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YES, BUT WHO IS LOCKING IN?
News of the probable return of the 30-year Treasury bond puts the U.S. government in an anomalous position. It is, for once, setting an example of responsibility and financial discipline. Naturally, the people cannot believe their eyes. As the Treasury proposes to lock in generationally low long-term borrowing costs, more and more Americans are choosing not to. Instead of the standard 30-year, fixed-rate mortgage, they are taking out ARMs. In the past two years the share of adjustable-rate mortgages in new-purchase originations has leapt to 60% from 20%. Who is right, the people or their government? The words do not come easily, but let me try to say them: The government is right.
It was wrong to discontinue issuance of the long bond in 2001. The Administration had a pretext: The deficits in place and in sight were temporary, and long-term yields were high in relation to short-term yields. The Administration has reconsidered, but the public is stuck on ARMs – on all varieties, especially the interest-only kind, in which for a period of years the borrower amortizes no principal but pays interest only. The American house used to be a kind of savings account. People paid down their mortgages, then removed the cash. Now they take out cash as they go. Last year the homeowning population extracted $640 billion, primarily via home-equity borrowing and cash-out refinancing, or because buyers tend to take out bigger mortgages than the balances owed by sellers.
Long-term interest rates the world over are at 50-year lows, and, indeed, just might go lower. But the U.S. Treasury, in disclosing the possible return of the long bond, has asked the right question: Why not lock in low rates while we have them?Link here.
STILL TIME FOR TREASURYS
The Treasury Department is thinking about reintroducing the 30-year bond, come February 2006. I am delighted at the prospect; the Treasury stopped issuing 30-year debt in 2001. I have been almost alone since 1981 in consistently recommending the long bond. Back then, when the yield peaked at 14.7%, I stated, “We’re entering the bond rally of a lifetime.” The last-issued long bond, due in 2031, now yields 4.4% to maturity, and that yield is headed lower. The bond’s price, that is, has not stopped climbing.
Economists and professional bond managers are all but unanimous in believing that long-term yields are going to rise. In each of the six semiannual Wall Street Journal polls since July 2002, between 87% and 98% of economists have forecast higher yields. Bloomberg’s monthly poll found that on May 6 all 61 economists surveyed expected higher yields six months hence. International Strategy & Investment’s duration survey shows rising bond manager negativity since late 2001. Fellow columnist James Grant is also in the bearish camp. He suggests that the Treasury wants to lock in cheap borrowing for 30 years before rates rise [see above]. Nevertheless, the long-bond yield has fallen from 5.8% in March 2002.
We are in a deflationary world of excess supply. Furthermore, with earlier monetary and fiscal stimuli fully absorbed, U.S. growth is slowing, which curtails business in the many lands that depend on exports to America for growth. The flattening Treasury yield curve and the General Motors disaster are pushing investors out of junk bonds, emerging market stocks and bonds, commodities and foreign currencies – and into Treasurys. Pension funds hunger for Treasury bonds as they lick their wounds after the dot-com collapse. The long bond allows them to match long-term maturities with their very long-term obligations.
If you had bought a 25-year zero coupon Treasury at the 1981 rate peak and rolled the money into another 25-year each year to maintain its long maturity, you would have comfortably outperformed someone buying the S&P 500 at the index’s low in July 1982 and reinvesting dividends. The Treasury investors would have earned 21% a year to a mere 15% for the S&P investors. Our hypothetical zero buyer would have turned $1 into $93.
If my forecast of 1%-to-2% deflation is valid and Treasury bonds rally to 3% yields, they will continue to be superior. Over two years the Treasury due February 2031 will return 35%, including interest payments. The zero maturing in August 2029 will gain 48%. Meanwhile, I do not think you should expect much from the stock market in the next several years. I look for a good deflation of excess supply, but the transition to it may look like the bad deflation of deficient demand as excess debt and other imbalances are worked off.
The bond rally of a lifetime is still under way. If you do not already have it, consider meaningful portfolio exposure to Treasury bonds. For the biggest action, buy zeros. For something tamer, get the new 30-year bonds when and if available. Yields have come a long way from 14.7% to 4.5%, but there is still one big rally left.Link here.
STOP THE MERCANTILISTS
Mercantilism was an insidious economic theory that held Europe in its thrall in the 16th, 17th and 18th centuries. The mercantilists decreed that a nation’s economic success could be measured by its stockpile of gold and that the way to make the pile higher was to encourage exports and restrict imports. Adam Smith routed the mercantilists in Book IV of the Wealth of Nations (1776). His lesson was clear: Open markets and trade are “goods”, not “bads”.
The war, alas, is not over. Mercantilism is back. Its adherents use new lingo and make slightly different arguments – they hoard jobs, not gold – but their poisonous creed is in essence the same. It is that a nation can enrich itself by boosting exports and chasing imports away. Mercantilism is behind the campaign to make the Chinese revalue their currency upward. The preposterous notion here is that America would be enriched if Chinese apparel cost a little more.
Washington’s modern-day mercantilists believe trade deficits can be managed by altering exchange rates. Therefore it is not surprising that China’s currency, the yuan, is in the crosshairs. According to the Washington consensus the yuan is undervalued. But the Cleveland Fed has concluded that, “Overall, movements in China’s real exchange rate since 1995 have not given that country a trade advantage relative to the U.S. or, for that matter, to China’s other key trading partners.” It is clear that China stands accused on false charges.
I smell a nasty trade war and a consequent weakening of trade-led economic growth. All those risk-oblivious speculators borrowing at low rates to invest in high-yielding junk and emerging market bonds will be deep trouble. You should go the other way. Sell junk and emerging market debt. Buy Treasurys.Link here.
THE BARBARIANS ARE BACK AT THE GATE
Buyouts are back, big-time. Leveraged buyout firms have closed on $26.4 billion through April, on pace to exceed the record-high $74.7 billion amassed in 2000. In late March software maker SunGard Data Systems agreed to be acquired by seven buyout firms, led by Silver Lake Partners, for $11.4 billion in cash. It was the largest private takeover since Kohlberg Kravis’ $31 billion purchase of RJR Nabisco in 1989. Thomson Financial says buyout funds have spent almost $30 billion this year on acquisitions, an annualized amount that is the highest since the record $97.2 billion they spent in 1988. Low interest rates and easy money from banks and bond markets will sustain the buyouts, says David Toll, managing editor of Private Equity Analyst. “LBO funds can borrow 70% of the enterprise value of a company on average – the most leverage they have been able to use in ten years,” he says.
Rank-and-file investors could benefit if they can guess right on who the next LBO target will be. SunGard’s stock rose 25% on the day the company announced it was considering a sale. For the accompanying chart we scanned for companies trading at less than eight times their enterprise value (market value plus debt, minus cash). Nonfinancial stocks have an average enterprise multiple of 12. Their stock also must be selling for at least 33% less than that of their industry peers. We omitted companies with enterprise values below $1 billion, inside ownership stakes above 30% or declining earnings per share in the past year. What emerges is a cheat sheet of particularly cheap targets.Link here.
What are mergers good for?
