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IS THE HOUSING BUBBLE POPPING?
Last Friday was a bad day for housing stocks and this could be a sign that the housing bubble may have sprung its first leak. This is what the Philadelphia Housing Index looked last week – losing about 5% for the week. Investors have made around 50% on their money since I first reported on the housing bubble and there could very well be more bubbling to come.
Here is a linear graph of high-flying Toll Brothers (TOL), one of the largest homebuilding companies. The stock has increased by over 50% in the last year. Optimists point to the company’s price-to-earnings ratio of “only” 15, which is below the market average. The pessimist case for a bursting or deflating of the housing bubble is the issue of rising interest rates. As Greenspan increases short-term interest rates it causes problems for those who have variable rate mortgages tied to short-term interest rates. Energy prices and a slowdown in the economy can also dampen enthusiasm in the housing sector.
The larger problem may be for long-term rates. As Greenspan increases short-term rates the thinking goes that he is reducing inflation expectations and thus reducing the likelihood of increases in long-term rates. However, if long-term rates rise, this is an indication that short-term rates are not rising fast enough to dampen inflationary price pressures. The graph below shows a big increase in the interest rate on 10-year Treasury bonds on Friday that coincided with the fall in homebuilder stocks. Here is a graph of the interest rate on 10-year Treasure bonds over the last six months. The interest rate made a “double bottom” this summer – below 4% – the lowest rate ever in my lifetime. A double bottom is a term from technical analysis which is a bullish indicator, which in this case argues for much higher long-term interest rates. Higher rates spell trouble for the home builders and give some indication the housing bubble might be coming to an end.
Hopefully, Alan Greenspan will know the correct lever to pull next. He did in the 1960s.Link here.
Given the seductions of 1% money, you might not be surprised to learn that this form of financing quintupled its national market share in the past 12 months. But two developments – one that took effect August 1, another due this fall – could reduce the promotions you see for cut-rate option ARMs. – link.
Once Southern California’s hottest real estate market, San Diego is feeling a real estate slowdown. It is a trend also starting to be seen in other regions, such as Las Vegas, Denver, Boston and Washington, D.C. Dramatic rises in home prices, particularly on the West and East coasts, have sparked a nationwide debate about whether the housing market is engulfed in a bubble that is about to burst. San Diego has become a focal point of that discussion. Those who believe the market is about to implode say San Diego’s cooling could be among the first signs of a pronounced downturn or even a possible crash in California. John Karevoll, chief analyst at DataQuick Information Services in La Jolla, which tracks home prices, called San Diego “our statistical canary in the mine shaft. It is further along in the current cycle, and what happens there could predict what will happen elsewhere.” – link.
What housing bubble??
Neil Barsky, managing partner of Alson Capital Partners, LLC, wrote an absurd opinion piece about housing in the Commentary section of the July 28 online issue of The Wall Street Journal in which he claims there is no housing bubble. Now, plenty of people, some just plain stupid, some with axes to grind, write the same thing. Typically, these opinions are not worth replying to, quite frankly, because they are so widespread and preposterous that one would spend all his time rebutting such nonsense. But Barsky is a special case, for reasons we will address later. In the meantime, let us review some of the nonsense spewing forth from Mr. Barsky …
… and then let us take a look at what some more sensible people are saying. The Orange County Register suggests, in “Region’s House of Cards Ready to Topple as Prices Reach Unsustainable Levels”: “Looking at the four big counties in Southern California, over the past decade, the percentage of households that can afford to buy the median-priced home (using conventional mortgage qualification standards) dropped by as much as 74% in Orange County (to 11%) and as ‘little’ as 56% in San Bernardino County (to 24%).” Hmmm. Only 11% of the people in Orange County and 24% in San Bernardino can afford a house. That is not a bubble?Link here (scroll down to piece by Mike "Mish" Shedlock).
That Hissing Sound
This is the way the bubble ends: not with a pop, but with a hiss. Housing prices move much more slowly than stock prices. There are no Black Mondays, when prices fall 23% in a day. In fact, prices often keep rising for a while even after a housing boom goes bust. So the news that the U.S. housing bubble is over will not come in the form of plunging prices; it will come in the form of falling sales and rising inventory, as sellers try to get prices that buyers are no longer willing to pay. And the process may already have started. Of course, some people still deny that there is a housing bubble. Let me explain how we know that they are wrong.
One piece of evidence is the sense of frenzy about real estate, which irresistibly brings to mind the stock frenzy of 1999. Even some of the players are the same. The authors of the 1999 best seller Dow 36,000 are now among the most vocal proponents of the view that there is no housing bubble. Then there are the numbers. Many bubble deniers point to average prices for the country as a whole, which look worrisome but not totally crazy. When it comes to housing, however, the United States is really two countries, Flatland and the Zoned Zone.
In Flatland, which occupies the middle of the country, it is easy to build houses. When the demand for houses rises, Flatland metropolitan areas, which do not really have traditional downtowns, just sprawl some more. As a result, housing prices are basically determined by the cost of construction. In Flatland, a housing bubble cannot even get started. But in the Zoned Zone, which lies along the coasts, a combination of high population density and land-use restrictions – hence “zoned” – makes it hard to build new houses. So when people become willing to spend more on houses, say because of a fall in mortgage rates, some houses get built, but the prices of existing houses also go up. And if people think that prices will continue to rise, they become willing to spend even more, driving prices still higher, and so on. In other words, the Zoned Zone is prone to housing bubbles. And Zoned Zone housing prices, which have risen much faster than the national average, clearly point to a bubble.
In the nation as a whole, housing prices rose about 50% between the first quarter of 2000 and the first quarter of 2005. But that average blends results from Flatland metropolitan areas like Houston and Atlanta, where prices rose 26% and 29% respectively, with results from Zoned Zone areas like New York, Miami and San Diego, where prices rose 77, 96 and 118%. Nobody would pay San Diego prices without believing that prices will continue to rise. Rents rose much more slowly than prices: the Bureau of Labor Statistics index of “owners’ equivalent rent” rose only 27% from late 1999 to late 2004. Business Week reports that by 2004 the cost of renting a house in San Diego was only 40% of the cost of owning a similar house – even taking into account low interest rates on mortgages. So it makes sense to buy in San Diego only if you believe that prices will keep rising rapidly, generating big capital gains. That is pretty much the definition of a bubble.
Bubbles end when people stop believing that big capital gains are a sure thing. That is what happened in San Diego at the end of its last housing bubble: after a rapid rise, house prices peaked in 1990. Soon there was a glut of houses on the market, and prices began falling. By 1996, they had declined about 25% after adjusting for inflation. And that is what is happening in San Diego right now, after a rise in house prices that dwarfs the boom of the 1980’s.
Meanwhile, the U.S. economy has become deeply dependent on the housing bubble. The economic recovery since 2001 has been disappointing in many ways, but it would not have happened at all without soaring spending on residential construction, plus a surge in consumer spending largely based on mortgage refinancing. Did I mention that the personal savings rate has fallen to zero? Now we are starting to hear a hissing sound, as the air begins to leak out of the bubble. And everyone – not just those who own Zoned Zone real estate – should be worried.Link here.
This story remains under the radar.
You may recall my recent discussion (July 27) of how the homebuilders index had declined, despite all the “good news” about that sector. Those declines continued last week and into today. The various homebuilder indexes are down from 10%-15% over the past two weeks. This story remains under the radar – a curious thing indeed, given that homebuilder sector stocks had compiled the best one and five year performance record of any sector in the U.S. economy.
