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CHANGE FOR THE WORSE
Changes in technology create winners and losers. So do changes in rules. Two fine books demonstrate this masterfully. The World Is Flat: A Brief History of the Twenty-first Century, by New York Times columnist Thomas Friedman, shows how digital advances have changed global economics, fueling boom times in India and China but hurting U.S. workers whose jobs move to cheap offshore markets. And in Freakonomics: A Rogue Economist Explores the Hidden Side of Everything, the University of Chicago’s Steven Levitt describes how even small rule changes can produce dramatic effects.
Technology has vastly altered how investors trade, enabling rapid-fire, in-and-out trades and sparking the rise of hedge funds. Individual day traders are back, too. At Wall Street houses, trading for the firms’ own accounts is more profitable than advising corporations on mergers. Since trading occurs with a mouse click, transaction costs have been pared dramatically, to 2 or 3 cents per share. Thus even a 5-cent move in a stock can be profitable for the trader who traffics in significant blocks. I recall when commissions were 50 cents a share. If the market’s tempo slowed, brokers were allowed to place a surcharge.
This cost change is good for the average investor, right? Certainly it is cheaper. But a hidden downside harms investors: Research has suffered as commission income has plummeted. Thus retail investors must fly blind. A good analyst, once paid $1 million yearly at a Wall Street firm, now earns far less. Hence an analyst exodus is under way from the big firms, where they are supposed to advise ordinary shareholders, to hedge funds, where they are paid well to advise far more sophisticated clientele. So next time a company fails to meet Wall Street earnings estimates, do not blame just the management – also blame clueless analysts. They are under pressure to meet the trading desk’s quick-fire trading needs, and this focus is useless to long-term investors.
My advice is to stay clear of the rapid trading game. Ignore dumb analyst market calls and go for good long-term plays. Ignore such foolishness as Wall Street’s boneheaded wisdom nowadays that oil stocks have little upside because oil prices will falter, as they have in the past (they dipped below $50 for a while this spring). If analysts were not so shortsighted, they would know oil stocks have little relation to the per-barrel price. Exxon in December 1998, with oil at a mere $11 per barrel, was near a 52-week high. In 2005 a growing India and China mean oil company earnings will rise nicely, regardless of crude’s price.Link here.
NEW ISSUES, FRESH HOPES
The 2005 IPO market, uninspiring thus far, nevertheless has a few potential winners waiting for their debuts. Google galvanized investors when it went public last August, and it has tripled in price since then. Among today’s fledgling public stocks, which ones might be the great performers of tomorrow? Eight especially promising initial public offerings are on deck, expected to go public this summer and yet to be priced. This octet combines good business sense and firm financials, an analysis by Forbes and IPO researchers Renaissance Capital shows.
Technology firms are noticeably absent from coming offerings, since old tech speculators remain gun-shy and are investing in real estate instead. Renaissance believes offerings will pick up in 2005 and come close to the 170 IPOs completed in 2004, the best year since 2000 (340 offerings), the last act of the great bull market. The best-performing issue in recent years is decidedly low-tech; it does not make semiconductors, develop software, or hold online auctions.
IPO investors fared best in the depressed year of 2002, which reinforces the notion that in hard times underwriters bring only the best companies to market. Just 68 companies had offerings in 2002, but the group showed an average gain of 76% from their IPO prices to the end of May 2005. The S&P 500 was up 4.4% in the same period.Link here.
MAINLAND CHINA STOCKS ARE HOT, BUY MANY ARE SUSPECT
You know the China story: the double-digit economic growth, the exploding exports, the tantalizingly low labor costs, the scramble of Western companies to open operations there. But one of the hottest Chinese plays right now, just when some worry about a China bubble, is China stocks. Mainland companies are hustling to go public, with 52 initial offerings last year on Hong Kong, Singapore and U.S. exchanges and 21 thus far this year, says Goldman Sachs. Americans have bought 25% to 45% of recent Chinese IPOs. “The market is so big and the growth story so enticing that many investors will buy,” says Neil Torpey, a partner in the Hong Kong office of Paul, Hastings, Janofsky & Walker, which has helped take many Chinese firms public.
That is living dangerously. The sobering truth is that most mainland Chinese companies are no good. Investors would be wise to avoid stock in all but a few of mainland China’s businesses. Too many of these outfits are the stuff of scandal – of fabricated shareholder meetings, vast thefts by officers who vanish, routine insider dealings and byzantine ownership structures. Worse, in a bit of Comrade Capitalism, the Beijing government can interfere in listed companies’ strategies, courts often do not enforce contracts, and regulatory changes can roar in as unexpectedly as a typhoon.
Luckily for them, foreigners are barred from buying shares on China’s two stock exchanges, Shanghai and Shenzhen. Both markets trade at 8-year lows after falling about 15% last year and 12% so far in 2005. A vast overhang of state-owned shares has investors worried the government will flood the market with shares for sale, further deflating prices. But even China stocks listed in Western-influenced Hong Kong and in New York can be roiled by events on China’s mainland. Some of these Hong Kong and New York listings are suspect, too. Some of the biggest China IPOs due this year are in the shaky sector of banking. Academics and economists outside China say 25% of all Chinese bank loans are bad. A bailout would cost China a punishing 17% of its gross domestic product, or $280 billion, UBS says. No wonder these institutions want fresh equity capital.
The accompanying table lists five solid Chinese companies that trade in the U.S. Four sport low price/earnings multiples. Hong Kong investment adviser Marc Faber says China stocks are suffering growing pains: “It is like human rights in China. You should compare it to the time of Martin Luther King.” Honest capitalism, like racial justice, will take a while.Link here.
FORBES ANNOUNCES ITS 2005 CELEBRITY 100
In the wired world, where everyone has access to a camera, a screen or both, it is easier than ever to find fleeting fame. A hit TV show will do the trick: The cast of Desperate Housewives, largely unknown less than a year ago, is all but overexposed today. Nowadays you can be famous just for being famous – see Paris Hilton – for for having a run of good luck, as Ken Jennings did during his six-month winning stint on Jeopardy!
Yet some stars earn their status by good old-fashioned accomplishment. Tiger Woods has won 60 tournaments in 10 years. George Lucas’s lifework, his Star Wars franchise, has generated billions of dollars in ticket and merchandise sales over three decades. Though Revenge of the Sith is his last chapter, profits will flow to him for years to come. And Oprah Winfrey, who perennially ranks near the top of our Celebrity 100 list, takes the No. 1 spot this year for the first time. After 21 years, her daytime chat-fest still rules the airwaves, minting new celebs – and hundreds of millions of dollars in profits.Link here.
CHECK THE CURRENCY RISK. THEN MULTIPLY BY 100
Currency trading is not just for money center banks, multinational corporations and hedge funds anymore. Online traders with a hankering for high-risk speculation have embraced the vast and volatile forex market, as the global foreign exchange market is called. Getting started is a snap. Investors can open an account over the Internet with a deposit of just a few hundred dollars. Downloading a trading platform takes minutes. Then they can start wagering in real time on which currencies are headed up or down. Because trading occurs in Tokyo, London, New York and other world financial centers, it is possible to speculate day and night from Sunday afternoon to Friday afternoon Eastern Standard Time.
But watch out. The leverage on a standard trade is a breathtaking 100 to 1. That means a customer who puts up $1,000 controls 100 times that, or $100,000. Trading primarily with borrowed money magnifies even minuscule moves of one currency against another into sudden big gains or huge losses. A 100% gain on a position, or a total wipeout, can take place in a few minutes. For example, a one-cent change in how many dollars it takes to buy a euro – say, to $1.22 from $1.21 – amounts to an actual price shift of less than 1%. But in a spot forex trade, when 100-to-1 leverage is used, the same slim move is multiplied a hundredfold. So there is a $1 increase for each $1 staked by traders on the euro’s climb, and an equivalent drop for those expecting the dollar to go higher.
Of course, profits and losses are not realized until a position is closed out. But investors who leverage themselves to the hilt in pursuit of quick outsize returns often find that they are rapidly burning up the capital in their accounts when a few trades go sour. Firms provide mechanisms to dial down the leverage to, say, 10 to 1, reducing exposure to risk. But leverage still makes this one of the most hazardous markets for the average investor. “Currencies should be and are becoming an integral part of a well-diversified portfolio,” said Marla Miller, chief operating officer of the MG Financial Group, one of the first firms to offer foreign exchange trading for individual investors. “However, they are appropriate only for investors who can assume the risk of losing everything.”