To most investors, mergers are the stock market’s equivalent of catnip. Takeover bids typically provide a nice boost to investors’ portfolios and confirm their stock-picking smarts. And to hear the executives orchestrating them tell it, they always produce greater profits at the combined company down the road. Business publications and newspapers, including The Times, celebrate the deals with breathless tales of how they came together, complete with photographs of smiling executives shaking hands in front of a crowd. This year, with the stock market moving sideways, buyouts and the gains they generate are prized all the more. There have been a lot of them, too.
And yet, for all the profit and promise that mergers seem to hold, the truth about companies combining their operations is a darker one. Academic research suggests that few mergers add up to significantly more prosperous or successful companies and also that acquisitions during buyout booms, like the one we are in now, are more likely to fail than those made in other periods. And when one company acquires another using its own stock as currency, as commonly happens today, shareholders’ stakes in the acquiring firm typically decline.
What is worse, there is a disturbing trend among some of the most aggressive corporate acquirers to use deals to mask deteriorating financial results at their companies and to reap outsize executive pay. The complexity of folding companies into one another makes it more difficult, whether by accident or by design, for investors to fathom what is really going on. It is probably not just a coincidence that some of the biggest frauds in recent years have involved serial deal makers like Tyco International, Waste Management and WorldCom. Perhaps the biggest downside to mergers, however, is their human toll. Deals that combine companies are becoming a bigger factor behind large-scale layoffs across the nation.
Given all the forces that seem to be lined up in opposition to mergers, it may be a bit surprising that the deals keep on coming. But there are people for whom they make perfect sense: the executives and the Wall Street bankers behind them. There are several reasons for this – for example, acquisitions enable companies to show earnings growth that rising stock prices, and therefore investors, require – but the most compelling case for mergers may simply be the immense wealth that they generate. Executives began reaping big rewards from deals during the 1980’s, when so-called golden parachutes were introduced. (Today those payouts look positively quaint.) Back then, shareholders viewed large payouts to managers at a company subject to takeover as a way to induce entrenched executives to consider a change in control there. Those inducements then became embedded in every executive’s employment contract, growing to the gargantuan levels of today.
“Shareholders have to ask sometimes, Was this executive team motivated to do this deal only because they knew this pot of gold was waiting for them at the end of the rainbow?” Pat McGurn, special counsel at Institutional Shareholder Services, an investor advisory firm, says. “In some cases, it does border on what could be considered corporate waste.” Michael S. Kesner, principal in charge of the executive compensation practice at Deloitte Consulting, says it is not uncommon for payouts to management to reach 8% of a merger’s total cost.
“I speak with senior executives in the course of my research,” said Robert Bruner, the Darden business school professor. “They all tell stories about how they are charged with maintaining earnings growth. They can only get 5 to 6 percent growth organically, yet the C.E.O. has set a target that is much more ambitious, and they must make up the difference by acquisitions.” Bruner is critical of this process, which he calls financial cosmetics. “It invites the creation of growth for appearance rather than growth that creates wealth for investors and society,” he says. Indeed, shareholders who own stock in companies that make a lot of acquisitions – serial acquirers – should consider whether the deals are being cooked up by executives concerned about a slowdown in growth inside their operations. “The only thing people get paid for these days is growth, not running a company well,” Jack Ciesielski, editor of The Analyst’s Accounting Observer in Baltimore, says. “The cult of growth will always encourage companies to buy other companies to paper over the valleys in their earnings patterns.”
An academic study from 2000 examined the relationship between chief-executive compensation and mergers in the banking world. Richard T. Bliss, a professor at Babson College in Massachusetts, and Richard J. Rosen, then a professor at the Kelley School of Business at Indiana University, studied bank mergers that occurred from 1986 to 1995. They found that these deals had a positive effect on the size of executive compensation and that even when an acquiring bank’s stock declined following a merger, the compensation paid to the chiefs running the institutions grew significantly enough to offset any losses to their stockholdings. “The net result is that even mergers which reduce shareholder value can be in a manager’s private interest,” Bliss and Rosen concluded.
Their study found that more than three-quarters of the mergers in the sample led to a 10% or greater boost in executive compensation. The median change in compensation following a merger, the study showed, was an increase of between 20% and 30% of a chief executive’s premerger pay. Bliss and Rosen also compared increases in chief executive compensation at banks where assets grew organically with those at institutions that grew, more quickly, by acquisition. For every $1 million in new assets a bank acquires through a merger, the study found, its chief executive received an increase in total compensation of $54, on average. For every $1 million in assets grown organically at a bank, its chief executive received an average $30 rise in compensation. But those are numbers from the mid-1990’s and are probably a fraction of the riches that executives receive in mergers today.
The single biggest factor behind these eye-popping numbers are stock options, which typically vest over a period of years but in a merger can be cashed in immediately. But executives also receive other goodies in one lump sum following a merger. First they get a hefty multiple of their average base pay – usually 2.99 times the amount. (Any more than that and a federal tax kicks in.) Corporate executives involved in a merger may also receive enhanced retirement benefits, like a crediting of their service to age 65, even if they are nowhere near that. One apparent drawback to these enormous payments is the enormous tax bill they generate for executives. Happily for them, however, their contracts almost always require the companies to pay those bills.
One reason that shareholder outrage about these payments has been muted may be that few people, beyond the executives themselves and maybe the company’s compensation committee, know how costly these pay deals are. Even with all the scrutiny of corporate governance in recent years, a full tally of what executives will earn under a change of control is undisclosed until the deal is struck. Experts say that many compensation committees do not even understand the size of these pay packages because they do not routinely ask their consultants for detailed lists of the various pay components.
What may be most troubling about the lavish benefits and perquisites paid to executives is that they are doled out even as lower-level employees at the merging companies lose their jobs. For most executives that do deals, it is necessary to eliminate jobs after combining the companies’ operations in order to clear the performance hurdles that investors demand. What might end today’s fever? “Rising interest rates and falling stock markets” could curb mergers, Robert F. Bruner, professor of business administration at the Darden School of Business at the University of Virginia, says. “And either self-regulatory systems of accounting and industry watchdogs as well as government regulators may challenge practices that have grown aggressive during the height of the boom.” Till then, however, we can count on more mergers, more money paid to executives and fewer jobs for everyone else.Link here.
THE EVERYTHING REIT’S
You know the old saying about the jack-of-all-trades. Well, Steven Roth is master of them all. His Vornado Realty Trust does not accept the conventional wisdom that real estate investment trusts must focus on one kind of property. Roth is now putting the finishing touches on a 56-story midtown Manhattan skyscraper that will combine a home for Bloomberg LP with luxury condos. Vornado owns Chicago’s Brobdingnagian exhibit facility, the Merchandise Mart. The REIT has 27 million square feet of office space, mainly in New York and Washington, D.C. Also supermarkets, shopping centers, cold-storage vaults, even a hotel. Not to mention stakes in Sears, Roebuck and Toys “R” Us. Vornado, with ally Related Cos., has the edge in bidding to build an office structure above New York’s new Penn Station, says Peter Slatin, editor of a real estate newsletter, the Slatin Report.
In an era when the phrases “pure play” and “core competency” ring loudly on Wall Street, Roth’s Vornado has acquitted itself superbly. This trust’s average annual return since 2000 has been 26%, compared with the 15% returned by office REITs and 20% by all REITs. Starting out in 1980 as a collector of shopping centers, Vornado has grown to $20 billion in assets to become the nation’s fourth-largest REIT.