On the other hand, perhaps it is not so curious. For all the talk this year about a “housing bubble”, the truth is that nobody behaves as if they think a bubble exists: homeowners, homebuyers, lenders, investors, mortgage brokers, you name it – they all behave as if 20%, 30%, or 50% annual gains are normal.Link here.
Fannie restatement: wait till next year.
“We are leaving no stone unturned,” says the president and CEO, whose company has not filed a quarterly report with the SEC for more than a year. Fannie Mae acknowledged that it would not complete what could amount to a $11 billion restatement until the second half of 2006. As a result, the company conceded, it would be breaching the New York Stock Exchange’s listing standards. The mortgage giant “is engaged in regular discussions with the staff of the New York Stock Exchange regarding the status of our restatement and [its] continued listing,” said president and chief executive officer Daniel H. Mudd, in a statement.Link here.
LONG VALUATION WAVES
Just this week the US stock markets blasted up to impressive new 4-year highs, continuing the bull market that launched back in March 2003. Since those dark days the mighty S&P 500 has soared 55% higher! This is an absolutely glorious run by any standards. In light of this powerful cyclical bull in stocks we have witnessed in the past two years and five months, many investors understandably wonder how on earth anyone could be bearish today. Indeed, the shorts have been beaten within an inch of their lives in recent years and bears have been relentlessly hunted to the verge of extinction.
espite the scorn heaped on the stalwart remaining bears, I still find myself sojourning in this very politically-incorrect camp. It is certainly not that I want the markets to go down, I do not. But as a lifelong student of the markets and speculator I know that the markets are the world’s ultimate probabilities game. To me it makes little sense betting against fundamental probabilities no matter how powerful technical momentum may seem. And today, whether we love it or hate it, probabilities are conspiring against the bulls. It is for these bulls, including my own dear friends and family members, that I am penning this essay today. People work hard over a lifetime to save capital and provide for their families and it breaks my heart to see investors risking their precious capital while naďve of the great risks weighing on the markets today.
Thus, for the first time in nearly three years, I want to delve into the Long Valuation Waves again. These waves, like ocean waves, are great valuation cycles that run about a third of a century or so each. Depending on where in the wave cycle one happens to be, investment strategies vary tremendously. Investors not aware of these cycles face anything from zero returns over a decade at best to catastrophic losses at worst. These fascinating long market cycles meander so gradually that they tend to escape detection. The Long Valuation Waves tend to run a third of a century or so each. If the average investor today starts investing at 25 and retires at 65, he only has 40 years to perceive a 34-year cycle! This cannot happen casually but rather requires intense study.
Stock investing, when you strip away all the glamour and sandblast out the emotion, is ultimately about owning a fractional share in the future earnings power of publicly-traded companies. For every dollar invested, investors want their companies to earn the highest percentage of profits possible each year. A company earning 20% profits on your dollar is superior to those only earning 10% profits. Honest investors will readily admit that they could not care less about what sectors in which they invest, they just want the best returns. And over the long run the best returns always emerge from the most profitable companies. Therefore, the essence of investment is about finding the companies that are earning the most profits, and are likely to continue to, per dollar invested.
These profits come at a price. Companies’ stock prices are far more volatile than their underlying profits. Because of this, there are times when future profit streams are cheap to buy and times when they are expensive. The financial metric used to measure the relative cheapness or dearness of profits is the venerable price-to-earnings ratio, or P/E. Stocks are cheap, and great long-term bargains, when P/E ratios are low. Now over centuries these P/E ratios have had an average of 14x earnings, investors were paying $14 for each $1 worth of annual profits. This is considered fair value in Long Valuation Wave studies, the horizontal center around which the waves lazily oscillate through time. Consider it like “sea level”. Across centuries, cultures, markets, and countries, 14x earnings, or 7% earnings yields, just seems to be the most natural fair-market price for balancing markets’ capital surpluses and deficits.
After my own extensive studies of market history, my inner mathematician likes to deal in multiples. With vast databases to back up this assertion, I consider half of fair-value, or 7x earnings, to be cheap, a great bargain. Conversely 21x earnings is moving into the realm of expensive valuations. And double fair value, or 28x earnings, is bubble territory. For long-term investors, the valuations at which they choose to buy is the single most important factor guiding the long-term success of their investments. Hopefully the concept of Long Valuation Waves is starting to make sense now. They are called long because they have wavelengths running a third of a century or so. And they are valuation waves because they track the price that investors are generally paying for $1 of earnings at different points in these long cycles.
On top of these core foundations we need to then add psychology. There are periods of history when investors cannot get enough stocks and are willing to buy at any price, regardless of valuations. Thankfully 1999 was not too long ago so we all remember well what these mania periods are like. And there are other periods when investors will not touch stocks with 10-foot poles. Unless you were actively investing from 1974 to 1982 you have never experienced one of these. This herd psychology moves in great waves too, and is actually the underlying driver of the Long Valuation Waves. Early in the 34-year cycles investors are fairly neutral about stocks, but gradually they get interested and a Boom ignites. After maybe a decade of booming, greed festers and a Bubble spawns, pushing prices up far faster than earnings and sending valuations spiraling heavenwards. Sooner or later this mania psychology fails when all the capital that can be enticed in has been sucked in. Without any new buyers mania prices collapse in the Burst phase. And then over the next half wavelength the Bust manifests itself.
The ultimate goal of investing is to Buy Low Sell High, and if we rewrite this core equation in psychology terms it can be stated as Buy Fear Sell Greed. Prices are lowest when investors are generally scared making that the best time to buy. And prices are highest when investors wax the greediest so that is the best time to sell. In Long Valuation Wave terms these opportunities manifest themselves at the peaks and troughs of the waves.
This next chart is where the rubber hits the road. It distills over a century of stock-market prices and market valuations. The stock index used is the Dow 30, since it is the only major American index today with enough history to run this long of a study. Note that stocks were always cheap (near or under 7x earnings) near secular valuation bottoms and always expensive (above 21x earnings) near secular valuation tops. While you cannot tell as much from this chart, our final chart below will illuminate the actual returns for investors if they bought near these major tops and bottoms.
From the 1929 top to the 1966 top, one full Long Valuation Wave marched through. It ran 36.3 years in duration. The next wave started immediately after and ran from 1966 to the blisteringly high 2000 top. It, rather uncannily, weighed in at exactly 33.9 years, a perfect match with our conceptual 34-year valuation cycle. These waves are symmetrical when measured trough-to-trough as well, just as they ought to be. From the 1949 bottom to the 1982 bottom the full wave ran 33.1 years, a third of a century. As you digest this chart and ponder the blue waves above, realize that these Long Valuation Waves are real. They are not mere vain academic babblings like the goofy Efficient Market Hypothesis, these are real forces driving real markets. Investors only ignore them at their own great peril.
With a full wavelength running about 34 years, a half wavelength is, amazingly enough, about 17 years. The Great Bull in US stocks from 1982 to 2000 was a 17.4-year secular bull riding an incoming Long Valuation Wave. Now if you did not have me droning on, and just had these charts, I suspect you would independently arrive at the same morose conclusion I have: if these cycles are so steadfast in history and tend to run with such regularity, the outlook for the U.S. stock markets in the next decade cannot be good.