Currency trading is not merely risky. It is also complex, from the rudiments of trading techniques to understanding the supply-and-demand factors that lie behind the constant shifts in relative currency values. To follow the fundamentals of the forex market, it helps to be a maven of global macroeconomics and a fiend for geopolitics. Technical traders ignore such fundamental issues, instead taking positions by analyzing chart patterns with arcane mathematical tools like Fibonacci retracements and Ichimoku clouds. Such traders have adapted readily to the foreign exchange market because currencies tend to move in long-term trends. The interest of many technical traders was galvanized by the 3-year climb of the euro against the dollar, from around 85 cents at the start of 2002 to just above $1.35 at the end of 2004. This year, of course, the dollar has changed course, rallying sharply against most major currencies, including the British pound and the Japanese yen but especially against the swooning euro. Traders are divided over whether the dollar’s rebound is simply a respite in a more prolonged drop or the start of a major reversal.Link here.
UCLA FORECAST WARNS HOUSING BOOM IS UNSUSTAINABLE
A prominent economic forecast stepped up warnings that the housing market is overheated and due for a correction. The University of California Los Angeles Anderson Forecast, which has been bearish on the housing market for a couple of years, warned that the market is at risk, largely because of the breakneck pace of price gains. “There is no reason a house should be worth 40 percent more today than it was two years ago,” said UCLA economist Christopher Thornberg, co-author of the report. “And this housing market is heated far beyond the point of sustainability.”
The quarterly Anderson Forecast, a widely read prediction of state and national economic conditions, said the housing boom has helped drive the U.S. economy, creating jobs and fueling consumer spending. But the future of housing looks dim, according to the economists who produced the forecast. They portrayed housing as so top heavy with appreciation and investment that it could topple, dragging the overall economy down with it.Links here and here.
Unbuilt homes sell like crazy.
The number of houses for sale even before they are built has jumped 47% the past 12 months, adding to worries that overbuilding and speculation could bring the housing boom to a bust. The Census Bureau says that 88,000 houses were for sale but not yet started in April, the latest data available, vs. 60,000 a year earlier and 40,000 five years ago. The numbers track houses scheduled to be built in developments where buyers can view plans or models. April’s number is the highest since the government began tracking it in 1973.
A glut of new houses could end the housing boom – and, possibly, stick builders and speculators with undeveloped property if the boom goes bust. “Builders have a long pipeline for development that will be difficult for them to shut down, even when demand begins to weaken,” says Mark Zandi, chief economist for Economy.com. “They are geared for growth, and it will be hard for them to pull back.” Another worry: Unbuilt homes for sale could be used for flipping, buying in hopes of selling for a quick profit. In pre-construction flipping, a speculator puts a deposit down on an unbuilt home and sells it on completion – or even before.
So far, the increase in unsold, unbuilt houses has not translated into a glut of homes for sale. But Zandi and others worry that unsold homes eventually will weigh on the market. “Builders are incredibly optimistic about long-term demographic fundamentals,” he says. “It suggests they won’t turn cautious when demand does begin to weaken.” Others see the rise as one more sign of a housing bubble, along with the sharp climb in interest-only and adjustable-rate mortgages. “It shows that we are where we’ve never been before,” says James Grant, editor of Grant’s Interest Rate Observer.Link here. Real estate speculation raises prices, concerns – link.
Soaring house prices have given a huge boost to the world economy. What happens when they drop?
Perhaps the best evidence that America’s house prices have reached dangerous levels is the fact that house-buying mania has been plastered on the front of virtually every American newspaper and magazine over the past month. Such bubble-talk hardly comes as a surprise to our readers. We have been warning for some time that the price of housing was rising at an alarming rate all around the globe, including in America. Now that others have noticed as well, the day of reckoning is closer at hand. It is not going to be pretty. How the current housing boom ends could decide the course of the entire world economy over the next few years. This boom is unprecedented in terms of both the number of countries involved and the record size of house-price gains. Measured by the increase in asset values over the past five years, the global housing boom is the biggest financial bubble in history. The bigger the boom, the bigger the eventual bust.
Throughout history, financial bubbles – whether in houses, equities or tulip bulbs – have continued to inflate for longer than rational folk believed possible. In many countries around the globe, house prices are already at record levels in relation to rents and incomes. But, as demonstrated by dotcom shares at the end of the 1990s, some prices could yet rise even higher. It is impossible to predict when prices will turn. Yet turn they will.
Many people protest that house prices are less vulnerable to a meltdown. Houses, they argue, are not paper wealth like shares; you can live in them. Houses cannot be sold as quickly as shares, making a price crash less likely. It is true that house prices do not plummet like a brick. They tend to drift downwards, more like a brick with a parachute attached. But when they land, it still hurts. And there is a troubling similarity between the house-price boom and the dotcom bubble: investors have been buying houses even though rents will not cover their interest payments, purely in the expectation of large capital gains.
One other big difference between houses and shares is more cause for concern than comfort: people are much more likely to borrow to buy a house than to buy shares. In most countries, the recent surge in house prices has gone hand-in-hand with a much larger jump in household debt than in previous booms. Not only are new buyers taking out bigger mortgages, but existing owners have increased their mortgages to turn capital gains into cash which they can spend. As a result of such borrowing, housing booms tend to be more dangerous than stockmarket bubbles, and are often followed by periods of prolonged economic weakness.
A study by the IMF found that output losses after house-price busts in rich countries have, on average, been twice as large as those after stockmarket crashes, and usually result in a recession. The economic damage this time could be worse than in the past because house prices are more likely to fall in nominal, not just real terms. Most important of all, in many countries this house-price boom has been driven far more by investors than in the past, and if prices start to dip, they are more likely to sell than owner-occupiers. Owners who have been using their home like an ATM to extract cash, or who were relying on rising house prices to provide them with a comfortable pension, will suddenly realize that they need to start saving the old-fashioned way – by spending less of their income.
The whole world economy is at risk. The IMF has warned that, just as the upswing in house prices has been a global phenomenon, so any downturn is likely to be synchronized, and thus the effects of it will be shared widely. The housing boom was fun while it lasted, but the biggest increase in wealth in history was largely an illusion.Link here. Economist and author (Irrational Exuberance) Robert Shiller’s thoughts on the housing bubble here (PDF file).
Do you see a bubble?
Do you see a bubble, dear reader? Housing prices in certain areas of the country are definitely in bubble-mode. They are rising at an unreasonable and unsustainable rate. People do not ask questions when prices are rising. But if they did they would want to know why a house is worth twice as much in 2005 as it was 10 years ago … how it is possible for house prices to grow faster than GDP, inflation and incomes … and what happened around the turn of the century that caused house prices shoot up faster than they have done in the last 50 years?
When a city stretches out around its center, its buildable surface area expands by the square of the distance from downtown. The outer circles of growth are many times bigger than inner ones. So the supply of housing easily keeps up with demand – unless it runs into a physical barrier, such as the Hudson and East rivers around Manhattan and the mountains hemming in Aspen, Colorado. But even though builders are putting up thousands of new houses all around the Capital Beltway, prices are now running up as much as 10 times faster than real GDP growth. This phenomenal inflation of house prices only began after 2001. Part of it could be caused by George W. Bush’s big boost of spending, which puts more money into the local economy.
But a larger cause almost certainly comes from the Fed’s “emergency” level interest rates. The original emergency was trying to get the U.S. economy out of its 2001 slump. The recession ended with the New Years’ parties of 2002. Mr. Greenspan has since raised rates – but they are still at or below real rates of inflation. Which is to say, the Fed is still giving away money. A bank may take the money directly. But an individual cannot borrow directly from the Fed. Still, he can take advantage of the Fed’s apparent generosity by refinancing his present house or buying another one. This is the gas that is causing the nation’s property bubble.
If they were in the mood to ask questions, people might also wonder what the emergency is now? Why does the Fed not “normalize” rates? The maestro edged towards this question recently in unemotional terms. He referred to a “conundrum”. Specifically, he wondered why long bond yields were falling, even as he pushed up short ones. He did not mention it, but he might also wonder why employment numbers are still disappointingly low. Our guess is that the Fed chief sees a new emergency – trying to undo the damage from his last emergency operation. Cutting rates so low for so long Mr. Greenspan turned a slump into a residential property bubble. If he were to “normalize” rates, the bubble would pop. Then comes the real emergency.Link here.
If it looks like a bubble…
Bear Stearns published a research report that analyzed past asset bubbles and found there were quite a few similarities. Using these similarities, they were able to construct how bubbles were created, fostered and subsequently deflated. The report found that: “In short, ample financial liquidity fosters a prosperous economic backdrop, eventually leading increasingly optimistic investors to assume ever-increasing financial risk and engage in speculation. Speculation then evolves into an asset bubble, which subsequently bursts, often bringing devastating consequences for the broader financial landscape.”
