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SLAUGHTER OF THE HOUSING SPECULATORS
These days, “Get Rich Quick” has been the mantra for too many people trying to cash in while buying real estate speculatively. With so much “free” money still flowing from the Federal Reserve, it has become a real estate speculator’s dream world. These so called speculators have purchased over 3 million residences, practically with their eyes closed, with the sole intention of flipping them like pancakes to the next guy, marked up 25 percent or more. However, signs are beginning to appear that indicate this game of getting rich quick may soon be over.
Less than 20% of Californians can now afford a home with a fixed rate mortgage. The Federal Reserve is still raising variable interest rates. In 2004, when the housing bubble was really gathering steam, the National Association of Realtors calculated that 23% of homes purchased were for investment, and 13% were for second homes. Home sales run about 9 million a year (this includes housing starts of 2 million and existing home sales of 7 million). If over 20% of homes purchased are investor properties, it appears that practically all new housing starts in America are accounted for by speculative buying. If second home buyers are added into the equation, speculative and investment buying of real estate (not owning to live in) actually exceeds total housing starts! There are problems associated with owning second homes and investor properties. Unless these properties are rented out, they yield no cash income and become cash vampires, sucking the owner dry because of escalating taxes, maintenance, the Alternative Minimum Tax, and higher floating-rate mortgage payments.
Today’s inexperienced housing investors may not realize that the hard costs (tax, insurance and maintenance) along with the soft costs (revenue lost due to vacancy, and property management services so you don’t have to become the landlord) can easily eat up over 30% of rental income before even making the mortgage payment. In looking at some cities with major price appreciation (New York, Boston, San Diego, Miami, to name a few), in today’s world it just does not seem possible to buy a house or condo and expect to make an economic return renting it out! Nationwide, there are over 3.8 million vacant units available for rent. In some communities, the over-supply of rental units on the market has pushed the average rent down as much as 20%. There remains a surplus of rental units.
First quarter 2005 statistics indicate, nationwide, there are 440,000 new homes for sale and 2,400,000 used homes for sale. By recent historical standards, these numbers account for a 4-month supply and do not look worrisome. However, given what is really going on, this is about as safe as saying “if you see ice on a pond, it must be safe to walk on”. The latest HUD statistics show that of all occupied housing units, over 69% are owned (not rented). If housing speculators stop buying, who is left to buy? The average American with a job has already bought.
One of the biggest problems I see for our housing speculator is the forward supply of new homes they have already been locked into. Certainly, on the east and west coasts and in Las Vegas – and other frothy vacation and major markets – high rise after high rise are coming out of the ground. There is another “dark side” to speculating in real estate. Hundreds of thousands of units that have been sold in advance by developers to speculators. It could get interesting over the next six months as interest rates continue to go up and thousands of high-priced housing units come on the market that have been artificially snapped up by the get rich quick crowd. It may pay to simply sit back and watch the slaughter from a distance.Link here.
Cuckoo for condos!
Get in early! Get out fast! Sound familiar? Everyone knows how the dotcom party ended. Right? Right? Condos are to the real estate boom what Internet stocks were to the 1990s bull market. And like the Internet day-traders before them, the new condo flippers, with their talk of instant riches and easy money, are about to become the life of every cocktail party. And why not? Condo prices have soared 80% in the past five years, making the same period’s 40% rise for single-family homes look almost pokey. Developers are constructing new condo units at nearly twice the pace they were in 1999, and investors are literally lining up to buy one, two, three or more. In Miami, as much as 75% of some condo towers are investor-owned.
No cash? No problem. Banks, with their loosened lending standards, no-money-down loans and teaser mortgage rates, are making it easier than ever to be a mogul-in-training. Mix it all together – rising prices, record levels of construction, fast-and-loose mortgages and swelling ranks of new investors – and you get a market more volatile than Tom Cruise. “To some degree, what’s driving condo prices is sheer greed,” says economist Gleb Nachayev of Torto Wheaton Research, which forecasts a relatively mild drop of as much as 3% for U.S. housing prices overall in the next year. “Condo prices have increased faster than single-family homes – and they will fall faster.”
As they did little more than a decade ago. Overbuilt and over-concentrated in city centers, the condo market collapsed in the early ‘90s, smashing overstretched owners in the process. No one knows when history will repeat itself. But c’mon: The easy money has been made. The right time to invest is not after a record 5-year run-up in prices. It is not when the supply of new product is set to nearly double. If you are really drawn to the market, you need a deeper understanding of what is driving prices up – and what can drive them down. Above all, do not confuse what has worked in the recent past with what will work over the long haul.Link here.