Valuations in 2000 at the end of the greatest bull market in U.S. history were the highest in U.S. history at an utterly mind-exploding 44x earnings. In the past five years valuations have fallen dramatically yet are still above 21x earnings, very expensive in historical context. If full valuation waves tend to run 34 years in duration, and major secular bulls and bears tend to run 17 years or so each, then odds are the U.S. stock markets will face tough sailing until 2017! That is 12 more years friends, not fun! And since we each only have about 40 investing years in which to build our fortunes, we cannot afford to be wrong on the next 12.
This is why I am bearish on the U.S. stock markets, because the Long Valuation Wave that lifted us until 2000 has been relentlessly ebbing since then. Long-term investors long the U.S. stock markets today are facing a valuation winter, when valuations gradually march back down from expensive levels to cheap levels. The same dollar of profits that sells for $21 in stock price today will almost certainly go for under $7 before this current Long Valuation Wave ebbing fully runs its course. Unfortunately, and you really ought to share this with anyone you love with heavy long US stock exposure, investors in the past who ignored these Long Valuation Wave ebbings were slaughtered like sheep.
Investors buying in 1914, 1949, or 1982, near the valuation-wave troughs where everyone hated stocks, could have reaped magnificent secular gains of 629%, 516%, and 1409% on the Dow 30 over these 17-year bulls. These are the stories, especially since 1982, that inculcate market lore today and make stock investing for the long term seem so romantic and foolproof. But the dark side of investing, the stuff that Wall Street never talks about in public, is represented by the secular bears between every secular bull. Long-term investors buying in 1929 would have waited 19.8 years for a 58% loss! Not only did long-term stock market investors buying in 1966 lose 20% of their precious capital nominally by 1982, but the remaining 80% could only buy one third as much in terms of real purchasing power as the original capital deployed.
There is no need for anyone to fight a secular headwind for 17 years. Right now, sadly, probabilities are in favor of 12 more years of a secular bear, probably endless sideways grinding, before the next Great Bull. Thankfully the prudent can weather this valuation storm. While stocks wane for 17 years as a valuation wave trough approaches, commodities tend to thrive in these same 17-year periods! ommodities long waves are almost perfectly offset by one-half wavelength, making them bullish when stocks are bearish. Indeed commodities are now in a secular bull market and are rapidly becoming the best performing sectors in all of the markets. Long-term stock investors can avoid the worst of the Long Valuation Waves by deploying in commodities stocks rather than the general stocks, techs, and financials that were so popular in the last bull market.Link here.
Some would think that the real driver for the stock market is the discovery that the economy is in the perfection of the “Goldilocks” mode, which was last “discovered” in late 1999-early 2000. At the time, we thought it was a rationalization to stay long the biggest stock speculation in history. Now it is to stay long the next bubble. On that one, the focus was tech stocks; on this one, it is industrial commodities and residential real estate. In January, 2004, Stephen Roach, at Morgan Stanley, wisely observed, “The image of the Fed as a ‘serial bubble blower’ is not that far fetched after all.”
Our own view on this has been that the Fed has been blowing bubbles since they opened the doors in 1914 and, at some point, the world will wake up to the realization that great speculations will always occur and that it is best that central banks do not add their own speculative theories and practices to events that occur naturally and so regularly. Previously we have used the term “Geriatric Bull Market” and would add that when the party is in full swing and the Rolling Stones Satisfaction is on full blast, even the oldest in the crowd can kick up their heels. On this sequence, the market for stocks, commodities, and homes is about at the equivalent of Pretty Woman, and Roy Orbison’s line “No one can look as good as you. Mercy …” seems descriptive. By this model, the excitement is high and there are only two numbers left. These could use up all the available speculative energy by mid-September. As the saying goes, dance close to the exits – the air is usually cooler and fresher.Link here.
THE CHICKEN OR THE EGG?
On March 4, 2005, we made the following statement: “The performance of the DAX Index suggests the [German] economy is likely to improve. The hard data should post some impressive numbers.” That was an audacious claim at the time because German analysts were expecting quite the opposite. In Q3 2004, German GDP did not grow at all, and in Q4, it turned negative. Predictably, experts were concerned that this year’s growth would also be slow.
Surprisingly, it was not. After German economists tallied the Q1 figures, they saw the fastest economic growth in four years, a drop in business bankruptcies, increased trade surplus and factory orders. That upbeat trend continued into April, when the country’s unemployment dropped below 5 million. Jobless claims also fell in May, June and July. In May, preliminary GDP data showed that the German economy was still growing at the “fastest rate in four years.” In June, business confidence jumped more than expected. In July, it increased again. And so on – you get the picture.
When we made that March forecast for “better times” in Germany, it was not just a lucky guess. We got our clues from the DAX. As Elliotticians, we know that the stock market leads the economy. The DAX had been advancing strongly since September 2004, so it was very reasonable to expect the German economy to improve soon – which it did. Of course, what you hear on financial TV is completely opposite: They say it is the economy that leads stocks. But this is not “the chicken or the egg” kind of an argument. Simply plot the economic numbers on a stock market chart and you will notice that stocks tend to advance while the economy remains flat or in a recession. Amazing, eh? On the flip side, the stock market often turns down while the economy is still posting impressive numbers. For now, both the DAX and the German economy are keeping their upward momentum. But another forecast we made back in March was for the DAX to rally to at least 4,846 this year. As of today, the index stands slightly above our target.
Economic numbers are what most analysts use to forecast the stock market. Since the German economy is improving, you will now see more and more analysts turn bullish the DAX. Most investors, lured by the “strong economy”, will also pile into stocks. However, what they are focusing on are the lagging indicators. By focusing on the past, they are ignoring the forward-looking information that the stock market is currently offering. That is the pitfall of the conventional investment practice.Link here.
LONGER & DEEPER LEADS TO LARGER & MORE EXPLOSIVE?
The history of the U.S. stock market shows that the longer and deeper the decline, the larger and more explosive the bull market afterward will be. A few examples: 1.) From September 1929 to July 1932, the Dow Jones Industrial Index declined by 90%. In the eight weeks after that July low the Dow gained 90%, and rose another 80% from September 1934 to April 1936. 2.) From July 1973 to December 1974, the Dow declined 40%. From that December low through August 1975, the Dow gained 48%. 3.) In September & October of 1987, the Dow declined 35%. From that October low through July 1990, the Dow gained some 70%.
There are more examples, but the rule is simple enough: After a major bear market comes a very powerful bull market. Still, there are exceptions – and in fact, we are in the midst of one such exception right now. The news made much of the S&P 500’s recent 4-year high, but consider this: The 2000-2002 bear market was the longest since the Great Depression, and saw the major indexes lose anywhere from 40% to 80% of their value. Yet the Dow Industrials have rallied only about 40% from the 2002 lows, and most of those gains came during 2003.
In relation to the historical precedents, this “bull” market scarcely deserves the name. A USA Today story made this point today in an article titled, “Why does this bull market lack powerful punch?”, though it used examples on a lesser scale than the ones I offer above. Still, the piece was factual enough to make clear that the stock market’s performance has been anemic, at best. The question that begs to be answered is, “Why?”Link here.
THE ART OF SHORT-SELLING
James Chanos is a famous short-seller at Kynikos Associates in New York, the firm he founded in 1985. Chanos got a lot of press for his accurate bearish call on Enron several years ago. There are few better at the business of betting on stock price declines than Chanos, who has been at this a long time. I recently finished reading an interview with Chanos, and I would like to share with you some of his best ideas. What follows is a summary of his three favorite situations – broad categories in which he has found good short candidates. I think you will find this schematic useful in your own trading and thinking. We will also take a look at three of his current favorite trades, one of which I recently recommended to the subscribers of my Crisis Point Trader.