How does Roth manage to be so multifaceted, shifting from warehouse refrigeration units to lobby floor materials? “This guy is very nimble,” says Scott Latham, a New York real estate broker with Cushman & Wakefield, who has sold two buildings to Roth. What helps is Roth’s willingness to use Vornado’s big bankroll to go outside and lure experts into his company. It is not easy to be a successfully ambidextrous REIT like Vornado. These so-called diversified REITs matched the five-year total return of all REITs (20% annually) yet trailed slightly over ten years (12% versus 14%). Of the six biggest REITs owning large chunks of more than one property type, three have done well: Vornado, Washington REIT and Lexington Corporate Properties.Link here.
HOUSES ARE CONSUMER DURABLES, NOT INVESTMENTS
Over time, under a 100% gold standard, a house would gradually depreciate in value. A house, after all, is nothing more than a durable consumer good – it is a capital good if it is a rental property. However, when living under a fiat-currency regime, perceptions can be radically altered. For example, not only is a house believed to be an appreciating asset, it is considered to be an investment. Additionally, under conditions of rapid money and credit growth (which, for a period of time, leads to artificially low interest rates), people will come to think of themselves as real estate entrepreneurs – wisely “investing” in a house, to live in, with the confidence that a big payday looms ahead upon sale of same house. Presently, with lending standards so low – in order to keep credit flowing – the housing boom has become an outright speculative bubble in many parts of the U.S. I would argue, in fact, that a hyperreality has emerged in which real estate is perceived to be a one-way street to wealth. The bust will come, inevitably, and millions of Americans will be wiped out financially – and only the Austrian School of economics provides the correct explanation as to why the housing boom contains the seeds of its own destruction.
As Roger Garrison explains in The Austrian Theory of the Trade Cycle, the boom-bust cycle emanates from the Federal Reserve: “The Austrian theory of the business cycle emerges straightforwardly from a simple comparison of savings-induced growth, which is sustainable, with a credit-induced boom, which is not. An increase in saving by individuals and a credit expansion orchestrated by the central bank set into motion market processes whose initial allocational effects on the economy’s capital structure are similar. But the ultimate consequences of the two processes stand in stark contrast: Saving gets us genuine growth; credit expansion gets us boom and bust.” We certainly know that today Americans are saving little if any money. Thus, America’s housing boom has emerged directly as a result of Alan Greenspan’s easy-credit policies, not from savings.
For the time being, the real estate party is in full swing. Americans are clamoring to participate in this ride to “Easy Street”. People are willing to take on punishing mortgage debt loads, “knowing” that houses will always appreciate in value and that the higher the leverage, the higher the rate of return. Moreover, as a house appreciates, home equity loans can be taken out to purchase consumer durables such as high-end kitchen appliances, granite countertops, a hot tub, and even a kit to build a backyard barbecue. Once these consumer durables are “attached” to a house, they magically become investments that add value to, and appreciate with, the house. With Alan Greenspan at the helm of the Federal Reserve, Americans have discovered investment Nirvana. Indeed, the house has been transformed into a perpetual wealth creation machine.
Sadly, there will be a comeuppance. In this case, a clustering of errors will be exposed on the part of the high-flying housing developers, lenders, and homeowners. Mortgage lenders, eventually, will find that homeowners cannot handle such crushing debt loads, especially as rising interest rates cause defaults on interest-only and adjustable rate mortgage loans. As mortgage payment delinquencies and defaults rise, bankers and other mortgage lenders will begin to see the error of their easy-credit ways. This is where boom turns to bust. Not to forget the housing developers: at this juncture, they will be caught with too much inventory on hand right when housing prices and demand are on the decline.
Just as night follows day, bust follows boom – as long as central banks exist. The housing bubble is merely another manifestation of the Federal Reserve’s reckless manipulation of money and credit. Presently, most Americans believe that houses are a sure-fire investment while adherents of Austrian economics know they are nothing more than consumer durables caught up in a speculative frenzy. When the housing bubble bursts, millions of Americans will find themselves buried alive in debt while living in their financial tombs.Link here.
The U.S. real estate bubble charted.
Any economist can recognize that the housing market has rescued and boosted the economy of recent, but at what cost? Even before the real estate bubble, our consumption-based economy had been accumulating household debt much faster than it could pay it off. How can this consumption-laden mortgage frenzy be healthy for our economy? In 2004 total residential mortgage debt outstanding (MDO) grew by a staggering 13.2% to $8.7 trillion, the fastest rate of annual growth since 1986. Numbers in the trillions are unfathomably ridiculous. To put this massive MDO number in perspective, our national debt is just about $8 trillion. Wow! Residential MDO is greater than our Federal Government Debt!
This Fed-generated Real Estate bubble is the fruition of a speculative mania along with the Fannie Mae and Freddie Mac debt-laden time-bomb that is rearing its ugly head. Now let us focus on how this will affect the average consumer and the socioeconomic burden that Americans will have to bear. There used to be an old rule of thumb that your total housing expenses, which include your principal and interest mortgage payment, property tax and home owners’ insurance, should at the most amount to 25% of your gross monthly income. In today’s society, that does not seem to be the case anymore. Many families are spending far more than 25% of their gross income on housing expenses.
The socioeconomic conundrum Americans are faced with can be explained visually in the chart below, which shows the national percentage savings rate mapped against annual household debt in trillions of dollars. Notice the distinct trends over the past 40+ years. Household debt is on a near parabolic upward trend and personal savings rates are tailing to precarious lows. Since 1980, household debt has risen 623% while personal savings rates have decreased from 10% to 2%. This chart alone tells the story of the state of our economy. America is so blinded by short-term bliss that it does not think about the future. Today’s society is taught that debt is good, and acceptable. Unfortunately it is a highly contagious and dangerous epidemic. We certainly do not have a good mentor on this issue either. Big Brother has been piling up debt like it is going out of style, with war and terror as government’s latest excuse to keep it rolling.
Before the Real Estate bubble household debt was becoming a major problem, but the recent infusion of cashflow created from increases in home equity has not only delayed the attention this problem demands, but has made it far worse. Our dollar-weakened, debt-laden economy will likely experience turbulent times ahead. An old proverb puts it plainly, “If your outflow exceeds your inflow, then your upkeep will be your downfall.” Unfortunately many people will learn this lesson the hard way.Link here.
Sometimes they ring a bell.
There has been a lot written on the housing bubble recently. On May 20, Alan Greenspan, Chairman of the Federal Reserve made the statement that there is no national housing bubble, but then stated, “There are a lot of little bubbles around the country”. Chairman Greenspan went on to tell the Economic Club of New York, “Without calling the overall national issue a bubble, it’s pretty clear that it’s an unsustainable pattern.” This is not the normal “Fed speak”. The chairman is apprizing the investment community of the Fed’s concern in pretty plain language. There is evidence that the Fed has begun to move to contain the housing bubble using credit standards in place of interest rates. With a little noticed memo, several Federal regulatory agencies have begun a major crackdown on excessive home equity lending.