Using the 10 items that were identified as contributing to a bubble, Bear Stearns counted that 8 1/2 are currently met. After establishing that the current environment is prone to foster an asset bubble, the report identified potential areas that could be a bubble. The most obvious is real estate. The evidence of a housing bubble has been hashed out numerous times and Bear Stearns views this as the “likeliest near-term bubble”. The other the three areas that that appear bubbly are China, hedge funds, and nanotechnology. It views nanotechnology as a possible future bubble and that there remains quite a bit of opportunity. So, short your house, buy a nanotech fund and reverse the trade in three years. Just kidding.Link here.
Double bubble trouble.
Some irony is so strong, it knocks you off your feet. That is what happened as I listened to the Mortgage Bankers Association First-Quarter National Delinquency Survey conference call. Delinquency and foreclosure rates have been falling and remain tame. That is good news. The reason, said MBA chief economist Doug Duncan, is strong job creation. There is a bit more to it than that, of course, something he elaborated on later in the call.
But the irony hit me right then, as I recalled reading the same idea in a piece from Northern Trust Company: “The future of the housing market is tied to employment conditions in the economy,” wrote economist Asha Bangalore. “The performance of the housing market has played a visible role in payroll growth.” So the crux of Ms. Bangalore’s findings was that the housing market was a success thanks to the housing market.
Creative loans let buyers purchase homes they could not otherwise afford, and that has helped fuel runaway prices. And that brings us back to the real reason why delinquencies and foreclosures are tame. When those buyers run into trouble with their unaffordable homes, they have so far been able to unload them at a profit. In the Pacific region, where the bubble is biggest, the seriously delinquent rate is 0.58%. In the East-North-Central region, where price gains have been anemic, the delinquent rate is 3.2%. The debate reminds us that falling prices not only will coincide with higher foreclosures, they also will be accompanied by millions of pink slips.Link here.
S&P tightens risk criteria on increasingly popular option ARMs, citing growing default risk.
The risk of default is growing for some home loans as mortgage-lending standards loosen, said Standard & Poor’s Ratings Services, which responded by tightening risk criteria for those home loans. The ratings company said the tightening applies to loans that are bundled into mortgage-backed securities for sale to investors as well as option adjustable-rate mortgage loans. Option ARMs give borrowers flexibility to reduce their initial monthly payments and have surged in popularity in recent months as rapidly rising house prices have made it more difficult for many Americans to afford homes and led buyers to seek ways to hold down monthly payments, the newspaper said.
Some economists fear that option ARMs and other loans that reduce initial payments are fueling house-price inflation by enabling people to bid more for homes than they could if they were taking out conventional loans. Option ARMs and similar loans are among “the only things left that are keeping home prices rising,” Stuart Feldstein, president of financial-services market-research firm SMR Research, said. Other factors include low interest rates and low inventories in many places.Link here.
ANNALY’S WAKE-UP CALL FOR MORTGAGE REIT’S
Investors in every high-yielding mortgage REIT got a wake-up call when Annaly sliced its dividend by 20%. While all mortgage REITs are not the same, with Annaly (NLY) among the most transparent, the reality is clear: The higher a REIT trades to its book value, the greater the risk its stock falls. As I noted on May 19th in my subscription newsletter, “Unless things change soon, the clock is ticking and market conditions are not working in Annaly’s favor.” By “market conditions” I was referring to mortgage prepayments and the spread between the 2-year and 10-year treasuries. Annaly makes money on that spread, which has been narrowing. That spread and Annaly’s stock have usually moved in lockstep.
Now, however, the spread has narrowed but the stock (relatively speaking) has remained stubbornly high. That is because Annaly, which invests in mortgages, has benefited from slower prepayments. The slower the prepayments, the higher the yield it receives – and the fatter its profits. The reverse is true as prepayments increase. Prepayments, in fact, may very well be the single biggest swing factor in Annaly’s earnings.
With prepayments low, Annaly’s return on equity has been unsustainably high (again, relatively speaking) at around 15.5%. That translates to its current stock price of more than $18 – or 1.5 times Annaly’s book value. As that happens – and this is the important part – as prepayments fall, so should Annaly’s return on equity to a more reasonable 10%, which is where many REITs trade. That translates into a stock price of around $12. While at the current rate the stock still yields a robust 7.7%, the dividend could be shaved even more and it could take a few years for investors to recoup the resulting slide in share price. That is something every REIT investor should realize. Sooner or later reality does hit. It is just a question of fully understanding the risk why you owned the stock in the first place.Link here.
WHAT TRIGGERS THE CHANGE FROM INFLATION TO DEFLATION?
Inflation seems to be the only side of the economic equation that the Federal Reserve worries about. At least it is the only thing Fed Chairman Alan Greenspan is willing to talk about. Since we here at Elliott Wave International see deflation as a greater threat than inflation, now might be the perfect time to re-examine what triggers the trend change to deflation. The primary precondition of deflation is a major societal build-up in the extension of credit (and its flip side, the assumption of debt). Near the end of a major expansion, few creditors expect default, which is why they lend freely to weak borrowers. Few borrowers expect their fortunes to change, which is why they borrow freely. Deflation involves a substantial amount of involuntary debt liquidation, because almost no one expects deflation before it starts.
A trend of credit expansion has two components: the general willingness to lend and borrow and the general ability of borrowers to pay interest and principal. These components depend respectively upon: (1) the trend of people’s confidence, i.e., whether both creditors and debtors think that debtors will be able to pay, and (2) the trend of production, which makes it either easier or harder in actuality for debtors to pay. So as long as confidence and production increase, the supply of credit tends to expand. The expansion of credit ends when the desire or ability to sustain the trend can no longer be maintained. As confidence and production decrease, the supply of credit contracts.
The psychological aspect of deflation and depression cannot be overstated. When the social mood trend changes from optimism to pessimism, creditors, debtors, producers and consumers change their primary orientation from expansion to conservation. The “velocity” of money, i.e., the speed with which it circulates to make purchases, slows, thus putting downside pressure on prices. These forces reverse the former trend.
The structural aspect of deflation and depression is also crucial. The ability of the financial system to sustain increasing levels of credit rests upon a vibrant economy. At some point, a rising debt level requires so much energy to sustain – in terms of meeting interest payments, monitoring credit ratings, chasing delinquent borrowers and writing off bad loans – that it slows overall economic performance. A high-debt situation becomes unsustainable when the rate of economic growth falls beneath the prevailing rate of interest on money owed, and creditors refuse to underwrite the interest payments with more credit. When the burden becomes too great for the economy to support and the trend reverses, reductions in lending, spending and production cause debtors to earn less money with which to pay off their debts, so defaults rise. Default and fear of default exacerbate the new trend in psychology, which in turn causes creditors to reduce lending further. A downward “spiral” begins, feeding on pessimism just as the previous boom fed on optimism. The resulting cascade of debt liquidation is a deflationary crash.Link here.
EXCHANGE TRADED FUNDS FOSTER FINANCIAL “TROMPE L’OEIL”
During the Renaissance, Flemish painters perfected the art of “trompe l’oeil” – creating such incredibly lifelike paintings that the images on the canvass literally “tricked the eye”. In 2005, exchange traded funds (ETFs) sometime create equally “lifelike” deceptions. We strongly suspect, although we cannot prove it, that ETFs sometimes exaggerate the price trends of their underlying securities. In the process, ETFs may be fostering temporary illusions of strength or weakness in a given stock market sector. Illusions on a canvass inspire awe; illusions on a computer quote screen inflict costly bewilderment.
ETFs arrived on the scene as exchange-traded mutual funds that would reflect the trends of a given sector. But some of the most popular ETFs have become so influential that they sometimes CREATE demand for the very stocks that they purport to mirror. Here is why: Market makers create and/or dissolve specific ETFs in response to the fluctuating demand for them. The market markets will create or dissolve as many ETF shares as needed to keep the price of the ETF close to its net asset value (NAV). Whenever demand for a given ETF surges, therefore, market makers will create additional ETFs shares, while simultaneously purchasing the underlying stocks that comprise each ETF. Clearly, the robotic buying by market makers occurs in response to their need to hedge exposures. It does not occur because thinking investors – one by one – make the decision to buy a given stock. Sometimes, therefore, this robotic buying can create an appearance of strength that is somewhat illusory.