Booms That Go Bust: Chanos cited this as his most lucrative field of operations: great booms that then go bust. But, he offered an important caveat on which ones to play. Specifically, he has found great success with “debt-financed asset bubbles” as opposed to those driven strictly by investor mania. The former are ticking time bombs, where you are betting on the inevitable, whereas the latter are simply plays on excessive valuation reverting to some more normal number. “My biggest mistakes have generally been because I stayed in things just because they were expensive,” he admits, “… valuations can be crazy and stay crazy.” The ongoing housing bubble is one example of a debt-financed asset bubble. But Chanos is not shorting homebuilders. They are making money and are in good shape financially. It is the consumer, Chanos notes, who will suffer the most when the bubble runs its course.
In today’s market, this intrepid short-seller sees a debt-financed bubble in Chinese manufacturing. “Plants are being built with debt for which return on capital will be very low,” he says. Since economies are prone to fits and starts, and even the brisk Chinese manufacturers will endure periods of slowdown and excess capacity, these debts are a threatening overhang. On the low margins Chinese manufacturers typically earn, they have little cushion against adversity. Another area Chanos thinks is an asset bubble in the making is in the steel industry. Steel capacity has grown 30-40% over the past few years, and the soaring steel prices have come down significantly from the $780 highs achieved in September 2004 (for a ton of hot rolled band). Currently around $400 (keep in mind, this industry lost money on $300 steel prices in 2003), analysts are projecting $500-600 steel prices going forward. Chanos believes the industry’s overcapacity issues will make that a hard price to sustain.
Technological Obsolescence – Victims of “Creative Destruction”: Economist Joseph Schumpeter gave us the phrase “creative destruction” to describe the process of new companies and technologies destroying and replacing older or obsolete ones. Disruptive technologies can wipe out entire industries and render old products worthless. This competitive process is ongoing. Chanos cites the transformation happening now as we move from an analog to a digital world. “While this has created great fortunes like Google’s,” Chanos notes, “it’s also wiping out whole businesses.” Traditional music retailing was one of the first to start disappearing, and now Chanos sees the same thing happening with video rental, as movie studios sell directly to retailers such as Wal-Mart, not to mention the rise of video-on-demand products.
Consumer Fads That Go Flat: The last of the trio, Chanos has also found success betting against consumer fads – the more obvious examples would be Cabbage Patch Kids in the 1980s, NordicTrack in the early 1990s and the Foreman Grill more recently. In these situations, Chanos is looking to capitalize on the all-too-human error of taking the present and extrapolating it into the future. Investors are generally overly optimistic about the prospects of faddish products. Today, he is short Palm, the makers of the popular PDAs. Palm, however, loses money on their PDAs and they do not produce the software that makes the system go. “The biggest problem is that Palm doesn’t control the Treo software – it’s just a box,” Chanos says. “Boxes with chips in them tend to be very good shorts if that’s all they have.”
Add any accounting irregularities to the above and you have a potential big winner on the short side. As to mitigating risks, Chanos says there are two basic methods: position-sizing and stop losses. He favors the use of position limits of no more than 5% on his portfolio and he cuts back on ideas that move against him. As for mechanical stop losses, Chanos is philosophically opposed to using them: “We’ve never used stop losses. We feel like having a mechanical rule that takes you out of positions regardless of the fundamentals makes no sense.” For more reading on short-selling, there are few good resources. The best is Kathryn Staley’s The Art of Short Selling. Also, Manuel Asensio’s Sold Short is a good read and lets you into the mind of another long-term successful short seller.
Now, let us take a look at Chanos’s investment ideas. First, in the category of “Victims of Creative Destruction”, we have Eastman Kodak (EK). In Chanos’s worldview, we are moving from an analog to a digital world and the consequences of that are being felt by a variety of businesses. Chanos believes Kodak is another Polaroid, a company that is slowly being eaten alive by the competition. Their most profitable business has traditionally been film. Now, even professionals are moving to digital. Another short candidate is Fairfax Financial Holdings (FFH). “We think this is a zero,” Chanos said. Basically, this Canadian property & casualty company grew aggressively with acquisitions in the 1990s. Today, it runs a chronic underwriting deficit. It is also one of the biggest players in finite reinsurance – the stuff that Spitzer is on a rampage about. Fairfax is highly leveraged and heavily under-reserved. The earnings quality, Chanos believes, is poor.
Unfortunately, Fairfax Financial is a relatively illiquid stock with a very illiquid option market. So that makes the stock even more dangerous than the average short-sale candidate. Nevertheless, Kodak and Fairfax are both very interesting ideas.Link here.
THE ECONOMICS OF YELLOW JACKETS
Yellow jackets are fascinating creatures. I am one of the few people who truly enjoy and benefit from these pesky creatures. Every fall my wife and I enjoy the benefits of what is left of the free market system. Yellow jackets prove how profound the free market is. Believe it or not, we earn money collecting and selling yellow jackets, hornets, and wasps. While everyone else is running from them, we have a seasonable business in which we seek them out. In free market economy everyone should walk away feeling like they gained the better end of the deal. Yellow jackets can show us how economic interdependence benefits everyone involved.
Free market economics means everyone wins. In my case, the homeowner wins because they got rid of their yellow jackets, hornets, or wasps for free. I win because people are finding them for me and I now have plenty of bugs to sell to the medical lab. The medical lab wins because they have good quality insects. Sting allergic patients win because they can be freed from the fear of going out into nature without worrying about going into anaphylactic shock. Everyone wins because the environment is not filled with nasty pesticides poisoning our water and our food.
Wouldn’t it be great to have someone like me in every county in America? Alas, because we do not have totally free market pharmaceutical companies will continue to push epi-pens. These pens do not cure anything and have a high rate of failure. Insurance companies do not offer desensitization as part of their plans because it costs too much. They would rather people pay for epi-pens which, if used properly, may give a sting allergic patient enough time to get help. I say “may” because these pens are known to fail. Many allergists do not promote sting desensitization even though it is the single most effective cure in all of medicine. Because of this the medical lab only needs a few collectors who will come to your house and remove your stinging pest for free. Instead of people getting cured and homeowners getting this free service all over the country, there are only a few guys like me around.Link here.
MIGRATING TOWARD MEDIOCRITY
It is nice to step back from the world of mainstream media, where I have been making the case I made in The Bull Hunter. The mainstream media is reluctant to embrace the ideas I have outlined, or at least to follow them through to their logical conclusion. And what is the logical conclusion, you might ask? America is creating jobs over 207,000, according to the Labor Department last week. But when you look closer, 50,000 of those jobs were in the retail business. Most commentators viewed this with anxiety, but for the wrong reason. The conventional wisdom is that the report indicates inflationary pressures and that the Fed will have to keep raising rates. In reality, the bigger concern is that American jobs are being created, on average, at lower average hourly wages.
This is the vaunted shift to the “service” economy, driven by spending. Step back for a second and ask yourself this simple question: How does a nation get rich spending money? If you have a good answer to that question, let me know. In the meantime, the other big drivers of employment growth were construction and government. In fact, since 2001, over 40% of new jobs have been in housing related industries (construction, real estate, mortgage lending). This is just one example of how housing-centric the U.S. economy has become. In a healthy economy, business investment creates new employment, which in turn creates new incomes and jobs. Business spending (out of the pool of available saving) comes first. Consumer spending comes next.