In an unusual joint release issued on May 16, 2005 by the Federal Reserve Bank, Controller of Currency, FDIC, Office of Thrift Supervision and the National Credit Union Administration, entitled “Agencies Issue Credit Risk Management Guidance for Home Equity Lending,” the Federal agencies laid the groundwork for a tightening of lending standards for home equity loans and lines of credit. At present there are over $880 billion of the loans outstanding according to the Federal Reserve. It should be noted that these are mainly second loans not primary mortgages, although I suspect that primary mortgages maybe next on the list. In speaking with several of these agencies my impression is that there is concern that lending standards have slipped and the agencies would like to see them tightened. In addition, as many of these loans are floating rate loans, they would like to see the loans vetted for inherent vulnerability to rising interest rates. Consumers have used these loans to buy more real estate, pay off credit cards and maintain consumer spending at the expense of saving. In addition to cooling down the real estate market this will further slow down consumer spending. We believe this is a major move by the Federal Reserve to control the bubbles in the real estate markets, We also think that there will be other moves to get slow the lending and thereby cool the home market down.Link here. Fed officials warn on real estate values, interest-only loans – link.
Nipping the bubble in the bud.
And the beat goes on: Existing home sales for April hit a record high, while home prices saw the biggest gains in over two decades. The cover of Fortune features the words “REAL ESTATE GOLD RUSH” in bold caps. Meanwhile, The Washington Post reports that even Playboy Bunnies are turning in their tails for real estate licenses and one out of every four houses bought last year was, ahem, investment property (“speculative purchases” is just too crass for polite company). As the piece de resistance, adjustable-rate and interest-only loans represented close to half of all mortgages in the second half of 2004.
Greenspan says, “At minimum, there’s a little froth in this market.” At a New York luncheon, he went on to say, “We don’t perceive there to be a national bubble, but it’s not hard to see that there are a lot of local bubbles.” On surface inspection, there is not much to see in these remarks. The maestro seems to grudgingly acknowledge the housing bubble issue, now that it is too big to be denied, while simultaneously downplaying its importance. Dig deeper, though, and things start to look more interesting.
It was not so long ago that Greenspan adamantly denied the possibility of bubbles, or at least the ability to spot them with foresight. He argued that it is impossible to recognize a bubble before it bursts, and that even if you could recognize a bubble in the making, there is not much to be done until it pops. This “hindsight is 20/20” defense was used to justify the Fed’s response to the dot-com debacle, or rather, its utter lack of response. In the days of the late great tech boom, Greenspan essentially cheered on the way up and wrung his hands on the way down, waiting until the stock market imploded – to the tune of $7 trillion – before taking emergency measures.
The Fed’s long-standing bubble-blind stance was rooted in the efficient-market hypothesis, or “random walk” theory, which is dying a slow but sure death. For many decades, academics have believed that markets are perfectly rational and accurately priced at all times, making foresight worthless and the very existence of bubbles an impossibility. The efficient-market hypothesis is a silly and stupid belief, for a wide number of reasons; but like many other dumb ideas, it has managed to stick around and hold otherwise intelligent people in thrall. Only in recent years has the dogma been successfully challenged on academic grounds.
The connection between the Fed and asset prices is fairly straightforward. If asset prices are always and everywhere rational, as a dwindling band of academics believe, then the Fed does not need to target asset prices, because permanently rational pricing implies fair value at all times. If efficient-market theory is wrong, however, and the markets are not always rational, then asset prices have the potential to get out of whack … sometimes dangerously so. In this case, the Fed needs to pay attention to asset prices and discern whether current valuations are rational or bubblelike in making their decisions.
So back to the maestro’s offhand remarks: When Greenspan says, “It’s not hard to see that there are a lot of local bubbles” in the housing market, it is the equivalent of a lesser official shouting from the rooftops. By acknowledging the existence of asset bubbles (even if they are dismissed as local), the maestro has reversed tack from his previous bubble-blind stance and subtly acknowledged the Fed’s need to take asset prices into future account … or at least the possibility of such. From here, it is not a far stretch to imagine a future Fed targeting asset bubbles proactively.
If insanely greedy banks have so little common sense as to hand out zero-down, adjustable-rate, interest-only loans to speculative buyers already leveraged past their eyeballs, the Fed could surely provide some common sense on their behalf by adding a mandatory “sanity clause” to all lending agreements. Sadly, this is asking too much. In acknowledging that bubbles exist (in his roundabout, ineffectual way), Greenspan has cleared a path for his replacement. The longtime appeaser Greenspan, on his way out the door, is not up for the task. Hopefully, his successor will be.Link here (scroll down to piece by Justice Litle).
Real estate vulnerability index highlights varying risks across locales.
Housing prices have risen so far and so fast, who can afford to buy anymore? Plenty of people. Of course, those people do not live in New York … or San Francisco … or Miami. As everyone knows, home prices have increased around the country over the last few years. But prices alone cannot tell the whole story. To get a better picture of which cities are likely to be vulnerable to a real estate decline, with the help of Economy.com, we compared incomes to home prices, factoring in interest rates.
We were surprised at the results: While it has become much more difficult to buy the median house with the median income in many cities, in others it has actually become easier, pointing to a boom taking place in pockets, rather than the nation as a whole. That backs up what many economists, including Federal Reserve Chairman Alan Greenspan, have opined – that some areas appear more “frothy” than others and could be primed for a bust – or, more likely, a slow decline, as real estate prices tend to stagnate rather than crash.
Economy.com calculates affordability using incomes, sale prices for single-family homes and composite interest rates for a 30-year mortgage. The resulting index shows what percentage of a median home (the one for which half the sale prices were above and half below) a family can afford with the median income. A low number means that home owners cannot afford the standard home or that they must pay much more of their income toward it. A high number means the average house is easily within reach. Five of our 12 cities had affordability indexes below 100: San Francisco, New York, Los Angeles, Miami and Boston. Some of these cities – including Boston and Los Angeles – are slightly more affordable now than they were in 1980. But in nearly every metro area, affordability has declined in the past few years.
But it is all relative. In Dallas, the median income can get you more than 200% of the median home. In Los Angeles, you can still get only 57%. In Philadelphia, the median home price more than tripled between 1980 and 2004, rising 220% from $57,570 to $184,190, which would suggest that houses would be harder to afford. But incomes rose, too, albeit not as dramatically, increasing 195% from just under $19,000 to more than $56,000. In Miami, the affordability index hit a high of 124 in 1993, but now is down to just 75. Robert J. Shiller, a Yale University economics professor whose book Irrational Exuberance predicted the dot-com bubble, pegs Miami as a “glamour city”, where people are buying because it is glitzy and trendy, making the city more vulnerable to a bust.
So does this mean we are headed for a crash? In 2002, we dubbed the housing market a bubble and predicted its fall. Since then, home prices have gone up about 32%, according to the National Association of Realtors. But that does not mean a bust is not on the horizon – at least in some places. Greenspan used the phrase “irrational exuberance” to refer to tech stocks in 1996; it took another three years for the market to tank. And when it did, it hurt.Link here. Real Estate Vulnerability Index may be found here. Is there a housing bubble in Dallas? – link.
Top cities for risky, interest-only mortgages.