ETFs are a wonderful creation – one of the greatest financial innovations since the IOU. But as their popularity grows, so does their influence. “Underscoring the explosive growth of ETFs,” ETFNews.com reports, “in 2004 Barclays Global ETFs posted $43.8 billion in net inflows, more money than went to Vanguard and Fidelity.” Worldwide ETF assets jumped nearly 50% last year to more than $300 billion. Already, ETF trading accounts for three quarters of all transactions on the American Stock Exchange. And the volume figures are also growing rapidly worldwide. Morgan Stanley reports that ETF trading volumes worldwide jumped almost 30% last year.
Trompe l’oeil, as an art form, relies upon a scientific symmetry to create its effect. The stock market’s trompe l’oeil also relies upon a kind of symmetry – a symmetry that finds expression in the phrase: “What goes up may also go down”. If an ETF can exaggerate the upside behavior of a specific market sector or foreign market, we would be alert to the possibility that it could also exaggerate the downside.Link here.
CITY OF THE BUBBLE
Las Vegas is one big bubble. Sin City’s brand name has never been hotter. A channel surfer can find something on the tube involving Vegas, either fact or fiction, virtually and appropriately 24/7/365. Casino gaming company stocks trade at enormous price/earnings multiples whether the companies are operating and profitable or just opening its doors as in the case WYNN. Even the stocks of publicly traded community banks in Las Vegas trade at rich multiples with the expectation that the economic party upon which these companies depend will continue forever. Las Vegas residents can seemingly be divided into two groups, those who are real estate investors or developers and those who want to be. Why else would otherwise normally rational folks line up to hand over $5,000 or $10,000 checks to reserve high-rise condo units that they do not know what the eventual price will be or when or whether or not the project will even be completed.
A number of recent books have chronicled the financial bubbles of the past as the real estate and Vegas bubbles continue to expand. Edward Chancellor’s Devil Take The Hindmost: A History of Financial Speculation is perhaps the best, and should be read by anyone urgent to plunk down money on a condo. The stock market was still ascending when the book was published in 1999. Those who read it then, reflected on the past, and sold their stocks were saved financial misery in 2000. Chancellor takes the reader on a journey that begins in 1630’s Amsterdam where tulip bulbs were the can’t-miss speculation and ends with the geniuses of Long-Term Capital Management being bailed out after these Noble-prize winners’ mathematical trading models failed. The madness of crowds never wanes just the trading vehicles change. The author quotes financial journalist James Grant, “progress is cumulative in science and engineering but cyclical in finance.”
A historian by trade, Chancellor’s thoroughness is evident throughout the book that is densely footnoted with references spanning the entire philosophical spectrum. Chancellor deftly chronicles the story of single tulip bulbs in Amsterdam being bid to prices that would have bought “twenty-seven tons of wheat, fifty tons of rye, four fat oxen, eight fat pigs, twelve fat sheep, two hogsheads of wine, four tuns of beer, two tons of butter, three tons of cheese, a bed with linen, a wardrobe of clothes, and a silver beaker.” Other famous bubbles such as the South Sea scheme are examined fully as are the lesser known Canal and Railway manias. Chancellor turns from historian to polemicist when discussing modern junk bond and stock market manias of the 1980’s “decade of greed”, fixing the blame on economist Milton Friedman, Ronald Reagan, Margaret Thatcher, and Michael Milken.
The author’s occasional preaching does not detract from his numerous valuable insights. “Perhaps more than anything the bubble economy illustrates the danger that arises when investors believes that market risk is shouldered by the government rather than themselves,” Chancellor wrote about the 1980’s Japanese market mania and collapse. Words to remember the next time a financial commentator contends the Federal Reserve will not let the housing market collapse.Link here.
LEARNING ABOUT CRUDE OIL
My education on the subject of crude oil continues, but not without difficulty. Academic writers, who are notorious for making papers hard to follow, have nothing on what writers in the oil industry routinely turn out. In the business of producing and marketing petroleum, many people do not want the world to know the facts; there are too many secrets to be kept, axes to be ground, reputations to be maintained, and bureaucracies, government and corporate, to be pacified. Then there is the propensity of so many to actually look forward to the disaster they imagine will occur when the world “runs out of oil”. And one must suspect that the oil companies believe convincing people we have a problem is a great way to persuade them to accept high gasoline prices.
One particular feeble discussion suggests that the deep drilling required to tap abiotic oil fields, as the Russians are doing, is too expensive. The only solution is for us to take whatever oil fields we feel the need for. Those making this argument appear to assume that making war, supporting fleets at sea and in the air and killing people is done at no cost. Their thinking must be that if we keep the populace in a state of nervousness over the possibility of running out, if we can forecast food shortages and starvation, we have a great opportunity to establish big governments with armies and lots of cushy government jobs, as we resolve the problems of the world, real or imagined, all caused by a lack of that oil. There is now ample evidence that oil exists or is being produced in the earth’s mantle to migrate up to the crust where we can get at it. There is ample evidence that crude oil does not originate from biologic life and is not a fossil fuel like coal. And there is ample evidence that there is lot of it.
The earth’s crust averages some 9 miles in thickness; under the oceans it is much thinner averaging about 3 miles. Where the upward movement is too slow to satisfy us, deep drilling is the answer and Russia has become one of the world’s top producers using this technology. In 1951 Russian scientists formalized the Russian Ukrainian deep abiotic theory of the origin of oil. It suggests that crude oil either consists of primordial compounds or evolves from primordial elements located below the crust of the earth. Having been debated fiercely for 20 years in peer-reviewed papers (all in Russian of course) by Russian scientists it is not longer a theory. Using it Russian drillers have located deep oil, developed deep wells and are marketing abiotic oil to the world today, from a seemingly limitless supply.
The refusal of the oil industry in the West to abandon their scientifically unproven theory of a biologic origin for oil for one that continues to find oil is a serious mistake. Let us hope the industry wakes up.Link here.
Oil at a crossroads.
Crude oil finally reached $60 a barrel. Is $70 next? Or $50? Both sides of the crude oil debate make a compelling argument, but we are more persuaded by the bulls than the bears. In his collapsing oil view, Andy Xie (see “Scary Oil”, archived on the Morgan Stanley Web site) cites the potential for slower growth from Asia, particularly China. He also points to the aggressive development of alternative energy/oil substitutes like oil sands, coal liquefaction and LNG and even mentions the rising popularity of fuel- efficient vehicles. While Asia has begun to show early signs of slowdown, the rest of Xie’s argument seems a bit of a stretch. Alternate energy supplies might contribute meaningful supplies a few years from now, but they will not arrive in time to trigger a near-term drop in oil prices.
On the other side of the coin, you have plenty of well-informed observers who think we are in big trouble no matter what. This camp sees alternative energy as little more than a Band-Aid, and it presents very credible arguments, both for $60 oil today and for $100 oil within the next few years. For example, respected authority Matthew Simmons has written a book entitled Twilight in the Desert, focusing on potentially alarming problems in Saudi Arabia. While the Saudi government confidently claims plenty of oil for all, it refuse to allow outsiders to independently verify those claims. Seems a bit suspicious, does it not?
If the Saudi fields are approaching a sharp decline, as Simmons believes, then the government would definitely have interest in hiding it from the world for as long as possible. It is hard to imagine the turmoil and chaos that would erupt if news were to spread that the “central bank of oil” is running dry. The Saudi Kingdom would likely implode, and the world would panic. So where does that leave us? Clearly, Morgan Stanley’s Xie makes reasonable points for the long term. Alternative energy and fuel-efficiency advances will eventually moderate the global demand for oil somewhat. But this forecast has to be balanced against the stark realities that global energy demand is steadily rising, while the world’s once-reliable supplies are running down.
In the short term, crude oil’s high price is a rational response to the uncertainty of supply, coupled with exceptionally strong demand. We have a demand-driven “lack of slack” in the system, too little margin for error and too many potential problems hiding below the surface. As we see it, the most reckless speculators in the crude oil market are the brave souls who are betting on a DROP in oil prices.Link here.
Buffett says to invest more in energy.
Billionaire investor Warren Buffett said his Berkshire Hathaway is willing to invest more money in the U.S. energy sector than the $10 billion to $15 billion he previously discussed. At a conference of utility commissioners from U.S. Western states in Boise, Idaho, and in an interview with the Wall St. Journal, Buffett also said he sees more opportunities in the utilities industry, including nuclear power. Buffett did not specify how much Berkshire was willing to spend but he made it clear his company will invest more. “The bigger, the better,” he told the newspaper. Buffett said he is keeping an open mind about investing in a new generation of nuclear-power plants that would not create air pollution. Buffett said he would invest heavily in power-transmission lines, broaden energy markets and undertake other efforts to improve electricity reliability after his impending PacifiCorp purchase deal closes.Link here.