In an economy run by economic illiterates, consumer spending (through debt and home equity extraction) is praised. Savings fall to zero. No mention is made that the main drivers of employment and GDP growth are based on debt. No mention is made that American wages are in a soft, slow motion swan dive as a result of a globalized labor market. No mention is made of a study by McKinsey & Co. that up to 9 million white-collar jobs may be outsourced, in addition to the 3 million manufacturing jobs that have already left these shores. And no mention is made that Great Britain and the U.S. did not get rich by consuming and spending. They got rich by producing and trading.
I have been asked what America can do to turn things around, to get competitive, to fight back. My suggestion is that the most American thing of all to do is to take care of yourself and your family. There are some economic and monetary policies that could help. But I would not count on getting that help. Not anytime soon. In the meantime, paper assets driven by low interest rates are going to keep going down. Hard assets, driven by intense global demand for scarce resources, will go up. You will see rising prices in hard assets (like $64 oil) and falling prices for financial assets and stocks. This sorting out (or “reckoning”, if you prefer) is just now getting started.Link here.
A reality check for corporate America.
“History shows,” wrote Jim Rogers in the foreword to our first book, Financial Reckoning Day, “that people who save and invest grow and prosper, and the others deteriorate and collapse.” Business investment creates economic recoveries. Without that investment, we have no right to expect a recovery. The Fed and other monetary gurus claim that the low level of business investment is to be blamed on excess inventories and low demand overseas. But realistically, corporate America has gone through a trend in the past two decades in which dwindling profits have led to increased levels of mergers and acquisitions, but little change in the lagging profit picture. The belief, or the hope, that merging and internal cost cutting would solve profitability problems has been dashed. It has not worked.
Corporate America is coming to the point of having to face its own set of realities. First of all, merging does not improve profits if the market itself is weak. Lacking real investment in plant and equipment, long-term growth is less likely today than before the merger mania and the growing trade deficit. Coupled with this is an expanding obligation for pension liabilities among large corporations. The problem of deceptive reporting is not limited to the government. Corporations do the same thing.
Consider the following: many corporations have notoriously inflated their earnings reports – and not just Enron. Quite legitimately, and with the blessings of the accounting industry, companies exclude many big expense items from their operating statements and may include revenues that should be left out. Exclusions like employee stock option expenses can be huge. At the same time, including estimated earnings from future investments of pension plan assets is only an estimate, and cannot be called reliable. Standard & Poor’s has devised a method for making adjustments to arrive at a company’s core earnings. Those are the earnings from the primary business of the company, and anything reported should be recurring. For example, in 2002, E.I. du Pont de Nemours (DuPont) reported earnings of more than $5 billion based on an audited statement and in compliance with all of the rules. But when adjustments were made to arrive at core earnings, the $5 billion profit was reduced to a $347 million loss.
In accounting, any adjustment made in earnings has to have an offset somewhere. So when Citicorp overreports its earnings by $13.7 billion, that means it has also understated its liabilities by the same amount – a fact that should be very troubling to stockholders. One of the largest of the core earnings adjustments is unfunded pension plan liabilities. United Airlines, for example, announced in 2004 that it was going to stop funding pension contributions. After filing Chapter 11 bankruptcy in 2002, the United Airlines unfunded liability is an estimated $6.4 billion. We are just scratching the surface. When we hear that a corporation has not recorded employee stock option expenses of $1 billion, that also means the company’s net worth is exaggerated by the same amount – and the book value of the company is exaggerated. So all of the numbers investors depend on are simply wrong.
Filing for bankruptcy often becomes the only way out when the corporations cannot afford to meet their pension obligations. We can learn a lot from the corporate dilemma. And we can apply what we observe to the way the Fed is running monetary policies. In explaining the complexities of calculating value and explaining how or why dollars fall (thus losing purchasing power), the Fed has become very much like a corporate chief financial officer (CFO) trying to explain why things have gone south. Corporate management may be reined in, to some extent, by changes in federal law. The Sarbanes-Oxley Act changed the culture in some important ways. But until the accounting industry goes through some changes of its own, the corporate problem will not disappear. It appears so far that the disaster of Arthur Andersen has been viewed in the accounting industry as a public relations problem rather than what it really is: a deep, cultural failure within the business to protect the stockholders.
The parallels between corporate failures and government policy are alarming, if only because the Fed is not accountable to the SEC or to stockholders in the same way that a corporate CEO and CFO are – and civil fines or imprisonment are out of the question. So as far as accountability is concerned, it looks like the borrowing and spending should continue – with yet more wild abandon. The halfhearted debate over the twin deficits in trade and budget involve some big numbers, but the Fed is not concerned. The so-called U.S. expansion has been a nonexpansion. Corporate profits fell in the 1980s from 5.1% percent of GDP down to 3.7%. By definition, a profitless expansion is not really an expansion at all. The bubble economy of the 1980s was the beginning of a worsening effect in real numbers that built throughout the 1990s and beyond.Link here (scroll down to piece by Addison Wiggin).
WRITING COVERED CALL OPTIONS A VIABLE HEDGE AGAINST VOLATILITY
It is always true, dear investor, that some investor somewhere will be making more money on something than you will. Such is the natural order of the universe … someone is smarter, someone is prettier, someone is luckier and someone is making more money in the stock market. But we accept these realities without complaint. We do not care to join the “thin tails” of life’s bell curve, merely to avoid the losing side of the probability distribution. We do not care about winning the lottery, for example, we just do not want to lose our shirt. To further this ambition, selling options can be a helpful ally.
The nearby chart tracks the historical performance of two Valero Energy (VLO) investments: 1) An unhedged 500-share purchase in early March and; 2) A 500-share purchase hedged by the simultaneous short-sale of 5 VLO January 70 call options. The unhedged purchase of VLO would have produced twice the return of the covered call position established in early March, but it also would have subjected investors to much higher volatility. As of May 16, for example, the naked VLO buyer would have been nursing a paper loss of more than $4,000. By contrast, the covered-call investor never saw a loss of more than $1,800. That is because the drop in value on the “short” call option offset some of the losses on the “long” VLO stock. Such is the beauty of covered-calls.
And let us not forget that VLO might not have recovered as promptly as it did. It could have languished at lower levels for many months. In which case, the covered-call writer would be sitting on small profits or very small losses, while the naked stock buyer would be suffering large losses. We would also point out that the example used is one of the most conservative of all possible option strategies. Had we wished to be a little more aggressive, for example, we could have sold short options with a higher strike price, instead of the January 70s. If he had sold short the VLO January 80 call options, for example, the covered call position would be up about 20% right now, instead of 14%. Option-selling is not appropriate for every stock. But it is not a bad strategy for the “stocks that make you nervous.”Link here.
INEPT BOARDS NEED HAVE NO FEAR
HOW irresponsible does an outside director have to be before he or she faces legal responsibility for nonperformance of duties? Very, very irresponsible. The week’s most impressive affirmation of the right of directors to blithely take their fees while ignoring their duties did not come from Delaware, where a judge had harsh criticism for Disney directors in connection with the hiring and firing of Michael Ovitz, but concluded that they had acted legally. Instead it came from North Carolina, where a special committee of the Krispy Kreme Doughnuts board, composed of two directors who were brought on after that highflier crashed, concluded that directors should not face any legal responsibility.