When Federal Reserve Chairman Alan Greenspan told Congress on June 9 that “the apparent froth in housing markets may have spilled over into mortgage markets,” he was surely talking about mortgage markets like San Diego’s. BusinessWeek Online has obtained the first-ever measurement by metro area of the increasing popularity of interest-only mortgages, and it shows that San Diego rates No. 1, by number of “IOs” in 2004. In metro San Diego, 47.3% of all mortgages required interest payments only in their early years. The survey covered the top 50 metro areas in the U.S. and measured by the total number of mortgages issued. Atlanta, San Francisco, Denver, and Oakland, California, followed close behind San Diego. Milwaukee, Wisconsin, turned in the lowest number, just 4.8% interest-only loans last year.
Greenspan is not the only one worried about the sharp rise of interest-only mortgages, which accounted for less than 2% of all loans as recently as 2001. The concern: that they are helping supercharge already overheated housing markets. Because no payment of principal is due in the early years, interest-only loans offer lower monthly payments (even though the interest rate is slightly higher) than conventional ones. Based on the initial monthly payments, borrowers may be able to buy a more expensive house than they might otherwise afford. Trouble is, when borrowers do have to start making principal payments – after anywhere from 2 years to 10 years – the monthly payment could jump by up to 50%, or even more if the index for the adjustable rate rises as well.Link here.
Investors go online to buy into hot housing markets.
Location is the most important thing in real estate, they say, but if you are looking to invest in real estate, but do not want to travel to any of the hot markets, the Internet has created a “virtual realty” just in time for the housing boom. Take Mike Bozzo, for example. He owns a successful welding business in Dayton, Ohio. But every day, when he gets to his office, the first place he goes to is Florida. “I like to spend about an hour looking at different properties,” Bozzo says, adding that he visits a number of different real estate sites every day. “This is something I’m looking to do for the future of my family.” Bozzo says his Florida Web surfing is pay off. Over the last four years, he has made well into six figures by buying and selling Florida real estate online, and almost all of it has been sight unseen.
Mike Bozzo is not alone. With the housing market booming, 22 million people are visiting real estate Web sites every month. But before you jump on the Internet and start buying, beware – this is still a risky business, and it is made even riskier by doing it on the Internet. Bozzo confines his surfing to Naples, Florida. Not just because housing has appreciated 93% there in the last five years, but also because he has been going there since he was a teenager and he knows the area. And Bozzo does not only use the Internet to find properties through the Web sites of several local realtors. He also uses it to research tax assessments and recent sales – information that is readily available online. And he always gets a properties inspected, and has a realtor he trusts in Naples who will check out the property in person if necessary.Link here.
Home, very costly home.
The housing market in California may look like a textbook case of superheated “irrational exuberance”, but then how does one explain Spain? Home prices there have risen 130% since 1997, twice as much as in the U.S. These days, house-price vertigo is more than a local or national condition. It is a worldwide phenomenon. The American housing boom in recent years is nothing compared with the price run in countries like France, Spain, Britain, Ireland, Sweden and Australia, even though markets in Australia and Britain have cooled in the past year. Million-dollar two-bedroom apartments are not only a fixture of New York but also of London, Paris and Hong Kong. In New Zealand, housing prices rose more than 16% from 2003 to 2004. In Ireland, they rose more than 10% in that period.
The rise in prices is worrisome because the international housing boom is a byproduct of globalization. A house on a plot of ground is the most local of assets. But the financial markets that make it possible for people to borrow money to buy a house, or speculate, are increasingly open, global and linked. Interest rate policies in the industrialized world tend to move in lockstep, usually led by the United States. A growing community of affluent professionals around the world now buy second homes and invest in housing abroad.
The economic links act as a self-reinforcing network that has fueled the global surge in house prices but would also be likely to magnify the pain on the way down. The ripples would extend well beyond the housing markets. A fall in American house prices, for example, would crimp consumer spending – and free-spending Americans have supported growth in many export-minded nations, notably China. “The real concern is that the housing boom extends across so many countries this time,” said Susan Wachter, a professor of real estate at the Wharton School of the University of Pennsylvania. “That just raises the stakes, and the risk, when the music stops.”
Cheap credit worldwide fueled the housing market, making mortgage payments less costly. Homeowners refinanced their mortgages at lower rates, and the savings went into consumer spending. They took out home equity loans on houses of rising value, spending that borrowed money on cars, clothes, furniture, restaurant meals and vacations. The higher consumer spending and the soaring value of the home nest egg have kept the global economy chugging along. Hitching the world economy to the housing market has worked well for policy makers so far. But it probably cannot continue. Prices in general are continuing to rise both in the U.S. and abroad as speculative buying and interest-only mortgages are proliferating. The looming, unanswered question for the global economy is whether the housing boom will cool down in an orderly way over the next few years or end in a bust.
In a recently published paper, Thomas Helbling, an economist at the IMF, studied 75 housing price cycles in 14 industrialized countries from 1970 to 2002. He found that not every boom was followed by a bust but that booms are often signs of possible trouble. So applying Helbling’s historical standard for booms to today’s housing markets makes for nervous reading. All eyes must be looking anxiously to Britain and Australia, where prices have peaked, and the question is whether they will experience a bust. History, of course, teaches that sooner or later, economic gravity will return to house prices, either gradually or swiftly, soft landing or meltdown.Link here.
The interest rate conundrum is challenging enough. But now the dollar is springing back to life in the face of America’s record current account deficit. In my view, this defies both the history and the analytics of the classic current account adjustment. Is this just another example of a world turned inside out, or is it a head-fake likely to be reversed? As I now see it, given the urgency of a U.S. current account adjustment, further dollar depreciation is a logical outgrowth of the benign climate in the bond market. Of course, precisely the opposite is now happening. After an orderly three-year descent of about 5% per year, the broad dollar index has been edging higher over the past four months.
I do not agree with the view that the dollar’s structural decline is over. By my count, this is the fourth trading rally in the dollar’s recent 39-month downtrend. Like the first three, I believe this one will also fade as the power of the U.S. current account adjustment regains its prominence as the dominant macro theme shaping foreign exchange markets. In the absence of an upward adjustment to U.S. real interest rates, I believe this possibility is even more compelling than might have otherwise been the case.
The next downleg of the dollar should be very different from the first one. The euro has borne the brunt of the dollar’s decline over the three years ending January 2005. Most Asian currencies – especially the yen and renminbi – were completely unscathed. If the dollar resumes its downward descent, as I suspect, that will have to change. If the Chinese and Japanese currencies strengthen, most other Asian currencies should follow suit – with the possible exception of the Korean won, which has already moved a lot.
The currency call has long been one of the trickiest in the macro trade. In large part, that is because foreign exchange rates are relative prices that reflect shifts in a broad array of comparative metrics between nations – namely, productivity growth, inflation, interest rates, perceived returns on assets, capital flows, and the like. At the same time, monetary authorities often attempt to target their currencies through intervention and/or policy-directed reserve-management practices. And the toughest aspect of the currency call is that the markets do not assign constant weights to the factors above – the main drivers of fluctuations in foreign exchange markets are seemingly never the same from year to year.
Of course, currency markets are also highly sensitive to swings in investor sentiment. And with the benefit of hindsight, we should have known that the dollar was about to surprise on the upside. Nevertheless, I think this counter-trend rally will be short-lived. The imperatives of global rebalancing – underscored by America’s massive current account deficit in conjunction with an aborted adjustment in U.S. real interest rates – points to nothing less.Link here.
Less to the dollar than meets the eye.