SEARCHING FOR LOSSES
“I’m recommending put options on Google…” my friend Porter Stansberry told me two weeks ago. “So my readers can make triple-digit profits as shares fall back to earth.” I replied, “Okay, Porter … But isn’t that like standing in front of a freight train right now?” It may be out of gas, he tells me. “Steve, a secret signal you showed me years ago, plus the activity in its options, tells me that we’ve seen the top in that stock…”
I cannot tell you the secret indicator. But I can share with you what the options trading in the world’s most widely used search engine may be telling us about where the stock price is headed… And I can show you how to track the options activity in the stocks you own, employing the put call ratio, to help determine when they might change directions on you. I find the chart below fascinating. The red line is our stock’s share price, while the blue line is the stock’s put-call ratio for options. Simply said, when the blue line gets extremely high, it is time for the stock to rally. And when the blue line gets extremely low, it is time for the stock to crash. First, take a look at the chart. When the blue line peaked two years ago (at the beginning of this chart), shares of its stock jumped from $100 to $200 a share in no time. Now, today, the blue line is at all-time lows. Time for it to tank?
The put-call ratio can be used as one gauge of investor sentiment. When the put call ratio reaches extremes in either direction, it can signal a turning point in the stock’s direction. Since “the crowd” now believes that GOOG will rise, we may be at an extreme that signals a turning point – it may be time to bet against the crowd. Another way to check out the extreme in optimism is to look at where these options traders have placed their bets. As I write, we are talking in the area of $280 a share. Talk about optimism… As you can see from the chart below, there are many people betting on shares exceeding $380 a share, by mid-July! Now, that’s optimism!
Put call ratios are far from perfect. Jason Goepfert of SentimenTrader.com, is fully aware of this, so he has made a few “tweaks” to the classic put-call ratios to make them more useful. He is devising new put call indicators to specifically target what the “dumb” money is doing now. For example, one of Jason’s indicators is his “ROBO” put-call ratio. “ROBO” stands for “retail-only, buy-only”. Jason isolates the small options trades (trades of 10 contracts or fewer – “retail only”), and he only looks at people making “buy” orders (instead of short-selling options – “buy only”). He thus figures he is getting at what the “retail investor” – the “dumb” money in the options market – is doing with his money. Jason’s ROBO ratio has accurately picked the major tops and bottoms.
When you are trying to gauge the end of a move (in either direction) in a stock (or the overall market), put call ratios are a useful arrow in your quiver. They should not be used by themselves, but their message should not be ignored either. In summary, the put call ratios we use in our example today suggest GOOG may be “over-loved” and ripe for a fall. My friend Porter’s call might not be that crazy after all.Link here.
Let us start with a quote from Friedrich von Hayek: “The means of perception employed in statistics are not the same as those employed in economic theory.” American economists think far too much in statistical terms, regardless of underlying economic processes. While the statistics do, indeed, show general enrichment, in reality, there is none at all. The homeowner has zero gain in his comfort of living or income. This perception of wealth has its true basis in nothing but the famous “greater fool theory”; that is, in the expectation that there will be a greater fool to buy the acquired house later at a higher price. Deluded by this wealth chimera, private households have run down their savings and piled up astronomic debts to be repaid with future earned income.
Where, then, are the economic benefits? The one obvious visible benefit is in the push to GDP growth from higher consumer spending, which also increases current incomes. Yes, but much of that spending on cars, furniture and houses is borrowed from the future. That is, the borrowing pulls future spending into the present, but, of course, at the expense of such spending in the future. If you think it over, you realize that in reality, such a borrowing/spending bubble adds nothing to economic growth. It only distorts the time pattern of spending in relation to its long-term trend, as in the case of the consumer determined by the underlying rate of income growth.
The second problem is that such a bubble distorts and deforms the direction of demand and production in the economy. Consider these grossly disproportionate increases in U.S. domestic spending since 2000: consumer durables +30.8%, residential building +29.5%, nonresidential investment +5.8%, imports +23.5%, exports +5.8%. Strikingly, all economies with housing bubbles have features in common that were, in the past, generally associated with ailing economies. These are collapsed savings; skyrocketing debts; chronic, large trade deficits; and booming residential investment, but weak business investment.
This coincidence is not accidental. The common denominator of these countries is runaway consumer spending. That is the key point. The big spending excesses in these countries are in consumption, while business fixed investment is in the doldrums. Consumption never creates wealth. The capital stock decreases when consumer spending exceeds production. What is happening in these countries is the exact opposite of wealth. It is capital consumption in the sense that consumption absorbs a growing share of GDP at the expense of investment and the trade balance. On the macro level, this is impoverishment.
American economic reality on the macro level is not record wealth creation, but national impoverishment, foreboding a declining living standard. Take the borrowed import surplus away, and U.S. living standards collapse. Among the industrialized countries, Japan and Germany are the two great exceptions that have missed the global housing bubble. Japan is still struggling with the aftermath of its building bubble in the late 1980s, while Germany is struggling with the building bubble that developed in eastern Germany in the wake of unification. Yet speaking of a global housing bubble, we hasten to emphasize again that there is one all-important difference in such bubbles. There are countries where rising house prices have been isolated events in the price system without significant effects on the economy, and there are countries where the housing bubbles have become the dominant influence both on the economies and financial systems. This really is the dividing line between bubble economies and nonbubble economies.
Major housing bubbles imperatively end in a hard landing. A second major adverse influence on economic growth implicitly arises from the sudden cessation of the building boom, yet the worst looming problem is always the potential damage to the banking system through escalating bad loans. On Dec. 5, 1996, when Alan Greenspan made his famous remark about possible “irrational exuberance” in the stock market, he asked a rhetorical question: “How do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions, as they have in Japan over the past decade?”
For a central banker, that is really a most astonishing question. With some knowledge in macroeconomics, bubble economies – in the sense that asset bubbles impact the economy – are most easily identifiable. Consider that last year, the U.S. had recorded an overall credit expansion of $2.7 trillion, versus virtually zero national saving. As you can see, the simple clue is in the relationship between soaring credit and collapsing savings.Link here.
A contrary (?) view: Bubblenomics and bubble brains.
So, are home prices a bubble, ready to burst and implode the economy with it? No! Real bubbles are never commonly referred to as bubbles in the press until after they have burst. Real estate does not qualify. You cannot pick up a reference to home prices in any newspaper or magazine nowadays without seeing the word bubble nearby. That is true here and around the Western World. Only here is it seen as American-only. In Britain, for example, they not only bubble-fret about their housing, but also ours. The sign of a real, honest-to-God bubble is an entirely different kind of public discussion, one in which there is talk of a “new paradigm”, or words to that effect. Recall tech’s heyday, when absurd prices were justified by the theory of a global “New Economy” via eyeball-counting on the Internet. My March 6, 2000 column calling tech a bubble was out of the mainstream.
In the late 1980s not many people talked about Japan being a bubble. The common view was that its way of doing business was simply superior and that this nation would sooner or later replace America as the world’s economic leader. Michael Crichton’s 1992 bestseller, Rising Sun, was based on that notion. The book and the movie it generated look silly now. When something is commonly labeled a bubble that has not burst that means there is fear of it. There is little or no fear of a real bubble. Fear, priced into markets, reduces risk. I have no clue where home prices will go from here; they might go sideways or drift down. But this is not a bubble, because it has been widely called one for two years, in America and elsewhere.
What keeps housing so strong? Long-term interest rates, specifically rates for mortgages, remain low. If mortgage rates remain benign, housing may keep booming. But the housing sector is not in a bubble. As 2004 and 2005 began, most experts believed long rates would rise markedly. Instead they have fallen, both years, in America and throughout the world. The real bubble must be the airholes in those brains that thought interest rates would rise. There is scant media discussion of how long-term rates are down globally, much less why. The reason is that inflation is lower than expected. Despite regional and sector ups and downs, prices, globally, are pretty flat. Expect more of this and with it a sweeter world than the bubble brains forecast.
Last month I detailed how companies with seemingly high price/earnings ratios could be taken over with free money at today’s low long-term interest rates. Here are a few more to buy now.Link here.