Hero for speculators: Davy Crockett
What this country needs is a new national holiday. We have a holiday to honor the founding fathers, with their stoic dedication to republican virtue. We honor a leader who showed moral strength under the extreme stress of the Civil War. We honor a visionary who had a dream of a better America. But for the speculators, the gamblers, the go-for-broke players who bet the mortgage money on the 100-1 long shot? Nothing.
I have a nominee: David Crockett, born on Aug. 17, 1786. I cannot think of a better hero for our times – when real-estate speculation has become required backyard chatter, when Wall Street cannot wait to throw money at lenders of any stripe, and when the derivatives market is so busy creating new products to control risk that it cannot be bothered to figure out the risk in the paper products it has already invented.
Why Crockett? If you know of Crockett at all, you likely know him as a coonskin-hatted man of the backwoods, and as a hero at the battle of the Alamo in Texas, where he died fighting against hopeless odds. But Davy Crockett was much, much more. Crockett’s career combined politics and real-estate speculation, showed that no risk was too big, emphasized flipping assets and left the grinding hard work of building real wealth to others. He is exactly the icon for our times.Link here.
Three generations, one home.
The number of American households with three or more generations living under the same roof rose 38% from 1990 to 2000, according to a new report from the U.S. Census Bureau. Multigenerational households still represent a small percentage of US living arrangements. But the increase – more than double the growth of U.S. households overall – shows that many Americans are starting to reverse the long-term pattern of living independently, experts say.
Both the longevity of seniors and their desire to live in age-integrated communities plays a role in multigenerational living. Many times unmarried mothers will move back with their parents. Immigration from countries where the cultural norm is to live with extended families is also a factor. But many experts say it is a trend that, even with positive byproducts, is driven in large part by financial strain.Link here.
Updating the Mortgage Finance Bubble.
This is a most fascinating period for analyzing the Mortgage Finance Bubble. On the one hand, with both home transaction volumes and average prices at all-time highs, mortgage credit growth remains at extreme levels. Fannie’s latest forecast has mortgage debt expanding by 10.4% this year, this following the doubling of mortgage borrowings over the previous seven years. On the other hand, there is clearly newfound seriousness by bank regulators seeking to stymie the riskiest bank lending practices. And while home sales remain at a record pace, the inventory of unsold homes is rising. Some of the hottest markets are experiencing a rapid buildup of houses for sale. The highflying mortgage REIT and subprime stocks are coming back to earth, while MBS spreads are quietly widening. Meanwhile, the media are now all over the housing bubble story.
If this were a decade ago, I would be forcefully arguing that the top was in and warning that air would soon be seeping from the Mortgage Finance Bubble. Such assuredness would stem from my confidence that regulatory restraint would soon instill caution throughout the banking community, especially in the conspicuously frothy markets. Credit availability and marketplace liquidity would almost immediately be impacted, ushering in the downside of the credit cycle. Today, the nature of the analysis leaves me less confident. Bankers were supplanted as the marginal source of housing liquidity by the securities markets and the leveraged speculating community.
Can today’s securities and speculator-driven marketplace/credit system effectively regulate credit creation and marketplace liquidity? It certainly does not appear that it can. While a spike in yields would abruptly and perhaps radically change liquidity and speculative dynamics, is there some market rate below the crisis point that would stabilize mortgage credit excess without bursting the Bubble? I doubt it is possible. The bottom line, with regard to Updating the Mortgage Finance Bubble, is that interest rates and marketplace liquidity remain highly accommodative to ongoing dangerous excess. The worst-case scenario continues to play out. As such, the fluid environment beckons for the attentive monitoring of the interplay between the Mortgage Finance Bubble and the Leverage Speculating Bubble.Link here (scroll down to last section).
Where real estate is unreal.
Welcome to Bubbleland, USA. Here on vacation, my bride and I were wandering around this quaint tourist village across the bay from downtown San Diego when we came across a cute little house a couple of blocks off the beach. It is a pretty nice house, not all that different from a lot of houses you can find in Prairie Village or Raytown (Kansas). Built in 1960, the three-bedroom ranch totals a little more than 2,000 square feet of space, roughly average for an American house. In a nod to the nearly perfect year-round weather in San Diego, where locals profusely apologize to visitors if there is a single cloud in the sky, the house features an in-ground pool on the quarter-acre lot. And, it is for sale.
The temptation was simply too much for a veteran open house junkie such as your faithful correspondent. I sidled up the sidewalk and pulled the offering sheet. The asking price: $3.5 million. It was enough to make us glad we live in Kansas City, where we live in a bigger, more distinctive house for which we paid way less than one-tenth the price of the Coronado house. If the owner of the Coronado house has any sense at all, he should find a greater fool quickly, cash out and move here to the heartland, where he could easily buy 10 houses just like the one he is trying to sell – and still have money left to vacation regularly on Coronado beach.Link here.