You cannot keep a bad currency down, the dollar bulls would have you believe. After reeling off an 8% rally against the euro since the beginning of 2005, and making a new 7-month high, global currency traders seem to be telling us the buck is back. Not quite. The dollar has its pros and cons. We will take a look at three of each in moment. But in truth, there is less to the current dollar bull market than meets the eye. What is more, investors could see a surprising rally in the euro in early June. And for the remainder of 2005, look for strong performances from Asian currencies, grains, and – of course – gold.Link here.
SEE A BUBBLE?
It is a good time to be a financial-disaster writer. Disasters abound, and even when they do not, people are eager for your opinion on when the next bubble is going to pop. Scarcely a day goes by without a warning of some dire calamity – in the dollar, in housing values, in pension funds. The way people crave financial info, we must be the best-informed, most economically literate society ever. But we do not sleep any better for it. Is all the anxiety warranted, or even productive?
A few years ago, the chief claim on the public tranquillity was the fear of “deflation”, meaning that the price of just about everything would fall. Before that, it was fear of “Y2K”. Neither transpired. This is not to say that disaster never strikes. The number of bubbles and consequent meltdowns over the last quarter-century could fill a proper B-school syllabus. In order of appearance, oil drillers, precious metals, personal computer makers, the stock market, commercial real estate, Trump casinos, junk bonds, biotechs, Russia and Internet stocks each had their moments of glory and returned to earth.
Not every bubble ends with a crash, but sometimes, because of a linkage or feedback mechanism, one loss triggers another and leads to a sort of contagion. In 1929, people who bought stocks on credit were forced to sell, which spurred more losses, more loan repayments and more forced selling. This is what people worry about: the Big One. Japan experienced a somewhat similar meltdown in the early 90’s. Almost by definition, the spark for such calamities is unforeseeable. This explains our vigilance. What is less appreciated is that excessive, or inappropriate, vigilance also exacts a price. It does so in several ways. People who insulate their portfolios against phantom risks pay a toll, just as they paid to protect their computers against Y2K.
George Bernard Shaw observed that every profession is a conspiracy against the laity. The financial profession duly warns us of meltdown risk, but it has adopted a pinched definition of risk that has led us into fruitless and sometimes harmful diversions. The odds of a meltdown being necessarily uncertain, Wall Street fosters an overly precise, pseudoscientific approach. Investors are told to “balance” portfolios (rather than to select stocks), to “allocate” (rather than to “invest”) their assets and to reckon with quarterly earnings forecasts down to the penny per share – an absurd irrelevancy for someone whose retirement is years away.
Wall Street properly worries about what might go wrong, but it has recast the issue in spurious terms, detaching us from the messy and often subjective considerations that might help us avoid truly perilous bubbles: those that (like the dot-coms) subject us to the risk of enduring loss. If you tune in to enough financial shows, you are bound to stop asking considered questions like “Is the Web going to be full of other companies competing against this one?” and to start toying with numerics like a stock’s volatility or the percent of your holdings in a given “sector”. No wonder people are jittery: this stuff changes every second. To listen to the anchors on cable TV, we should reshuffle our portfolios in response to each new, tangential threat – oil prices, the dollar, real estate. And, of course, we should diversify in the extreme.
Diversification is insurance against the possibility that we might do something stupid; it also heightens the chance that we will do something stupid. People with flood insurance build their homes closer to the shore, and people in the 90’s, having diversified, figured they could afford to take at least a small flier on dot-coms. Risk prevention can lead to risk.
If you are searching for the next financial storm, try derivatives. Come to think of it, most of the sudden financial disasters of the previous decade – Orange County, L.T.C.M., Enron – involved derivatives, too. There is a paradox here. A vehicle developed to help reduce individual risk has heightened risk to the system. At some point, the anxiety turned counterproductive. There was a time, of course, when people could buy only the homes they could afford and invested in only a few, carefully chosen stocks – when traders could not run certain risks because no derivatives existed to provide a hedge. Today, whether you are a trader or homeowner, bank or corporate treasurer, our financial culture offers a prophylactic against every conceivable worry. Maybe weaving a giant insurance net is really the way to manage anxiety, but maybe it has us worrying about what we will do if the insurance fails. Perhaps, if there were fewer traders dulling their anxieties with financial Zoloft and fewer investment options available to the rest of us, we would make better decisions – and sleep more soundly.Link here.
THE NEW MACRO OF GLOBALIZATION
Globalization is rewriting the script of some of our most time-honored macro relationships. That is true of the forces shaping employment, real wages, income generation, inflation, and trade and capital flows. On all of those counts, the rich countries of the industrialized world are under pressure as never before, as globalization spreads wealth and prosperity from the developed to the developing world. Courtesy of IT-enabled connectivity, this diffusion of economic activity is now occurring at hyper-speed. Economists, policymakers, workers, investors, and politicians do not comprehend these seismic shifts. This underscores the risk of a potential backlash against globalization.
Mounting trade tensions are a very visible manifestation of how the body politic has lost confidence in the gospel of free trade and comparative advantage long espoused by most economists, including yours truly. Persistently subpar employment and real wage growth in the world’s most powerful economy fuel that confidence loss. In effect, workers have lost patience with the promises of classic free-trade economics, and opportunistic politicians have seized on that angst. Globalization has met its demise in the past – and the circumstance of that backtracking took the world right to the brink of World War I. Yes, history rhymes, rather than repeats. But the downside of a backlash against globalization is something we cannot afford to take lightly. It would be the ultimate comeuppance for ever-blasé financial markets.Link here.
BIG PENSION PLANS FALL FURTHER BEHIND
Although the financial markets have been on the upswing recently from their post-boom low, many of the nation’s private pension plans have been sinking deeper into the hole, according to new figures from the government’s pension insurance agency. The 1,108 weakest pension plans – those whose assets are at least $50 million below the value of the benefits they promise – were short by an aggregate $353.7 billion at the end of last year, figures from the government’s Pension Benefit Guaranty Corp. show. That was 27% more than the shortfall a year earlier, contrary to the hopes of many that funding would improve as the economy strengthens.
The number of traditional pensions has fallen from more than 100,000 to about 31,000 over the past two decades. And though the remaining plans still cover 44 million workers and retirees, a growing number of workers and families now have only retirement savings plans, such as 401(k)s, and other savings for retirement. In a 401(k) plan, there is no promised benefit; whatever is in the account at retirement is what the retiree gets.
In traditional pensions, benefits are promised and employers generally bear the burden of funding them. Employers, with the PBGC as a backstop, are supposed to make up the shortfall if the pension fund’s investments do not do well. But the end of the stock market boom, and changes in the fundamental economics of entire industries, such as airlines and steel, have left many plans underfunded and have thrust others into the arms of the PBGC. Also, loose funding rules allowed companies – more than three in five of the largest ones each year from 1995 to 2002 – to avoid putting new money into their plans, a study by the Government Accountability Office found.Link here. Pension loopholes helped United hide troubles – link.
HITTING THE LONG BALL WITH BONDS
Stocks, schmocks – these days, the line outside the U.S. bond market is longer than the crowd crammed around a Yankee Stadium bathroom during the seventh-inning stretch … of a World Series game. It is heel to toe and getting tighter, as the call for lower yields grips the finest of Wall Street’s financial minds. In the words of one seasoned bond manager: “I can’t help wondering whether we’re near the point when apocryphal shoeshine boys start recommending bonds.” I wonder how many investors ran out to get their penny-loafers polished after that statement went public.