MR. PONZI SALUTES
For us, it is a compelling conclusion that this debt explosion overwhelmingly mirrors Ponzi finance, meaning that debt service is paid with new debt. Assuming an average interest rate of 5% on outstanding debts of $36.2 trillion in the U.S., current overall debt service is running at an annual rate of about $1.8 trillion. Focusing on the consumer, we note the following financial development. In 1996, the start of the equity bubble, his disposable income rose by $280.3 billion. Simultaneously, he increased his spending on goods, services and new housing by $312.3 billion, and his borrowing by $332.2 billion. In 2000, the equivalent figures were $499 billion for disposable income, $478.9 billion for total spending and $558.6 billion for total borrowing. For 2004: disposable income up $474.1 billion, total spending up $560.1 billion and borrowing up $1,017 billion. In 2004, household debt increased more than twice as fast as disposable income. Debt production in the U.S. has run absurdly out of proportion to income production.
Earlier, we mentioned that it is mainly bad loans on real estate that have paralyzed Japan’s banking system. America’s commercial banks, not to mention its numerous subprime lenders, are doing their best to beat the follies of their Japanese brethren. Real estate lending by commercial banks has soared as a share of total lending in the past few years, lately accounting for 63% of total outstanding loans, as compared with 41% 10 years ago. So is there a housing bubble? An infallible measure of a housing bubble is associated debt creation. In the U.S., the increase in debt defies economic and financial reason – and imagination.
Asset and credit bubbles implicitly end in busts. Only a bust’s timing is unforeseeable. In the United States, the lenders are desperately trying to prolong the bubble by laxer and laxer lending conditions. Credit bubbles drive asset bubbles with tremendous leverage, as the price of the last trade is mechanically translated into an equivalent change in the value of all existing houses. Put bluntly, when the prices of a small percentage of existing houses are sold 5% higher in any given month than trades in the prior month, this lifts the value of perhaps 150 million existing houses in the U.S. by the same percentage. This is around 200 times leverage in wealth creation. In reality, it is dubious statistical arithmetic.
“Wealth creation” is the prevailing euphemistic American interpretation. According to reports, American households are amassing wealth in this way as never before, vastly outpacing their soaring debt growth. For us, it is scandalous that policymakers and economists can propagate this nonsense without a single voice of protest. What about the wealth aspect? In principle, a rise of asset values can have three different causes: first, higher yields; second, higher available savings; and third, artificially low interest rates driving credit-financed purchases. Of the three possible causes, the third is definitely decisive for the protracted rise in U.S. house prices. This unmistakably qualifies it as “house-price inflation”, not as “wealth creation”.Link here.
THE MANY EVILS OF INFLATION
Many people know how to earn money, but few are aware of what the Federal Reserve System, acting on behalf of the U.S. Government, is doing to their money. It is inflating and depreciating the dollar at various rates – at double-digit rates during the 1970s and early ‘80s and at single-digit rates ever since. The present dollar is worth no more than 10 cents of the 1970 dollar and 50 cents of the 1980 dollar. The reasons and explanations given for this loss may change over time, but the consequences are always the same. Inflation covertly transfers income and wealth from all creditors to all debtors. It dispossessed present creditors of 90% of their 1980 savings and enriched debtors by the same amount. The dollar savings accumulated since then have shrunk at lesser rates but are fading away notwithstanding.
No wonder, many victims readily conclude that thrift and self-reliance are useless and even injurious and that spending and debt are preferable by far. They may join the multitudes of spenders who prefer to consume today and pay tomorrow, and they may call on government demanding compensation, aid, and care in many forms. Surely, the hurt and harm inflicted by inflation are a mighty driving force for government programs and benefits.
The biggest debtor also is the biggest inflation profiteer. With some $8 trillion in debt, the Federal Government is by far the biggest winner. In fact, it gains not only from debt depreciation, which at just 3% amounts to some $240 billion every year, but also from Federal Reserve money and credit creation that enables the U.S. Treasury to suffer annual budget deficits of some $500 billion a year. Without the power to inflate and depreciate the dollar at will, the U.S. Government would be a different institution, like that which the Founding Fathers had envisioned. But endowed with the power of inflation it has become an almighty organization that redistributes income and wealth and refashions the social and economic order. The primary beneficiaries of the new order are its own managers: legislators, regulators, and a huge army of civil servants. They are first in power, prestige, and benefits. Federal politicians and agents are the wise and virtuous judges and juries of benefits amounting to more than $1 trillion every year. How “honorable” would they be, pray tell, without Federal Reserve assistance in financing the deficits and its power to print more money?
There is no conscience in politics. Economic policies may be changed, reformed, and readjusted because they are ineffective, unproductive, and unpopular, but rarely ever because they are immoral. Debt may be a grievous bondage to an honorable man, but it may be a “national bond” which, in President Roosevelt’s words, “is owed not only by the nation but also to the nation.” Surely, politicians have a code of laws to observe and obey, but honesty in matters of debt and money is not one of them. If it is true that we cannot do wrong without suffering wrong, we must brace for more grief to come.Link here.
INVESTING LIKE A SEVENTH-GRADER
The golf course has always been fertile ground for business talk, but for an 11-year-old caddy, it changed his life – and set him on the path to become one of the most celebrated legends of Wall Street. And the secrets that this boy picked up on the fairways during the 1950s could also help you build an incredible portfolio of small-cap winners. Who was this club-toting wunderkind? Peter Lynch, of course – the storied fund manager of the Magellan Fund. As a boy, Lynch learned about investing in the 1950s, when he was a caddy at a posh golf club. He constantly heard corporate executives and financial bigwigs talk about stocks during their golf games. Lynch quietly noted down the names of stocks he heard about at the golf course. Then he looked up their prices and found that months later, these stocks were going up.
That process led Lynch, decades later, to the development of a stock-picking theory based on companies that “make sense”. Because back then – before computers, before the quarter-to-quarter rat race, and before cutthroat global competition – the kinds of executives that Lynch caddied for invested in companies that produced the unglamorous staples of industry and daily life. At age 33, Lynch became one of the youngest fund managers when he took over Magellan. By this time, he had had a stint in the Army and had a degree from the Wharton School of Business – giving him the kind of background that applied both practical and theoretical strategies for finding great companies that “make sense”. So for Lynch, to “make sense” meant putting the money of Magellan’s investors into businesses that were easy to understand. It meant investing in companies that made everyday products. And the payoffs were huge. If you had put $10,000 into Magellan when Lynch took over in 1977, 13 years later, when he retired from the fund – your $10,000 would have grown into a whopping $288,000.
How did Lynch do it? His technique was to keep it simple. For example, he invested in retail stock because he understood the business – everybody needs to shop for clothes, and he observed consumer behavior through his family’s shopping sprees. Lynch achieved great success by investing in companies he understood and by staying away from businesses that he could not understand. In fact, even Warren Buffett has often admitted that he stayed away from the tech mania of the late ‘90s only because he did not understand technology and computers. The simple policy of staying away from what you do not understand can save you a lot of money. And investing in what you do understand can make you a ton if it.
The typical mutual fund manager gets his stock picks from piles of annual reports, stock screens flickering on his computer and the mainstream media. He talks to colleagues on Wall Street for investment ideas – the people that read the same annual reports, run the same stock screens and read the same Wall Street Journal articles every day. Lynch, on the other hand, gets his investment inspiration from the mall, the streets, his daughters, his dining table and even from his barbershop.
Lynch himself has often said that the small scale, individual investor has an advantage over the large mutual funds – individual investors are not governed by the kinds of rules institutions have to follow. This means retail investors can invest in stocks that institutions cannot. Also, individuals are not under pressure, like the investment banks, to tout the stocks they have taken public. Lynch was a fan of a certain group of small-scale investors: 7th-grade students at St. Agnes School, Massachusetts. This group of students built a model portfolio of companies whose products they used and understood, like Walt Disney, Gap, Nike and Wal-Mart. The 7th-graders bought what they knew. Which is why they bought Pentech Int’l – a maker of colored pens. This model portfolio gained 70% from 1990-92, while the S&P 500 gained 26% for the same period. And this buy-what-you-know portfolio beat 99% of all equity mutual funds during that period! Their success proves Lynch’s point further – buy stocks that make sense to you.Link here (scroll down to piece by Sala Kannan).
ARE COLLECTIBLES THE NEW REAL ESTATE?
Everyday it seems that another collectible is sold for a record price. Consider three widely publicized sales in the last month. Babe Ruth’s contract, which sent him from the Red Sox to the Yankees in 1919, went for nearly $1 million. A 1913 Liberty Head nickel went for $4.15 million, up from $3 million a year earlier. And a 1918 upside-down biplane stamp sold for $525,000, more than three times its pre-auction estimated price. Are collectibles a sound financial investment? If the past is any guide, the answer is no. Historically, collectibles have yielded a much lower return than stocks and carried more risk.