Wall Street tunes into housing boom … or bubble.
Research reports written by Wall Street’s top gurus used to focus mainly on price-earnings ratios, highflying stocks such as Google, and bull and bear markets. Not anymore. In their missives to clients, investment strategists are increasingly shunning stocks and devoting more ink to the booming housing market. Wachovia Securities, for example, devoted its 35-page midyear outlook to predicting what the economic and financial landscape might look like after home prices peak. Money manager Cumberland Advisors published a three-part series on the real estate bubble, with provocative titles such as “Deflating the Housing Balloon: Ka-Pow! or Pssssssss”. Citigroup’s chief U.S. equity strategist Tobias Levkovich penned a 14-page report headlined “Homesick?”
Hard assets have replaced paper assets as the topic du jour. The shift in emphasis reflects the growing amount of investor wealth tied up in real estate, housing’s increasing clout in the overall economy and a sharp increase in client questions related to real estate. Wall Street prognosticators are obsessed with trying to predict what impact a bursting bubble would have on the economy, consumer spending and the stock market. The demand for housing-related analysis is on the rise. Until it becomes clear how the real estate boom will end, expect a bull market in real estate reports.Link here.
Homebuilders’ shares hit by home-sales drop.
Existing-home sales may have declined and the inventory of unsold homes on the market may have increased in July. But as any bull on housing will tell you, the housing market remains red-hot. Pundits and stock pushers will also tell you that because everyone’s talking about the housing bubble – and about how it is seemingly deflating a bit – then it is not really happening, and there is nothing to worry about. Hmm, if that does not sound like delusion, then what does?
The denial is more acute as there may be signs that the smart money is bailing out of housing stocks. Taking a look at the Philadelphia Stock Exchange Housing Index since late July, it is hard not to notice the downtrend. After hitting an all-time high of 586.06 on July 28, the index has fallen nearly 10% through Monday’s close. The housing index was recently down another 1.6% Tuesday after the National Association of Realtors said existing-home sales dropped 2.6% in July to 7.16 million, compared with economists’ average forecast that sales would fall only 1.1%.Link here.
House party finally over?
Is the US housing market partying like it’s 1989, the peak of the previous housing boom? No, say mortgage industry officials. Those who see a housing bubble agree: this time, they say, it is much worse.Link here.
“Flip This”, “Flip That” – should you give a flip?
Consider these recent facts about the housing market: 1.) The inventory of properties in foreclosure jumped 5% in July; 2.) Insider selling (the legal kind) of homebuilder stocks reached 5.1 million shares in July, the largest one-month amount on record; 3.) Among the U.S. civilian working population, annual spending on residential investments has reached some $5200, by far the greatest constant-dollar amount of the past 60 years; and 4.) The Dow Jones Home Construction and Mortgage Financing indexes are the two worst performing sector averages of the past month, each down about 11%.
None of this bodes well for housing, though I failed to include the most persuasive piece of evidence that the real estate market is at a major turning point, namely: THREE new TV series have aired in the past two months, which purport to tell viewers how to buy, fix up, and sell houses for a quick buck. These shows are named Property Ladder, Flip This House, and Flip That House. I am NOT making this up.
Here is one more fact regarding real estate: If a new record high in home sales is not enough to drive the index higher, odds are that most if not all bullish expectations have already been baked into prices.Link here.
30 years of reasons to fear housing market.
David Rosenberg, the chief economist for North America at Merrill Lynch in New York, is “convinced that the housing market is ripe for a price correction.” If he is right, 30 years of history suggests any collapse would imperil the outlook for global economic growth. Thomas Helbling, deputy chief of the world economic studies division at the IMF, tracked the housing market histories of 14 industrialized nations for the period from 1970 to 2002, finding 75 home-price cycles. Slumping property values can wreck an economy. “Housing price busts in industrial countries were associated with substantial negative output gaps, as real gross domestic product growth decreases noticeably,” Helbling wrote in his study. “On average, the output level three years after the beginning of a housing price bust was about 8 percent below the level that would have prevailed with the average growth rate during the three years up to the bust.”Link here.
GLOBAL REBALANCING BROADENS OUT
There are many paths to global rebalancing. I continue to believe that a long overdue consolidation of the American consumer will be an important piece of the equation. But there is now good reason to believe that other pieces are falling into place as well – namely, meaningful improvements in Japan and Germany, the second and third largest economies in the world. This is unambiguously good news on the road to global rebalancing.