But what is truly amazing to me is NOT the extreme in bond bullishness. It is the fact that so many experts still insist the bullish potential of bonds depends on the Federal Reserve. Case in point, on June 1, the Dallas Fed President suggested the next FOMC meeting would be the “ninth inning” of the current tightening campaign. A string of headlines like this followed: “Bonds bet on baseball analogy and end of rate-hike scenario… Yields plunge to a new, 15-month low.” FYI: The 10-year Treasury yield has fallen as much as 90 basis points LOWER than it was when the Fed began raising rates last year. Mathematically speaking, on June 2004 the yield was 4.7%. Eight rate hikes later … in June 2005 the yield is 3.8%. The fact remains: No matter how shiny your shoes are, a bond strategy based on the Fed – or any other fundamental for that matter – is, simply put, a walking disaster.Link here.
DEATH OF THE CARRY TRADE
In the financial markets, the term “Carry Trade” refers to the way that most financial intermediaries (money center banks, Wall Street investment banks, and hedge funds) make their really large profits. Indeed, the engine driving financial profits is quite simple: borrow at low short-term interest rates, and lend at higher longer-term interest rates. In the Carry Trade, to enhance returns and make them exciting, leverage is used. For liquid assets like Treasuries and Agency Securities, leverage of over 25 to 1 is possible!
When the Federal Reserve was fighting the collapse of the NASDAQ stock market bubble and cut short-term interest rates to 1%, the financial markets were a “Carry Trader’s delight”. The interest rate yield curve was steep, and credit spreads were wide and narrowing. To make money, financial institutions simply needed to close their eyes, buy longer dated paper and lower rated credits, and then sit back and enjoy the Fed’s interest rate subsidy. There was a lot of easy money to be made and even corporations got into making money through finance. Currently, 40% of corporate profits in S&P companies are made from financing activities. Indeed, a firm like GM does not make money from manufacturing and selling cars anymore; it makes money by financing cars and houses.
So, wither the Carry Trade? The Federal Reserve has raised interest rates eight times with no end in sight and the yield curve is starting to go flat. Now that the yield curve has “lost its curve,” this profit engine has run out of gas. The only way to make money in the Carry Trade game is to take on more credit risk and increase leverage, but the problem with that is credit spreads are already at levels that have become so narrow that spread-lending offers little reward, and massive risk. The downgrade of GM and Ford to junk has come at a time when the credit cycle has started to turn from improving credits and narrowing credit spreads, to negative credit surprises and widening spreads. A widening credit spread can push down a bond price faster than rising interest rates.
Recently, there has been another rally in the Treasury market which has pushed yields down, and prices up, for Treasury notes and Agency Securities. Now seems to be the perfect time for Carry Traders to cash in their chips and leave the financial market casino with their winnings. Money managers who continue to borrow short to lend long have little to gain and much to lose!Link here.
GOOGLE NOW MOST VALUABLE MEDIA COMPANY
Google Inc. took over the top spot as the most highly valued media company this week, surpassing Time Warner Inc. in just 10 months of trading as a public company. Google’s share price on the Nasdaq rose another $2.18 to close at $293.12 on Tuesday, an all-time high. Stock market analysts have suggested the stock could go as high as $325 or $350 a share. With a current stock market capitalization of more than $80 billion, Google is now worth more than any other media company in the world. That includes Time Warner, created five years ago when AOL purchased Time Warner for $106 billion in a much-hyped combination of old and new media. But Time Warner’s share price has deteriorated since the dot.com bubble burst – its market capitalization on Tuesday stood at $78.1 billion – and investors view Google as the hot internet and media company these days.
Other, more traditional, media companies trail Google’s stock market worth by even more. Viacom and Walt Disney, for instance, hold stock market capitalization of between $54 billion and $55 billion. Even Yahoo, seen as one big internet media competitor, carries a market value some $27 billion less than that of Google. This all comes just 10 months after Google debuted in an initial public offering last August, priced at $85 a share. And it has led to some concerns that the company may be overvalued, a throwback to the hype of the dot.com era. Google’s sales last year, for instance, totaled just $3.2 billion while Time Warner’s stood at $42 billion. Google shares now trade at 50 times the average estimate of analysts surveyed by Reuters, but not one of the 30 analysts polled by Reuters lists Google as a sell.Link here.
THE DEADLIEST SIN, WHEN IT COMES TO INVESTING
In the 6th century A.D., Pope Gregory the Great categorized humanity’s most critical foibles as the “Seven Deadly Sins”. In the 21st century A.D., a New York editor of no particular repute encourages investors to avoid at least one of these deadly sins: Pride. Indeed, he would also encourage everybody everywhere to refrain from envy, anger, sloth, avarice, gluttony and lust. But pride seems to be the deadliest of INVESTMENT sins.
To illustrate today’s morality tale, we present Alberto Vilar, an individual whose self-evident arrogance led directly to his downfall. Vilar, the man behind the triumphs and tribulations of the Amerindo Technology fund, is currently warming a cot in Manhattan’s Metropolitan Correction Center, while trying to make bale. The fact that Vilar, a purported billionaire, cannot scrounge up $4 million for his bail, suggests that he might also be guilty of a lesser sin: deceit. Indeed, he finds himself in a jail cell precisely because he has been lying to the world about his “investment” activities.
When we first encountered the hero of our tale in 2000, he was scowling from the cover of Barron’s. In 1999, his Amerindo technology fund had produced an astounding one-year return of 249%, and Vilar was justifiably – and unjustifiably – proud of his achievement. In the Barron’s story, Vilar scorned the notion that his dazzling investment results might have been the fruit of recklessness, rather than genius. Indeed, he scorned everyone who dared to criticize his risky investment strategy. “These people don’t know my record,” he scoffed.
Unfortunately, Vilar’s excessive pride blinded him to the possibility that he might have been lucky, rather than good. His deadly sin prevented him from imagining that the once-in-a-lifetime tech stock bubble might not endure for his entire lifetime, or even for one more year. The Amerindo Technology Fund tumbled 84% during 2000 and 2001. “He’s a miserable human being and a basic scumbag,” says Donald Trump. We could not say for sure that Vilar is a scumbag, but we would not rule out the possibility. What we could say for sure is that investors with egos the size of Vilar’s, do not deserve to succeed. The investment world does not usually work that way.
Yes indeed, pride is a deadly sin, dear investor … particularly on Wall Street. An investor who has never learned to approach the discipline of investing with humility is an investor who is certain to learn humility in the future. Just ask Alberto.Link here.
SELL STOCKS ALSO
If the bond market is “right”, the stock market probably is not. In which case, share prices might be a shade too high. Please allow us to explore the possibility that bonds might be more right than stocks about the likely course of prevailing economic trends. Stocks and bonds have been rallying together for several weeks. But we suspect that this intimate tango will end very soon. The most important question, however, is which party will end the dance.