Benjamin J. Burton of Lehman Brothers and Joyce P. Jacobsen of Wesleyan University conducted an exhaustive summary of studies that estimated the financial return from investing in collectibles in an article published in The Journal of Economic Perspectives in 1999. They examined the payoff from holding several kinds of collectibles, including art, wine, antiques, ceramics, coins, stamps, books and Beanie Babies. Measuring the return from investing in collectibles is difficult because the items that are sold each year are not identical and some items are rarely sold. Three methods have been used to estimate the return. One involves tracking the prices of objects sold on multiple occasions. Another follows the prices of a portfolio of similar but not identical items each year. And a third tries to adjust statistically for the characteristics of items that are sold at different times – for example, a large Picasso should sell for more than a smaller one, other things being equal.
Despite the methodological differences, according to Mr. Burton and Ms. Jacobsen, the results from the various methods all support the same conclusion: “The majority of collectibles yield lower financial returns than stocks, and studies that include a measure of variability over time uniformly find that collectibles embody more risk than most other financial assets.” To be sure, there have been periods when artwork and other collectibles yielded a higher return than stocks, but those periods tended to be brief and hard to predict. The resale price of Beanie Babies, for instance, grew at an astonishing rate of 140% a year from 1994 to 1999 – and has since crashed.
Looking across all types of collectibles, Mr. Burton and Ms. Jacobsen find that collectibles tend to yield a higher return when the stock market does poorly (Beanie Babies notwithstanding). Still, collectibles do not provide as good a hedge against stock market risk as bonds or money market accounts, which probably explains why virtually all hedge funds and mutual funds have shied away from investing in collectibles. So why has the price of some prestigious collectibles surged lately? One possibility is that the news media has just played up some extreme, eye-catching cases. Given the high price volatility and wide variety of collectibles, it would be surprising if some prominent items did not rise sharply in value every year. Another possibility, however, is that we are in one of those infrequent periods when the price of collectibles is surging. Still, the average collector and investor would be wise to recognize that collectibles have historically been a poor investment but a good hobby.Link here.
WARREN BUFFETT REMAINS BEARISH ON THE DOLLAR
Warren Buffett said in an interview on CNBC he maintains a long-term bearish view on the dollar due to the size of the U.S. trade deficit, despite the currency’s recent strength. Asked if he believes the dollar will resume its downtrend, Buffett, who heads Omaha, Nebraska-based holding company Berkshire Hathaway Inc., said: “At some point, but I have no idea whether in a year from now the dollar will be stronger or weaker. I have some feelings about five years from now.” Buffett confirmed market speculation that he had profited from the dollar’s steep decline last year, but had lost money from the currency’s rebound this year.
As of March 31, Berkshire’s foreign currency contracts totaled $21.8 billion, compared with $21.4 billion at the end of 2004. However, the massive gap in the U.S. external accounts can only push the dollar lower over time, Buffett noted. “We are going down a path that has long been described as dangerous by some of the smartest people in this country,” he said, referring to warnings from Federal Reserve Chairman Alan Greenspan and former Fed chief Paul Volcker that the U.S. current account deficit is unsustainable. The latest available data show that the U.S. current account deficit widened to $195 billion in the first quarter of this year, or 6.4% of GDP – a record by both measures. This means the U.S. economy must attract around $2 billion of foreign capital every day just to balance its books, alleviate the downward pressure on the dollar and prevent a sharp spike in interest rates.
One of those consequences, Buffett said, is the kind of $18.5 billion bid launched by Chinese state-run CNOOC Ltd. for Unocal Corp. If successful, this will be the biggest overseas acquisition by a company from China. With the U.S.-China trade deficit standing at $162 billion last year – around a quarter of the entire U.S. global trade deficit – it is “an inevitable consequence” that surplus money in China is going to find its way back into U.S. assets, he said.Link here.
THE NEW SERFDOM
Low interest rates have made borrowing money easy. That has led to what I have called “flash bubbles” in all kinds of assets – mostly stocks, bonds, and commodities. But it has also affected housing values. We will soon find out just how durable the housing boom really is. On the face of it, more Americans own homes now than ever before – some 68%. But if you dig into the numbers, you see some ugly omens. First, there was nearly $3.8 trillion in mortgage origination volume in 2003, of which nearly 70% was refinancing. The year 2003 was big not just in the volume of mortgages, but also in the percentage of refinancing. For example, in the four quarters starting with Q4 2002, there was a total of $4.2 trillion in total mortgage originations. That was nearly as much as the previous eight quarters from Q4 2000 to Q3 2002, where refinancing activity constituted, on average, less than 50% of the market.
Clearly, 2003 was a banner year for refinancing and locking in low rates before they began to move up. But in 2004, the incentive of rock-bottom rates began to wane. In April, the Mortgage Bankers Association saw its refinancing index fall 30% on a week-over week basis. Since then, we have seen an increase in adjustable rate mortgages (ARMs) and a decrease in the percentages of refinancing originations. In plainer terms, once rates started to rise, mortgage activity shifted from healthy borrowers following the incentive of low rates to more inexperienced borrowers, often in the higher-risk or sub prime market, taking out riskier adjustable rate loans, and often paying only the interest on those loans. Why does it matter? These new borrowers are the fuel for home price growth. According to a speech by Federal Reserve Board governor Ed Gramlich, it is the subprime (higher-risk) borrowers that have driven up home ownership rates in America.
The unholy marriage of ARMs with subprime borrowers is hardly a foundation of strength on which a new housing rally can be built. But so what? Home purchases are a function of affordability. And even if rates rise and the marginal buyer is wiped out, it is not going to put everyone under water. Well, that is exactly the question. If everyone who refinanced in the last three years sits tight as rates rise, makes payments, and does not look to flip or sell the home, then falling home prices will not matter too much, will they? Who cares about liquidity when you are not looking to sell? True. Falling prices hurt less when you are comfortably paying your mortgage. But what happens when you combine falling home prices with rising monthly payments? Danger. Danger.
America is at least $33 trillion in debt. The only real question is whether the money borrowed was used to build factories and income-producing assets or simply wagered on higher financial asset prices. To be sure, some of it was invested rather than gambled away. But much of this debt was money borrowed to buy other financial assets, namely, stocks and bonds. And that is why you find that the other measure of a financial economy, stock market capitalization as a percentage of GDP, is still dangerously out of whack by all historical standards. Historically, the total market cap of the stock market is about 58% of GDP. At the height of the bubble in the Nasdaq, stocks were nearly 185% of GDP. Total market cap is about 100% of GDP today.
If stocks returned to their historic average, and did it all at once, you would see a $4.6 trillion loss in market cap, or a 42% decline, from current levels. It probably will not happen all at once. But I am fairly certain it will happen. And when it does, it will set unprepared investors back eight years, erasing what they have managed to make up in the last two to three years, and then some.Link here (scroll down to piece by Dan Denning).
FROM BUBBLE TO BUBBLE, THANKS TO MONUMENTAL FED POLICY BLUNDERS
It seems like yesterday. But it has only been a little over five years since we were going through the same drill that is playing out today – bemoaning the excesses of an asset bubble and hunkering down for the inevitable post-bubble shakeout. Five years ago, it was the equity bubble. Today, it is the property bubble. These are not isolated events. As night follows day, one bubble has spawned the next. And we have the Federal Reserve to thank for this grand continuum and the cumulative toll it is taking on the U.S. economy. Sadly, as America lurches from bubble to bubble, the endgame is looking all the more treacherous.
The debate has an eerie sense of déjà vu. Today, there are those who dispute the very existence of a U.S. property bubble. Similarly, five years ago, there were many who argued that U.S. equities were not over-valued – that, in fact, they were fairly valued on the basis of the powerful earnings potential of a high-productivity growth New Economy. Today, we hear tales of a “fundamentally-driven” housing boom – supported by increased homeownership, immigration, low unemployment, and, of course, low interest rates. And there are those who repeatedly caution against characterizing property as a broad asset class – especially in the context of fragmented real estate markets that are always distinguished by their “local” idiosyncrasies.
This is rubbish – five years ago and, again, today. In March 2000, not all stocks had risen to dot-com excesses. But enough of them did to take the overall S&P 500 index down by 49% in the bubble carnage that followed over the next 2½ years. Today, nationwide U.S. house-price inflation is at a 25-year high in real terms. That does not mean every home in the country has hit bubble-like valuations. But in the first quarter of 2005, double-digit house-price inflation was evident in 23 states plus the District of Columbia. Investors – not owners – are currently accounting for 11.5% of newly-originated conventional mortgage loans; that is up from a 2% low in late 1995. And mortgage financing has shifted dramatically in recent years into exotic and risky floating rate obligations such as interest-only and negative-amortization loans. As Tom Lawler of Fannie Mae notes, this shift into floating-rate borrowing cannot be explained by the factors that traditionally drive such trends – the level of mortgage rates and yield curve spreads. Something else must at work.