Krispy Kreme is a company whose apparent early success, the special committee now tells us, was based in part on accounting errors. When things appeared good, Krispy Kreme made money largely through payments from franchisees, but many of them have been struggling. In the long run, a successful franchisor must have successful franchisees, and there is no proof that is possible in this company. Think of Krispy Kreme as an un-tobacco company. You will not find doctors endorsing either cigarettes or doughnuts, but cigarettes are addictive and thus bring in good profit margins. Krispy Kreme doughnuts sales decline as the novelty wanes.
The board of Krispy Kreme watched on the sidelines as the disaster was unfolding. It rubber-stamped the spending of money from the initial offering to reacquire franchises, sometimes from insiders. It did so on the basis of what the committee says were brief analyses that “have a back of the envelope feel”. In one case, after the board approved the transaction, the management decided to pay $1 million more than the board had authorized, but apparently did not tell the board.
That transaction was significant because it involved a Northern California franchise partly owned by the former wife of Scott Livengood, then Krispy Kreme’s chief executive. The committee says she was treated no better than other owners of that franchise, but does not say if the price was fair. “OUR investigation left us with the impression that the board did not oversee management’s processes and decisions with an appropriately skeptical eye,” the committee concluded. “While we heard complaints by some board members about a lack of timely, meaningful information, it does not appear that the board forcefully sought more detailed and timely reports from management.” The committee lays out a harsh view of the directors’ performance but says the company should oppose suits against those directors.
The special committee, composed of Michael Sutton, a former chief accountant of the SEC, and Lizanne Thomas, a partner in Jones Day, a large law firm, deserves credit for what appears to be a thorough investigation. And they provide evidence of highly suspect stock sales by insiders while incorrect accounting results were being reported. But if their view of director responsibility does prove to be correct, it will be clear that careless and lazy directors need have nothing to fear.Link here.
DON’T FALL FOR OIL/GAS HYPE
Blame the media for gasoline hitting a record $2.37 a gallon this week and crude oil peaking at an unprecedented $65.01 yesterday. Why? Because instead of being a watchdog, the press has become a lapdog and dupe of the speculators and oil companies that want gasoline prices to stay high. Here are some facts and some fiction about the current state of the oil market.
Hype: There is a shortage of oil, and that is why we are paying so much at the pump. Fact: A government report released yesterday said the U.S. now has 320.8 million barrels of oil in stockpiles. – 0.9% higher than just the week before and 9.7% above the level last year. Hype: Oil could be shut off in the Middle East at any time. Fact: That is true, but that has been true for the past four decades. Middle Eastern oil producers need to sell us oil as much as we need to buy it, so while a disruption is a possibility we now have 9.7% more oil on hand than we did last year. And supplies have risen despite the U.S. government’s purchase of millions of barrels of oil over the past year for the Strategic Petroleum Reserve – our emergency supply – which is now 4.9% more full than it was last year. The SPR is almost at capacity, so Washington soon will not be competing with others on the open market.
Hype: The Iraqi war or demand by the Chinese could cause shortages. Fact: They could, but they have not. The U.S. is still awash in oil. Hype: There have been no new oil refineries built in this country in decades. Fact: True and false. There has been no new refinery built in the U.S. since 1976, but many of the existing refineries have been expanding, and our capacity is now 10% greater than it was in 1976. Plus, refineries are being built and expanded all over the world – especially in friendly countries like the former Soviet Republics. Hype: There will be a lot of hurricanes this year, which could disrupt refining. Fact: Maybe, but this is the kind of scare tactic that oil speculators use to enrich themselves. Hurricanes may not disrupt refining, too. Hype: There will be refinery fires this year. So what! Fires and breakdowns get fixed and the refineries go back into full operation.
Hype: There is going to be a shortage of heating oil this year. Fact: Our stockpiles of distillate fuel oil – diesel and home heating oil – are 5.6% higher this year than in 2005. Hype: But that will not be enough if it is a cold winter. Fact: This is another scare tactic used by speculators. The press should not simply take the word of so-called experts on Wall Street and in the oil industry who make money when the price of oil rises. The only real fact that matters: distillate fuel stocks are up a very large 5.6%. Hype: There is less gasoline today than last year. Fact: That one does happen to be true – 3.7% less, in fact. But our gasoline stocks are still as high as they were in November 2004. So why is the price of gasoline now at a record $2.37 a gallon?
Is the press so desperate for a good summer story that it is willing to sell out the public and go along with all this Wall Street hype? Apparently, yes.Link here.
Hedge funds see oil price surge as “inevitable”.
In chasing oil prices higher hedge funds are only hastening the inevitable because they anticipate a global shortage within years, a London-based fund manager said. Hedge funds, lightly regulated and normally able to deploy a wider range of investment tools than traditional fund managers, are often accused of pushing prices up or down beyond levels justified by underlying economics. But Ashok Shah, chief investment officer at London & Capital, expects demand for crude oil to rise by 2 to 3 million barrels per day each year if global economic growth continues at around 4% a year. “Excess capacity at the moment is only 2 million barrels a day,” he said. “Hedge funds are only accelerating a process that is unavoidable … They are basically the new vigilantes in financial and commodity markets.”Link here.
FLATTENING YIELD CURVE SQUEEZES BANKS
The Federal Reserve’s moves to keep inflation under control has put pressure on banks and Wall Street firms as the yield curve flattens, according to a report in The Wall Street Journal. A flattening yield curve - the difference between short- and long-term rates–- is generally an issue of concern for banks that borrow money at low short-term rates and lend it to consumers and corporations at higher long-term rates. As the spread between long- and short-term rates fall, banks are struggling to replace the loss of income. If market watchers’ predictions prove accurate, the yield curve could disappear by the end of the year.
The Fed is expected to raise rates for the tenth time in 14 months, bringing the short-term interest rate to 3.5%. But long-term rates are still dramatically low, and according to a poll by the Bond Market Association, 12 big Wall Street banks and securities dealers forecast that the spread between long- and short-term rates could fall to 0.15% by then end of 2005. As of Monday, the spread fell to about 0.27%.
And if short-term rates start to climb higher than long-term rates, banks could lose their incentive to lend. In the past, a flat yield curve inversion has signaled the start of a recession, but some economists see a different scenario this time around. Economists speculate that falling long-term increases have offset the braking effect of the short-term rate increases, which could allow people and companies to bypass banks altogether and obtain low, long-term rates from alternate lenders or the bond market. That is good news for consumers … and bad news for the banking industry.
The flattening yield curve has already taken a toll on second-quarter earnings at large players such as Bank of America, North Fork Bancorp, and J.P Morgan Chase, according to an analysis by Piper Jaffray’s banking analyst Andrew Collins. Citigroup financial chief Sallie Krawcheck blamed the flattening yield curve for the company’s lackluster second quarter. To compensate, banks have been cutting costs and setting aside less in reserves to cover bad loans to boost earnings. But that strategy could backfire if credit quality starts to deteriorate.Link here.
INDIVIDUALS CANNOT BE TRUSTED WITH SOCIAL SECURITY EITHER
Every time I write about Social Security, I get an email box full of letters from readers who just plain do not like the philosophy behind the government-run retirement insurance program. They do not like the idea that the government takes their money and, after “investing” it for them, decides how big a check they will receive every month after they have reached some bureaucratically determined retirement age. It is paternalistic because it assumes the government invests our money better than we would. And it is coercive because the government does not give most of us a choice about whether we are going to participate in the system. All of which is true. The program is bureaucratic, often arbitrary, definitely paternalistic and certainly coercive.