My fixation on global rebalancing dates back a little over three years. My emphasis on a U.S.-led global adjustment has been due, in large part, to the absence of alternative candidates to drive the process – underscored by lagging growth in domestic demand in other major economies of the world. Japan and Germany – the world’s second and third largest economies – now appear to be reawakening from interminably long slumbers. It now appears distinctly possible that they could regain more dominant positions as engines of global growth than is the case today. At current exchange rates, Japan and Germany collectively account for only about 18% of world GDP – vs. America’s 28% share. Not all that long ago – 1995, to be precise – there was actual parity at about 25% between the U.S. share of world GDP and the combined shares of Japan and Germany. But a once-balanced global economy then went down an extraordinarily unbalanced growth path.
Barring an outright collapse in the dollar – unfortunately a non-trivial possibility, given America’s outsize current-account deficit – the next leg of global rebalancing will need to involve a convergence of global growth spreads. There are two extreme developments that can force such a realignment – a slowing of the U.S. or an acceleration of growth elsewhere in the world … or a combination of these two extremes. For the longest time, it seemed as if a U.S. slowdown was the only likely path to global rebalancing. A persistent sluggishness in most other quarters of the world ruled out the alternative. China was a possible exception to this trend, but its 4% share in world GDP underscored the relatively small role it could play in sparking a major shift in the mix of world GDP. The persistence of a U.S.-centric rebalancing would have been dominated by the downside perils of a sustained shortfall in U.S. economic growth. By contrast, a more diversified strain of rebalancing that involves improvement in Japan and Germany would temper the growth drag from the U.S. and minimize the disruption to the global economy at large.
The global economy still faces some very formidable problems. Sky-high energy prices are a clear and present danger in the summer of 2005. The excesses of the American consumer remain a serious systemic risk in this unbalanced world. But there are new grounds for encouragement. The world’s second and third largest economies both appear to be at critical junctures in their own long-awaited restructurings. A broadening out of global rebalancing is now a distinct possibility. That is a welcome and encouraging development for the global economy.Link here.
HOW CHINA DELAYS A PLUNGE IN U.S. TREASURIES
A Chinese currency revaluation of the kind engineered last month was expected to slam the U.S. bond market. Letting the yuan rise means China may buy fewer Treasuries to hold it down. That, it was thought, would send yields skyrocketing and shoulder check the world’s biggest economy. That has not happened. The 10-year Treasury note yielded 4.16% on July 20, the day before China let the yuan rise 2.1%. It is now 4.22%, a negligible rise compared with what many investors anticipated.
Is Asia’s hold over U.S. bonds waning? Hardly. China is still the second-biggest holder of Treasuries with more than $243 billion at the end of June, up from $165 billion a year earlier. Japan is the largest with $680 billion. Add in Asia’s other central banks and this region’s Treasury holdings are about $1.2 trillion. Any broad move by Asia to trim those holdings would certainly hurt the U.S. economy by driving up borrowing costs. The U.S., it is often said, has built a huge and productive economy, but Asia holds the mortgage. There are three reasons Asia has not yet pulled the plug on U.S. debt, and each provides a degree of comfort it will not happen soon.
The upshot is that China may be delaying the meltdown in the U.S. dollar anticipated by investors such as billionaires George Soros and Warren Buffett. China is doing this by, (a) resisting pressure to let the yuan soar, and (b) inspiring little urgency in Asia to reduce the region’s massive Treasury holdings. It does not mean it will not happen. While the U.S., with its huge current-account and budget deficits, has defied the laws of economics, can it do so indefinitely? With U.S. imbalances unnerving investors and crude oil above $60 a barrel, it may be wishful thinking to expect the U.S. to avert a decline in the dollar.Link here.
VALUATIONS, GOOGLE, AND PUNCH BOWLS
Stories about Google’s stock have been a media favorite during the past year, for much the same reason that a parent cannot stop talking about an overachieving child. It is the dream come true that everyone believed in during the bubble five years ago, and today it is more fun to dwell on the one exception instead of the hundreds of failed “dream stocks” that helped the NASDAQ lose 80% of its value.
So, “Google is a good company that provides a popular service” seems to be a universally satisfactory answer to the question, “But why is it trading for $300 a share?” If you talk about how standard valuation methods show that Google needs to grow its revenue by 25% a year for the next 12 or so years. Or if you compare Google’s $6 billion in annual revenue and $2.9 billion in cash on hand, vs. Microsoft’s $44 billion in annual revenue and $38 billion in cash on hand, and ask “Whose stock should be $27 a share and whose should be $300?” Do things like these and you will discover how a turd in the punch bowl feels.
As for what we think of Google shares, we are happy to stick with the evidence we see on the price chart. By itself, the pattern alone makes it easy to explain why Google has declined by some 13% since July 21.Link here.
THE PROBLEM WITH INDEXES
Market benchmarks often are misleading. If your portfolio falls short of one of these gauges – indexes from the likes of Standard & Poor’s, Frank Russell, or Morgan Stanley – it typically appears that your money manager is doing a lousy job. Maybe, maybe not. Before jumping to conclusions, you should look closely at the indexes and recognize their flaws.Link here.
