Reserves Historical Data on the money supply (as measured by M3), when I was eighteen months old in 1959, the money supply stood at $292 billion. By the time I started college in September 1975, it had reached $1,145 billion. Even though I was totally clueless as to what was causing inflation, I nevertheless, began to notice its impact on the world around me. Prices were going up everywhere. By May 1995, when my third son was born, the money supply had climbed to $4,476 billion. But something peculiar was occurring; as we were inflating credit more and more, the prices of goods were deflating. Inflation was showing up; however, now it was showing up in our asset prices instead of our consumption prices. This would go on to produce the fastest growing stock market in history and continue to cause real estate prices to climb.
In the meantime, on the other side of the world, we failed to notice what was happening to Japan, the second largest economy in the world. As our markets were roaring, in 1989 the Japanese markets began a long-term secular bear market. They would watch their stock values decline and their real estate holdings fall sharply from a growing deflation of prices. In fact commercial real estate values fell 90% from 1989 to 2003. Since the government cannot make people borrow and spend money, deflation was something that the Japanese government could do nothing to stop. Meanwhile, in America, our money supply, and therefore inflation, continued to grow.
What most of us did not realize is the fact that from August 1982, when the Dow Jones Industrials hit 777, to the January 2000 price of 11,722, the money supply had grown from $2,396 billion to $6,605 billion. Consumer credit had grown from $383 billion to $1,541 billion. And while we only have information back to June 1985, real estate lending grew from $25.8 billion in mid-1985 to $177.1 billion in early 2000. These numbers confront us with the fact that much of our boom in the stock market and otherwise was actually the consequence of a massive inflation of money and credit.
So where do we stand today? Are we facing a deflationary or an inflationary environment? To answer this question, let us look at the growth of money supply since the bubble popped in early 2000, how this increase appears to have affected us, and what we can learn from Japan. As of March 2005, the money supply stands at $9,532 billion. The last 5 years have also seen consumer credit grow from $1,541 billion to $2,122 billion and finance company real estate lending grow from $177.1 billion to $282 billion. Clearly the cutting of interest rates from 6.5% in January 2001 to a low of 1% in June 2003 made it very appealing to borrow money.
On the other side of the world, Japan has lost money for so many years that its institutional investors and banks invest in the bond market versus stock market. The value of the Nikkei closed 72% lower on May 17, 2005 (at 10,825) than its high (of 38,915) in December of 1989. To this day, its people are focused on saving and its businesses are focused on debt reduction rather than expansion and growth.
Cheap money policies have allowed us to continue to borrow. The swell in dollars has created a swell in demand. While consumption prices have stayed low because of globalization, asset prices have inflated greatly. The primary effect of asset inflation can be seen most clearly in real estate prices, yet the stock and commodity markets reveal this as well. As our borrowing capacity begins to tap out, who will keep “inflating” these asset prices? If we are forced to pay down debt and thus have less money to buy assets and consume, is the next major obstacle inflation or deflation? Every investor will witness the answer to these questions. Our history, and that of Japan’s, teaches that asset classes and investment strategies work very differently in a long-term deflationary cycle. The real question is whether we, as individuals, will prepare now or be caught off guard at some point in the future.Link here.
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