But a recent study from Hewitt Associates, the global human-resources management and consulting company, argues that paternalism and coercion are exactly what most Americans need, at least when it comes to saving for retirement. It also says that the average 401(k) retirement savings plan could use a bit less freedom and a tad more paternalism and coercion. I know that goes against the philosophical and political grain for many of us. But frankly, the Hewitt Associates study says that many of us are not exactly in need of more financial freedom and that we are not ready to take on more financial responsibility. Put that in your pipe and smoke it when the discussion turns to how to reform Social Security.
Here is what Hewitt Associates found in a study of nearly 200,000 workers who participate in 401(k) retirement plans: 1.) 45% of workers take a cash distribution from their 401(k) plans when they leave or change jobs. In other words, they take money out of their 401(k) retirement plan and spend it. 2.) 66% of workers aged 20 to 29 take a cash distribution. In other words, the very workers who have the most to gain from compounding over time take money out of their retirement plan and spend it. 3.) 42% of workers aged 40 to 49 take a cash distribution. In other words, workers in their prime retirement-savings years take money out of their 401(k) and spend it. 4.) 73% of workers with balances under $10,000 take a cash distribution. In other words, workers with very little put aside for retirement, either because they have just started to contribute to a 401(k) or because they do not make much money, are saying, “To heck with a $10,000 nest egg and a lifetime of saving,” and just spend their balance.
Now, granted, the data I have seen from the Hewitt study do not distinguish between the worker who takes everything out of his or her 401(k) and spends every last dollar and the worker who spends just 10% before reinvesting it. But the picture still is not very comforting. When it comes to figuring out how a rapidly aging society can avoid a retirement crisis, I keep hearing the words of Walt Kelly’s Pogo: “We have met the enemy, and he is us.”Link here.
EXPERIENCE, SUCCESS, AND FAILURE: WHICH IS THE BEST TEACHER?
It is true that experience can be a great teacher, but truer still that people learn more from failure than from success. And when it comes to real estate in the past 20 years, success has been the only experience most people have had. It has usually paid to become a realtor, a mortgage broker, a homebuyer, a home seller; in the past two or three years it has even paid to become a speculator. This is all due to what has seemed to be the simple fact of life: Rising prices have been the defining truth about home values.
Yet there are other truths to consider, even if they do not fit into the experiences of enough people. One is that trends change. Another is that trends usually change at the point when the fewest people expect it. And while I am at it, trends in the stock market anticipate trends in the economy, not the other way around.
So what is the significance of the downtrend in the Home Builders and the Mortgage Finance Indexes over the past six to eight weeks? Well, the double-digit declines have gone virtually unnoticed in the financial press. It is also noteworthy that nothing like this has happened for a very long time, especially in the Home Builders Index. Clearly these sector index downturns do not reflect a move south in home prices themselves, although I did see that the Wall Street Journal ran a long story about the recent and very noticeable rise in the inventory of homes for sale, particularly in housing markets that have been the “hottest”.Link here.
“THE ABSENCE OF LOGICAL TRENDS”
Forex may be the world’s largest and most liquid market, but the success rate among currency traders is the same as of all other market speculators – namely, the absolute majority of traders end up losing money. To wit, the Financial Times reports that a small forex hedge fund has just been liquidated “due to disappointing performance.” This really would not be a newsworthy item if not for one detail: The fund was run by Mr. Avinash Persaud, “an academic and currency guru well known in the industry as chairman of financial advisory firms, professor of commerce at Gresham College, and previously global head of research for State Street.”
Professor Persaud’s operation was not the only “momentum-driven” hedge fund that has been struggling lately. While the U.S. dollar was trending against the euro and other currencies, momentum traders did well. But as the buck went into a sideways trading range in 2004, their performance began slipping. This year has been no picnic for trend-followers either, since most of them were caught off guard by the dollar’s surprisingly strong comeback. In fact, BNP Paribas’s data show that “the average currency hedge fund lost 1.3% in 2004 and 1.7% in the first half of 2005. As Professor Persaud puts it, “The absence of trends had made things hard. The absence of logical trends makes it even harder still.”
Now we are on to something. Just like the ill-fated Long Term Capital Management hedge fund that nearly collapsed the world’s financial system in 1998, many of today’s fund managers continue expecting the markets to behave logically. But markets rarely do, and forex markets are no exception. As a latest example, the Wall Street Journal observed today that, “the U.S. dolla’qs decline in recent weeks has come despite strong U.S. economic data.” Go figure. As Elliotticians, we believe the markets are driven not by logic, but by fear and greed – that is, human psychology with all its pitfalls and illogical extremes. And Elliott wave is only method we know that helps predict how and when collective psychology may go through another shift, logical or not.Link here.
INFLATIONISTS MISSING THE BIG PICTURE
The inflation versus deflation debate is the most interesting, as well as the most hotly debated, macroeconomic issue concerning the current secular bear market in global equities. The current cyclical bull market (2002-05) notwithstanding, the “Great Recession” is still with us. The five years that have passed since the stock market peak in 2000 most likely contain the easy part of the 10 to 20 year economic bust. A critical aspect for a person’s desire for capital preservation is to know whether the rest of the bust will be characterized by inflation or not. Ignoring the other side of the (for now) academic debate, as part of an “I’m right” zeal, can doom an investor to years of losses or sub par returns. Indeed, the world economy might deal a pernicious dose of both inflation and deflation to everyone’s dismay. While I cannot expose all my ideas on this issue in one short article, I first focus on one critical aspect, that bigger power brokers can trump big ones.
“Give someone a hammer, and everything looks like a nail.” Those inflationists with economics or mathematics backgrounds, with their data plots representing equations laden with logarithms, derivatives and exponentials (I took one, maybe two dozen college math courses), often fall into this logical trap. There is no room in their plots for outside-the-chart thinking that could result in discontinuities in the otherwise smooth lines or clean waves. Current trends NEVER continue! Many inflationists dismiss phenomena such as politics, mass psychology, and event risk. These messy and unquantifiable “what ifs”, however, still exist, and serious investors must literally take them into account. The focus on the realm of numbers, intensified by looking backwards in time, sits at the heart of why many inflationists miss the big picture.
Inflation versus deflation articles repeatedly delve into definitions. While I have my own extensive views about the meaning of up and down, I will (perhaps mercifully) postpone such irreverent discussion. At the risk of oversimplification, I will restrict inflation, with a few strokes of the keyboard, to the increase in price level of a basket of goods and services in the USA. Note that the popularized measures of this narrowly defined inflation, such as CPI, core rates, deflators, etc., do not even do a good job of this task. Their resultant effect on asset prices is what concerns investors struggling to profit in an overpriced world.
Now, back to the future. There are basically two camps on how the sharp end of the Great Recession will play out over the next ten or so years. The inflationists argue for a surge in inflation. Like that 1970’s show, irresponsible government and quasi-government institutions will print vast quantities of valueless fiat currency in the vain attempt to anesthetize the voting populace from any and all economic pain. On the other hand, the deflationists contend that the next decade will feel more like the desperate 1930’s. A few well-placed mortals cannot overcome the Kondratieff cycle of market economies, they say. The inevitable aftermath of the feel-good 1982-2000 “autumn” can only be a dark, deflationary winter.
GDP, trade deficits, trillions in debt, central banks, international asset, labor, and goods markets – what can be bigger than the global economy? Here the inflationists miss the boat on one important point. The crux of their argument stems in their contention that central banks, most notably the U.S. Federal Reserve Bank, one of the most powerful quasi-government institutions in the world, will never let deflation occur. Everybody knows that deflation renders central banks powerless. Their most potent weapon, the level of short-term interest rates, then become ineffective because zero is as low as they can go. When prices are falling, and people cannot earn money in a bank account, they will just withdraw it and stuff it in their safe deposit boxes. Thus, the “Fed” will just create money out of thin air in their own bank account. Computers are much faster than printing presses to this end.