HOW TO SHORT JUNK BONDS
Remember West Side Story? Just as they say in the musical, “There’s a rumble coming.” The Sharks and the Jets in this case are junk bond bears and bulls. Retail investors have been exiting junk mutual funds (so far this year removing $7.93 billion, or 6% of the funds’ assets), but hedge funds have kept buying junk, more than offsetting the mutual fund outflow. For once the retail folks are the smart ones. I have been warning for some time that high-yield bonds are not worth the risk. Unfortunately, if you heeded my warning then, you have left money on the table thus far in 2005. The high-yield market has gone from overvalued to extremely overvalued.
But the hedge funds will not continue their merry chase of junk prices forever. Junk is badly overpriced and overdue for a fall. The spread between a speculative-grade junk bond, one rated B2, and Treasurys is just 3.25 percentage points. That is not a lot of compensation for the risk of owning junk. The cumulative default rate over 10 years for this grade of bond is 44.5%, according to Moody’s. To be sure, you will be collecting a yield for the remaining 55.5% on a hypothetical portfolio over the ten years, but that would scarcely make you whole. If the long-running recovery stumbles, defaults will be worse than you see in these historical averages. In the late 1990s, even before the recession, defaults began increasing.
It used to be that the only way to deal with an overpriced junk market was to get out. Now you can do better than that. You can buy a fund that, in effect, has a short position in junk bonds. That fund is the open-end, no-load Access Flex Bear High Yield Fund, managed by ProFund Advisors. The opportunity does not come cheap: Minimum purchase is $15,000, and fees are a bit high at 1.45% of assets annually.
The Access Flex Bear High Yield Fund enables you to hedge your traditional high-yield fund during a market descent or just outright bet on a decline in junk bond prices and a rise in their default rate. While buying and holding is usually a good strategy, do not hang on to this fund; use it only when you think junk is overvalued and ready for a correction. If I think this fund is such a hot idea, then why have the leading mutual fund companies not caught on? They are too large and too enamored of their own bullish funds, I suspect. Short-selling is not a way to win a popularity contest on Wall Street. I am hoping that we will soon see exchange-traded funds that take short positions in the junk market. As ETFs, they will be liquid and likely cheap – well below 1%.Link here.
HOW TO HEDGE AGAINST STACKBUCKS PRICE INCREASES
Two things have doubled in the past four years: the net income of Starbucks and the price of a pound of coffee on the futures exchange. Do you want to inject a little caffeine into your portfolio? You could buy either Starbucks shares or coffee beans. Here we will make the case for buying the beans, leaning on the authority of commodities analyst Judith Ganes-Chase. She has been tracking coffee on Wall Street for 20 years, first for Merrill Lynch and Shearson Lehman, and now on her own at J. Ganes Consulting in Katonah, N.Y.
Ganes-Chase, 44, points to a variety of bullish forces in this volatile market. Worldwide consumption is advancing at a steady 2% pace annually. Crops in Brazil and Vietnam, the largest and second-largest producers, are disappointing. Eventually buying pressure will come from China as incomes there rise, people flock to cities and cafes spring up on urban corners. Do understand that this is a market for speculators, not conservative investors. Coffee, like many commodities, is subject to wild price swings, as large as 6 cents in a single day. The September contract, now $1.05 a pound, reached $1.45 in March. The big move from 2001 reflects the fact that in that year new supply from Vietnam flooded in, sending coffee prices to a 30-year low. A collapse like that could recur. Nevertheless, for those willing to put a little mad money at risk, the long-term outlook for coffee seems propitious.Link here.
BEYOND THE BALANCE SHEET: GOOD CAP-EX, BAD CAP-EX
The “Cash is King” philosophy has attracked quite a following on Wall Street. In this approach you focus not on a company’s earnings but on its cash flow from operations, equal to the sum of earnings and depreciation and amortization, plus or minus changes in working capital items (like inventory or payables) that help or hurt a company’s checking account balance. Take cash flow from operations and subtract capital expenditures to get free cash flow. This is what Warren Buffett calls “owner’s cash”. A company trading at a low multiple of owner’s cash is probably a bargain.
There is one big weakness in picking stocks in this fashion – it does not do justice to growth companies. A fast-growing outfit might be plowing all its cash flow into expansion, leaving nothing for dividends, and still be a terrific investment. There ought to be some way to distinguish a cement company that has no free cash because it consumes all its cash replacing worn-out machinery, from a retailer gobbling all its cash on new locations. In this, the seventh in our Beyond the Balance Sheet series, we aim to separate the cement companies from the Wal-Marts.Link here.