That something else is a bubble. Residential property has become the asset of choice for investors in a low-return world awash in liquidity. Long ago, when America’s Asset Economy was in its infancy, Alan Greenspan worried about “irrational exuberance”. But he quickly changed his mind and went on to champion the equity culture spawned by the New Economy. In my view, that was a policy blunder of monumental proportions. The rest is history – and a sad history at that. By electing to condone the greatest equity bubble since the late 1920s, the Fed has been snared in a low real interest rate trap – in effect, locking itself in to a serial bubble-blowing strategy.
Dangers cumulate as one bubble follows another – because debt invariably enters the equation. And that has certainly been the case in recent years. Not only does the outstanding volume of household sector indebtedness now stand at a record of nearly 90% of GDP, but this ratio has soared by 20 percentage points over the past five years (2000-04) – equal to the rise that took place over the preceding 15 years (1985-99). Moreover, household sector debt-service burdens are at historic highs when scaled by disposable personal income – truly astonishing in a climate of rock-bottom interest rates. History screams out the warning that has gone unheeded – debt bubbles and asset bubbles go hand in hand.
The exit strategy has always been the most problematic aspect of this scenario. Not only is that true of overly-indebted borrowers, but it is also true of central banks. The Fed prides itself in having learned the lessons of Japan. But, in fact, the game-plan is woefully incomplete. Yes, the U.S. central bank learned that it pays to move quickly once a bubble bursts. But then what? Unfortunately, there was nothing further to learn from the Bank of Japan other than it is very tough to wean a post-bubble, deflation-prone economy from low nominal interest rates. Some 16 years after the Japanese bubble popped, the BoJ is still stuck with its policy rate at zero. Five years after the U.S. equity bubble popped and the Fed is not a whole lot better off, with its policy rate still hovering around zero in real terms. As bubble follows bubble, the consequences of normalizing interest rates become more and more severe. In the meantime, asset and debt bubbles keep feeding on themselves.
This is a sad and depressing tale – especially for the world’s unquestioned economic leader. Alas, bubbles and imbalances are one and the same. One of the great mysteries of asset bubbles is what causes them to pop. Yale professor Robert Shiller has long argued that asset bubbles invariably implode under their own weight. We all hope for the benign endgame. But the bigger the bubble and its associated imbalances, the less likely that becomes. Don’t kid yourself. America’s property bubble did not just appear out of thin air. It is traceable directly to the equity bubble of the Roaring 1990s – and to a central bank that remains steeped in denial. The real lesson of Japan is that there may well be no easy way out.Link here.
THE MYSTERY OF THE GERMAN ECONOMY
Something “inexplicable” has been happening to the German economy. The biggest economy of the European Union shrank in the fourth quarter of 2004, worrying analysts that the GDP growth in 2005 would also be sluggish … or worse. To their surprise, in Q1 of this year, the German GDP posted the best growth rate in four years. And that was not the only good news: The number of business bankruptcies went down in Q1, the trade surplus went up, and March factory orders “exceeded expectations” (Deutsche Welle.) About the only fly in this bucket of ointment was the March slowdown in Germany’s industrial output.
Despite these strong economic fundamentals, German economists remained unconvinced. “This is likely to have been a one-off spike,” they said. “The underlying trend remains for German growth to stagnate, and it will take more than a single good quarter to shake this belief.” The Q2 GDP figure has not come out yet, but as if to spite the naysayers, preliminary data for May showed that the German economy was still growing at the “fastest rate of growth in four years.” What is more, the country’s total unemployment number for April dropped back below the psychologically important mark of 5 million, and it continued falling in May and June. And just last week, another piece of happy news came: Investor confidence shot up in June more than expected. Yet hopes for future growth remain weak. German retailers, for example, are still expecting another drop in business this year, for the fourth year in a row.
How can this be? How can the Germany economy continue to perform so well in the midst of negative forecasts by the country’s top economists and sour expectations by the public? From a conventional approach, it does not make much sense. So here is a different theory: the economy follows the stock market, as our research demonstrated. Indeed – what have German stocks done since late 2004? Well, while the German economy was shrinking in late 2004, the DAX was busy rallying. It ended 2004 in positive territory and continued moving up this year. The economy – at least in Q1, so far – followed. And it is not just a coincidence. If you compare the charts of the German GDP and the DAX in 2003-2004, for example, you again will find a similar correlation.
But why does the economy follow the stock market, in the first place? Does conventional economic theory not teach precisely the opposite? We believe that both the stock market and the economy are driven by mass psychology – or social mood – of a particular society. When society feels more optimistic, first stocks starts to rally – the stock market always reacts first to a rise in overall optimism – and then the improving social mood boosts the economy through people’s increased job efforts. Now, given what you have just read, what would you forecast the German GDP to be in Q2 of this year?Link here.
BOND MARKET: BULL, BEAR, … SPHYNX?
One of the most menacing characters in the Classic tale of Oedipus is the man-eating Sphynx. The lion/lady/bird beast forces a riddle on travelers who seek to enter or exit the gates of Thebes, biting the heads off and devouring all who fail to solve her teaser.
That is a wee bit harsh. But it does makes us think – Federal Reserve Chairman Alan Greenspan must thank his lucky stars everyday he is not living in a Greek tragedy. After months of head scratching, neither Mr. “G” nor his posse of mainstream policy-makers is any closer to cracking the infamous bond “conundrum”. The short of it: Since June 2004, the Fed has raised the overnight lending rate eight times (200 basis points), from 1% to 3%. Yet today, rates on 10-year Treasuries are LOWER than they were before the Fed hikes began.
In early June, Treasury yields broke (down through) the 4% barrier and investors, long patient for the market to obey the Feds orders, developed a very hearty appetite for answers. A June 3 Bloomberg writes: “The 10-year Treasury note was a ‘conundrum’ in mid-February at a yield of about 4.10%. Now, it looks more like Winston Churchill’s Russia: ‘a riddle, wrapped in a mystery, inside an enigma.’” Three weeks later, many in the bond business would opt to add, “Contained in a challenge,” that continues to confound Greenspan and the mainstream economic world in general.
Everyday, traders grow more and more anxious over the Fed’s inability to answer the bond “conundrum”. But th fact is – the Fed does not control the ups and downs in interest rates; social mood, as reflected in the wave pattern unfolding in prices, does.Elliott Wave International June 24 lead article.
HOW THE WEST WAS LOST
The biggest bubble in history expanded a bit more this week. Could it be approaching its limits? New home sales rose in May to the highest level since October. And the National Association of Realtors said 2005 is going to be a record-breaking year for sales of new and existing homes. “We’re seeing a very hot housing market and that had everything to do with interest rates,” said Wesley Beal, chief U.S. economist at IDEAglobal.com. “As long as interest rates stay low, the kind of home-value appreciation we’ve seen is going to continue.”
Does that not say it all, dear reader?
As nervous as it may makes your humble scribblers, many “experts” now seem to agree: “Many Americans are now less concerned by the price of a house and how much a home loan will cost over time,” said Nicolas Retsinas, head of the Joint Center for Housing Sstudies at Harvard University. “They are only asking how much it will cost next year.” Not only does it show how willing Americans are to live in a state of ignorant bliss, but it begs the obvious question: what happens when interest rates go up? Americans see no point in saving up to buy a house, or saving for anything at all, for that matter. Americans save 40 cents for every $100 dollars of disposable income. They depend on their homes to make them money – just like they depend on the kindness of their foreign neighbors to the East to support their spending binge.
In an interview with CNBC, Warren Buffett said that he maintains bearish on the dollar, despite its rebound, due to the size of the U.S. trade deficit. The U.S economy must attract around $2 billion of foreign capital every day just to balance its books, alleviate the downward pressure on the dollar and prevent a sharp spike in interest rates. It is no wonder that U.S. companies doubled their overseas investment in 2004, and figures show that China was the largest recipient of direct investment in developing countries.
Dan Denning [echoing sentiments from his new hot-selling book The Bull Hunter] puts it into perspective: “While China trades its accumulated dollar reserves for real assets and secures its energy and resource needs, Americans are trading homes to get rich. Hmm. Makes you wonder how many people realize that we in the West are now competing for scare resources with 3 billion new, ambitious, hard-working, high-saving people.
“Not many apparently, which in a way, is just fine with me. We’ll keep sounding the warning, and recommend to keep finding and buying the best companies to profit from the money migration, especially in energy.”Link here.
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