The implied omnipotence of central banks is an incorrect characterization. Central banks, including the USA’s and China’s, do not hold the commanding heights over their own economies, let alone over the global economy. There are other, bigger players, ready to overrule the central bank. If there were a currency crisis in the next decade, which could involve the mere threat of sudden devaluation, let alone an actual one like Argentina had just a few years ago, do you think the U.S. government would stand idly by and let the dollar crash in the currency markets? Elected government officials like and will continue to jealously guard their positions of power in Washington, DC. As they feel that power dropping with the dollar’s value, are they going to delegate economy fixing authority to a recession–phobic federal reserve? Not a chance. The U.S. federal reserve does not operate in a political vacuum.
How would the U.S. government fight a dollar crisis? Like backward looking generals, it would fight the last war. There was a dollar crisis in the 1970s, with the U.S. going off the gold standard, oil embargos, soaring inflation, mobbed gasoline stations, recessions, stagflation, exponential precious metals prices, and WIN (Whip Inflation Now) buttons. Eventually the elected politicians in the U.S. were forced to act strongly. Along came Paul Volcker, appointed to chairmanship of the federal reserve, armed with a single mindedness to destroy inflation, and determined to increase interest rates regardless of the economic cost. He provided a spectacular economic discontinuity in 1979-80. The resulting high real interest rates created benign disinflation from the mid 1980s to the late 1990s. A 2010 (to guess on a year) administration would see that paradigm, and think that we could do it again. The heat would be turned on the federal reserve to increase short term interest rates to save the dollar.
The result might not be the same next time, since all other things will not be equal to the 1970s USA. A scenario of downsized wages and benefits, unsustainably high consumer, corporate, and government debt loads, and the subsequent cascade of bankruptcies and credit destruction could mean that inflation drops below zero for an extended period of time – even 10 months, let alone 10 years, would feel like a long time – but that’s another article. Even now, the more I hear protests that the U.S. is not like the deflationary Japan of the 1990s, the more we’re turning Japanese. I have read that elected politicians would have no stomach to risk serious recession(s) by creating an environment in which real interest rates surge. I am not confident that the logic would match political reality. Interest rate hawks might have a strong political ally. I see the huge baby boomer segment of the population increasingly demand investment income, as opposed to capital appreciation. To those millions of registered voters with nonzero portfolios, increasing real interest rates would be a GOOD thing. The inflationists counter that the U.S. government would not want to raise taxes, and instead inflate away, its debt. Oh, really? Rather than risk superpower status, why not raise taxes in a politically palatable way? “An across the board tariff on all imported goods and services! Let’s get America back on its feet again.” This is one scenario out of many that I can envision in which an inflation and deflation combine to devastate the standard of living in the US, thus confounding both the inflationists and deflationists. Markets enjoy maximizing investor frustration.
Can the inflationists be correct? There is a possibility that shocking price increases, even hyperinflation, will negate the current deflationary pressures of globalization and irredeemable debt accumulation. Dollar devaluation would shift into high gear. Perhaps there is a cycle bigger than the “K-wave” that totally trumps deflation. While this “ugly” scenario might not be quite what most inflationists have in mind, the general idea of creating monopoly money from nothing is common. They remain convinced that the federal reserve bank’s supposedly unlimited power to create money will inevitably overpower deflation. Inflationists focus on chartable measures of money supplies, at the risk of ignoring innumerable factors that are integral parts of the economic big picture. Both they and their deflationist colleagues risk much more than they realize with their one-way bets. Krassimir Petrov proposes that China, with its huge surpluses, will do anything to prevent Stephen Roach’s “global imbalances” from crashing down before the 2008 Beijing Olympics. Thus, we just might have some time to theorize, strategize, invest, and hedge before the Great Recession decides the inflation question for us.Link here.
THE ART OF DOING NOTHING
Tomorrow morning your editor will hop a plane to Colorado, where he hopes to continue perfecting his aptitude for doing nothing … or at least for doing as little as possible. He would like to do SOMETHING while he is away, but he has come to understand how counterproductive that can be. The vacationer who does too much, risks exhausting the very mind and body he should be rejuvenating. Likewise, the investor who does too much, risks exhausting a portfolio’s potential to deliver capital gains. “Do nothing!” the world’s finest investors advise.
Folks like Warren Buffett, Ralph Wanger and Marty Whitman all hail from the minimalist school of investing. That is, they all practice a financial version of the Hippocratic Oath: “First, do no harm.” [Editor’s note: Contrary to the popular misconception, the Hippocratic Oath does not actually contain this phrase. Nevertheless, “do no harm” is clearly the sentiment that the oath conveys.] It is perhaps no accident, therefore, that all three of these gentlemen have quintupled their investors’ money over the last 12 years, handily outdistancing the S&P 500 in the process (see chart).
Warren Buffett is, of course, the founder and chairman of Berkshire Hathaway (NYSE: BRK/A), the world’s most successful holding company. Thanks to Berkshire’s many successes, Buffett has become the world’s second richest human. Ralph Wanger has never made the Forbes list of richest individuals, but his investment skills have brought infinite riches to the owners of his Columbia Acorn Fund (ACRNX), a mutual fund dedicated to small- and mid-cap value stocks. Marty Whitman also runs a value-focused mutual fund. His Third Avenue Value Fund (TAVFX) pursues a classic Graham and Dodd strategy: Buying well-financed companies at a substantial discount to their intrinsic value. Buffett unabashedly credits his infrequent investment activity for much of his success. In Berkshire Hathaway’s 1990 annual report Buffett wrote, “Lethargy bordering on sloth remains the cornerstone of our investment style: This year we neither bought nor sold a share of five of our six major holdings.”
Wanger advocates a similar approach, as he explained recently when chatting face-to-face with our own Chris Mayer. “Most investors over-trade,” he says. Instead of trading, they should be buying “boring stocks” that nobody wants, then hanging onto them for the long-term. “Give your stocks time to work,” Wanger advises. Whitman, no surprise, pursues a similar strategy … if we may call it that. “You make more money sitting on your ass,” Marty Whitman indelicately explained to Jim Grant recently. “We’re buy-and-hold. I’ve been in this business over 50 years. I have had a lot of experience holding stocks for three years; doubled, and I sold them to somebody else for whom it tripled in the next six months.”
Therefore, Whitman has become slower to pull the “sell” lever than he used to be. He will readily sell a “grossly overvalued” security, he says, but steadfastly refuses to eject a “modestly overpriced” one. Whitman’s unique style of “ass-sitting” seems to be working. Over the last 15 years, his Third Avenue Value Fund has produced double the return of the S&P 500 – a nifty 16% annualized. So what is this indolent investor sitting on currently? Japan’s Toyota Industries represents 6.4% of his fund. His other top-10 holdings include a bevy of real estate securities like St. Joe Co. (NYSE: JOE), Tejon Ranch (NYSE: TRC), Brascan (NYSE: BN) and Hutchison Whampoa (HK: 13). Whitman admits that these securities are not as cheap as they were three years ago. But he is content, nevertheless, to continue sitting on them … just like he always does.
The collective message from Messieurs Buffett, Wanger and Whitman is very clear; whoever hopes to become a truly successful investor must learn to do nothing.Link here.
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