A FLAWED MANDATE
So, here we are in the summer of 2005, nearing the end of the 18 year term of Alan Greenspan. We cannot help but marvel at two things – how lucky Mr. Greenspan was to have started his term when he did, and what a poor job he has done in the last 10 years. The reason we say this is that his term has benefited from one notable condition, low inflation (as measured by consumer prices), and Mr. Greenspan has responded to this condition in an inappropriate manner that has resulted in a series of asset bubbles and global imbalances that his successor will inherit.
Some say that the Greenspan Fed has been “fighting” inflation, and that is why it has remained low. This is far from the truth. Paul Volcker “fought” inflation by raising interest rates to near 20% and inducing a recession. The Greenspan tenure at the Fed has been marked by moderate energy prices and inexpensive imported goods from Asia, which have offset other rising prices to keep overall consumer prices relatively low. Some statistical slight-of-hand with inflation calculations and deliberately misleading reporting of inflation (i.e., emphasizing “core” inflation) has helped keep a lid on “reported” consumer prices as well. Both inexpensive energy and imports are beyond the control of the Fed and are not likely to continue.
The Federal Reserve has a three-part mandate for monetary policy – maximum employment, stable prices, and moderate long-term interest rates (it seems “maximum sustainable growth” used to be included here, but no longer). The fundamental error by the Greenspan Fed has been to make monetary conditions overly stimulative in order to facilitate job creation, while believing that it was achieving price stability. While statistically, these mandates have largely been achieved in recent years, the failure to address asset prices and to consider the effects of trade and currency policies on import prices has enabled the creation of huge asset bubbles and trade deficits, while resulting in job creation of increasingly poor quality. The apparently mistaken belief that energy prices would stay low indefinitely will likely turn out to be simply a case of good timing for Mr. Greenspan and bad timing for his successor.
It did not have to be this way. Instead of recognizing these factors and formulating monetary policy accordingly, the Greenspan Fed has consistently eased monetary conditions for any and all reasons, in part justifying these actions by pointing to a set of mild inflation statistics or sounding the alarm for deflation, which under a non-fiat currency system is the natural by-product of productivity gains. When looked at collectively, we can only conclude that the Greenspan Fed, for the last 18 years, has had a flawed mandate.Link here.
Borrowing, Spending, Counterfeiting
Few Americans truly understand how our Federal Reserve system enables Congress to spend far beyond its means, but the cycle of spending and printing money affects all of us. Simply put, the more money our Treasury prints, the less every dollar is worth. Our pure fiat money system, in place since the last vestiges of a gold standard were eliminated in the early 1970s, has reduced the value of your savings by 80%. Disregard the government’s Consumer Price Index, which substantially underreports price inflation. Monetary inflation is true inflation, and we only need to look at the cost of homes, cars, energy, and medical care to recognize that a dollar buys far less today than ever.
Economist Mark Thornton of the Ludwig von Mises Institute lays out a sobering case against the long-term health of the U.S. dollar. He identifies several facts and trends that bode ill for millions of Americans counting on dollar-denominated assets to fund their retirements. First, federal debt continues to grow exponentially and shows no sign of abating. Second, federal entitlement programs like Social Security and Medicare will not be “fixed” by politicians who are unwilling to make hard choices and admit mistakes. Third, future administrations are unlikely to challenge a foreign policy orthodoxy that views America as the world’s savior. Finally, we face a reordering of the entire world economy. China, Japan, and Asia in general have been happy to hold U.S. debt instruments in recent decades, but they will not prop up our spending habits forever.
All of these factors make it likely that the U.S. dollar will continue to decline in value, perhaps precipitously, in the coming decade. Will it take an economic depression before the American public finally holds the political class accountable for its reckless borrowing, spending, and counterfeiting? The greatest threat facing America today is not terrorism, or foreign economic competition, or illegal immigration. The greatest threat facing America today is the disastrous fiscal policies of our own government, marked by shameless deficit spending and Federal Reserve currency devaluation.Link here.
Worried about inflation … or deflation?
One of the main jobs of the Federal Reserve is to keep inflation in check. And recent news on the inflation front (up 0.5% overall in July; up 0.1%, excluding energy and food) suggests that the Fed can claim to be doing its job. But the biggest unspoken worry for the Fed is not how high prices can inflate but rather the kind of economic havoc that occurs when prices go in the opposite direction. To put it in Fed-ese: deflation is a difficult policy scenario – not to mention a difficult time for people living through a deflationary period. In this question-and-answer excerpt, Bob Prechter talks about why the Fed will find that its next big fight will be with deflation, not inflation.Link here.