Last week, as faithful readers may recall, your New York editor twice scorned 10-year government bonds yielding 3.84%. He has not changed his mind; he still prefers skimpy bikinis to skimpy bond yields. But he is prepared to consider the possibility that bonds are a buy, at least relative to stocks. Or to put it a little differently, the Nasdaq Composite Index at 2,060 might be an even better sale than 10-year bonds at 3.84%. The evidence of slowing economic growth is persuasive, if not conclusive. And if the economy is indeed slowing, stocks prices might be a shade too high. … In which case the bond market might be smarter than we think. But since we cannot quite decide whether to sell bonds or to sell stocks, we suggest a compromise: Sell both.Link here.
MORE SIGNS OF ECONOMIC DISTRESS
I wanted to write on the coming burst of the real estate bubble, but that topic has been skillfully covered by others. For anyone who does not believe that interest-only mortgage loans and soaring property values during a time of stagnant or falling wages are signs of gross excess, allow me toss out a few other indicators of the decline of the U.S. economy. When I was growing up, those who could not qualify for a bank loan might have to borrow from local lending companies or make payments at a used car lot. Such indebtedness was widely scorned as a sign of irresponsibility. After all, what kind of person would pay (horrors!) double-digit interest for a loan? What is happening today evokes nostalgia for the good old days of the early 1970s.
So-called “payday loan” shops are one of America’s fastest-growing industries. The business plan is simple, but very expensive for the customer. People write postdated checks and pay 25% interest a month for a short-term loan of $100 to $1000. Suckers are encouraged to roll over their debts, continue borrowing, and create a vicious cycle. What kind of moron would pay a 300% annual interest rate, you ask? Stupidity and a poor knowledge of basic math are prerequisites, but the problem goes deeper than that. Desperation is the main motivating factor. In many cases, the payday loan clientele is totally tapped out. The credit cards have been charged to the limit, income is erratic or falling, and the borrower sees no alternative. Others are addicted to consumerism or casinos, and they would rather spend or play the slots today than live cheap and restore sanity to their finances.
Does this mean payday loan operators are doing booming business in ghettos and low-income areas? The real action is far from the ‘hood. Drive through any middle-class district or prosperous-looking suburb, and you will soon see several of these shops offering instant cash for a very steep price. If you really are in a bind for a few bucks, talk to Knuckles, Rocco, or other old-time loan sharks. Their rates are lower than the payday loan crowd.
Even though I have seen it up close many times, it is still a shock to watch someone charge their groceries with VISA or MasterCard. Creditholics often swear they use the card just to get airline miles or future rebates, but the truth is somewhat different in many cases. There seems to be a common denominator among those who borrow to buy food. They are brain-dead shoppers who are totally unacquainted with obtaining good value. It does not matter if they are putting $10 or $200 on the plastic, because the pattern is the same. Everything in the shopping cart is a name brand, priced at full retail. Sale items are rarely purchased by the grocery charge-card crowd, but there is no lack of high-priced convenience food and other impulse purchases.
Need more evidence? What does it say when Dairy Queen, Wendy’s and other fast-food outlets devote valuable signage space to the phrase “Visa and MasterCard accepted”? Clearly, there are plenty of customers who do not have even a few bucks on hand to pay for a burger or an ice cream cone, but they will whip out the magic plastic card and add to their indebtedness. It is called living in a fool’s paradise. Disregard all government and mainstream media propaganda about the condition of the U.S. economy. We are in a heap of trouble, and it is fixin’ to get worse.Link here.
Many years ago, I met a guy who had developed a backup battery to help cars start on cold mornings. Car batteries were nowhere as near as good then as they are now. He figured there would be a great market in places like northern Europe, Canada and the northern U.S. where freezing winters often meant cars would not start on cold mornings. The giant battery maker Eveready agreed. They offered him $500,000 for his invention. Did you ever hear of such a battery? Of course not – because he turned down Eveready’s offer. He figured he would make a lot more on his own … but it never got off the ground.
A while later, I introduced another friend of mine to a stock promoter I knew in Vancouver. My friend had just started a business, had one location in southern California, and planned to franchise it nationwide. The stock promoter thought it was a great idea and offered him $5 million on the spot for 50% of the business. Well, to my friend this just confirmed the value of his idea. Positive he could make a lot more money than that; he decided to do it on his own. Unfortunately, he was very good at starting businesses – but hopeless at developing and running them. A year later, he was bankrupt.
These are examples of what I call “windfall profits”. A windfall profit is like winning the lottery. Something completely out of the ordinary happens to drive up the price of your investment. But they quickly evaporate if you do not grab them. The question is, can you recognize them when they happen? My two friends could not – and they have both regretted their decisions not to take the money many, many times since. The trap is that you can take a sudden jump in the value of your investment as proof of all your expectations. After all, if your stock just doubled more or less overnight, surely this can only mean there is more to come.
Maybe. The last thing you want to do is to take a profit just because it is there … and then see it double or triple again. To make the distinction you need to find out why your investment has zoomed up. If there has been some dramatic improvement in the business – or if Wall Street has just recognized the value you saw in this company – then maybe there is more to come. But if the cause is some extraneous factor, then it is probably time to take the money and run.Link here.
EURO VS. DOLLAR: NOW WHAT?
Remember the public hysteria about the U.S. dollar at the turn of this year? “The Disappearing Dollar” on the cover of The Economist, “The Incredible Shrinking Dollar” on the cover of Newsweek, “Chinese merchants refuse taking dollars, prefer yuans instead”, “Central banks are raising their euro holdings, with 29 cutting back on the U.S. dollar…” etc., etc., etc. EUR/USD hit its all-time high of $1.36 December 30, 2004. Since then, the USD has gained around 15 cents, and those who dumped their greenbacks six months ago are probably wishing they had not been so hasty.
Have you ever wondered what got the dollar to rally when the New Year began? That seems the least likely moment for a reversal. If markets are driven by the news, then for the dollar to get stronger, the news should have supported the rally. But it did not. On the contrary, opinion polls were showing the public’s expectations for further declines. And yet, just as it was being decimated on every corner, the dollar suddenly got the upper hand. It staged a comeback. And what a comeback it has been: The USD stands at a 9-month high against the EUR. Economics teaches that it takes strong fundamentals to sustain a rally. But by most measures, the U.S. economy is arguably in the same shape it was late last year, when the dollar was in the dumps. The same problems that were “scaring holders of U.S. dollars” last December are still with us: the rising U.S. trade deficit, for one. So how come the dollar keeps getting stronger?
In the financial media, the euro’s latest weakness is attributed to the slowing European manufacturing, the negative French and Dutch EU Constitution votes last week, and even to a “smaller-than-expected” U.S. trade deficit figure. But even if you accept these latest news items as plausible explanations for the most recent euro sell-offs, you are still left without a good fundamental reason for the dollar’s turnaround. Here is a good reason of a different kind: market psychology. What changed at the end of 2004 – and has continued changing since then – is the public’s attitude towards the dollar. Last December, we witnessed a market extreme, when collective psychology stretched as far as it could go in one direction – and then snapped back. Indeed, in the absence of “fundamental” reasons for the dollar’s rally, what other explanation is there?
The euro now stands at a 9-month low, and the public is starting to hate it just as they hated the dollar last December. Some in the European Union even want to do away with the single currency altogether. Are we seeing the opposite sentiment extreme? Don’t bet on it until you see our very latest charts…Link here.
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