FIRE DANGER: EXTREME
There are few places on earth as beautiful as Lake Tahoe in late summer. Those who only come for the skiing do not know what they are missing. But as you become acquainted with summer life at the lake, winding your way through the towns and communities that dot Tahoe’s 72 miles of shoreline, you will notice something quietly disconcerting. There is one thing, or rather the looming prospect of one thing, that challenges the tranquility of this scene. Fire. It does not take long to notice the wooden signs posted by the Forest Service at various points around the lake. These color-coded advisories alert campers, hikers and assorted recreationalists to the estimated fire danger for any given day. The advisory least pleasant to see, presented in glaring, ominous red: “FIRE DANGER TODAY: EXTREME”.
What does “extreme” mean in this instance? The Forest Service offers a description: Fires start quickly, spread furiously, and burn intensely. All fires are potentially serious. Development into high intensity burning will usually be faster and occur from smaller fires than in the very high fire danger class… Under these conditions the only effective and safe control action is on the flanks until the weather changes or the fuel supply lessens. Tahoe is surrounded by approximately 200,000 acres of forest. Nearly a third of this vast acreage is in a “serious state of decline,” according to the U.S. Department of Agriculture, due to “drought, overstocked forest stands, and the suppression of fire since the Comstock logging area.”
Fire, as it turns out, plays a critical role in maintaining the health of the forest. The occasional blaze is Mother Nature’s version of creative destruction. When a low- intensity wildfire moves through, dead and diseased trees succumb to the flames; the heartier, healthier trees remain intact. Excess underbrush is burned away, clearing the forest floor. Sturdy old growth survives, even as the fire’s consumption makes way for new growth. A rough balance is maintained. But the picture is very different today, thanks to persistent human intervention. From 1890 onward the U.S. Forest Service maintained a policy of “zero tolerance” towards any and all forest fires. Mother Nature’s cleansing efforts were thus thwarted by human hands.
Misguided human intention – the desire to rein in fire – laid the groundwork for the mother of all fires to occur. And occur it did: The great Yellowstone fire of 1988 awoke the rangers to what “zero tolerance” had wrought. A small, nondescript fire in June of that year, started by a lightning bolt from a summer thunderstorm, inexplicably grew to become a raging inferno. The destruction was multiple orders of magnitude worse than anything ever seen before. The Forest Service has learned from the error of its ways, and is now working feverishly to correct the problem. Vigorous policies of deadwood culling, underbrush clearing and “controlled burns” are now under way. Yet the task is akin to sweeping the Augean stables, and rangers admit their efforts may prove too little, too late. The Forest Service website offers this grim assessment: “Today’s forests, dense with green vegetation, may seem to be beautiful, but in fact are deadly. Many forests are choked with brush and dead trees that make catastrophic fires a certainty.”
What does this have to do with markets and finance, the normal purview of this space? As it turns out, plenty. There is another long-standing agency, established 1913, that is dangerously addicted to “zero tolerance”. It is frighteningly easy to recast the rangers’ warning in a manner fit for the Federal Reserve: Today’s economy, flush with green liquidity, may seem to be beautiful, but in fact is deadly. Many consumers / banks / hedge funds are choked with leverage and debt burdens that make catastrophic downturn a certainty.
Greenspan has emulated the bad old ways of the Forest Service prior to their Yellowstone awakening. The Fed’s zealous suppression of downturns over the years has created a build-up of potentially catastrophic proportions. Thanks to massive liquidity stimulus, business operations that should have folded linger on. Credit lines that should have been cut back are extended. Speculators who should have tempered their bets are encouraged to become more aggressive. Excessive reliance on easy credit is mistaken for economic strength, and even bigger bets are made.
A catastrophic fire needs more than ample fuel to get underway. It also needs the hot, dry conditions necessary for flames to spread rapidly. If debt is the primary kindling, then savings are the dampening agent that keeps the fire from getting out of hand. Alas, The Economist opines that the “global savings glut” is actually a “global liquidity glut”; thickets of cash have grown so dense that bonds are merely catching the runoff. Worse still, U.S. consumer savings have recently hit zero, as homeowners double down on property gains at the very worst time. The well does not get much dryer than that.
The last question, then, is what might kick things off. How and when will the next fire start … and will it be the big one. We have no more of a crystal ball than the rangers in this regard. Are we in the midst of our summer thunderstorm, lightning waiting to strike? Or will we be spared for another season?Link here.
THE MYTH OF INTERNATIONAL DIVERSIFICATION
When I recommended Japan in March 2002, I did so primarily because the Street in general was frowning so broadly, but specifically in contrarian reaction to BusinessWeek’s cover story entitled, “Land of the Setting Sun”. More often than not, betting against BusinessWeek has been a damn good bet. Well, the esteemed mag is at it again. More than three years after I recommended investors look at China, BusinessWeek has finally hopped on the bandwagon. All you need to know about their recent double issue – “China & India: What You Need to Know” – is that it was their cover story, which, if history is any guide, puts the nail in the coffin in which resides China and India as investments with outsized profit potential. As I bellowed repeatedly in Vancouver, “You don’t make money in the market by looking in the same place as everyone else.” And if perennial Johnny-Come-Lately BusinessWeek is looking there, then everyone else has been for quite some time.
Indeed, the weakness in Chinese stocks has already begun. Since December 2004, the Halter USX China Index, a basket of 48 Chinese stocks that trade in the U.S., has underperformed the Dow Industrials, the S&P 500, the NASDAQ, the Russell 2000, the French CAC, the German DAX, London’s FTSE, the Toronto Stock Exchange, the Sydney All Ordinaries, the Tel Aviv 25 and 100, etc., etc. etc. Translation: Stick a pair of chopsticks in it: It’s done.
Last weekend, when I first wrote to you, I planned to give you my rationale for looking, instead, to Germany as a potential horn of investment plenty. Then the mail came. Nestled in between my wife’s Victoria’s Secret catalog and my own copy of the Victoria’s Secret catalog, was the latest issue of The Economist, which catalogs a slew of reasons why you might consider throwing a shekel or two behind Germany. At the risk of siding with the mainstream media, The Economist, I must admit, does a good job constructing the argument, dispensing with the need to cover it here.
Let us consult not the TV guides but what should be our only guide, the empirical evidence … and it seems no matter what part of the globe, no matter what the question, the empirical evidence always points in the same direction: small caps, small caps, small caps, again and again and again. So I have one question for you: Have you hugged your small-cap guru today?Link here (scroll down to piece by Carl Waynberg).
HOW TO SELL THE DOLLAR
In 2004, Treasury Secretary John Snow was traipsing around the globe trying to “talk the dollar down.” Why? In a word: debt. The U.S. national debt stands at about $7 trillion, with interest payments alone in fiscal 2003 totaling $318 billion. But the Fed and Treasury have engineered a strategy to pay off the debt with weaker and weaker dollars. And guess what? So far, so good. Since November 2002, the dollar has fallen 25% against the euro, and more than 50% since its high in October 2000. Of course, this is not the first time we have gone through a managed devaluation of the currency. In the 34 year period since Nixon slammed the gold window shut and subsequently ended Bretton Woods exchange rate mechanism we have had only five major currency trends.
1.) Weak dollar 1972-1978 (7 years)
2.) Strong dollar 1979-1985 (7 years)
3.) Weak dollar 1986-1995 (10 years)
4.) Strong dollar 1996-2001 (6 years}
5.) Weak dollar 2002- (? years)
The most notable period spanned the 10 years from 1986 through 1995. Then as now, the United States was fighting a historic current account deficit through managed debasement of its currency. But because the bear market only began in February of 2002 the current cycle looks like it still has a number of years to run. In the best-case scenario, if the current bear market follows the trajectory set be the 1986-1995 slump, we could see a weakening dollar for up to 10 years. This presents an opportunity for selling the dollar in one of four ways: direct and indirect speculations, using short- and long-term options for each. These plays will help you safely position your money outside the dollar bear market. And you stand to make a fair amount of money, too.
But there is a great danger ahead. Since the trade deficit has passed the $500 billion mark – nearly 6% of GDP – foreigners must shell out about $1.5 billion a day just to keep the dollar afloat. And even during the managed dollar decline of 2003, the trade imbalance continued to grow. We have relied on the kindness of strangers for too long. “We’re like the untrustworthy brother-in-law who keeps borrowing money, promising to pay it back, but can never seem to get out of debt,” Jim Rogers writes. “Eventually, people just cut that guy off.” There is no way the U.S. can possibly pay off its creditors should they decide to cash in their IOU’s.
It is hard to imagine, isn’t it? The world’s reserve currency spiraling downward, out of control. But then, that is what the British must have thought in 1992 when they attempted to manage a devaluation of the pound. Despite the Bank of England’s best efforts, sterling got away from them; the currency collapsed and Britain was kicked out of the Exchange Rate Mechanism (ERM) established to pave the way for the euro. On the day, know as Black Wednesday in Britain, currency speculator George Soros is rumored to have made as much as $2 billion. Do not be surprised if more fortunes emerge in the future as the dollar slips dangerously close to free fall.Link here.
THE BLACK ARTS OF FINANCE
The era of the conglomerates is brief but instructive. Flourishing in the roaring market of the late ‘60s, it was a doomed effort at the new math. Then it was called “synergies”. The term is used less today by the historically minded, because it brings to mind this somewhat neglected chapter in financial history. Synergies are what the managers of the so-called conglomerates sought to achieve, though these enterprises rarely referred to themselves as conglomerates. They usually preferred high-minded and self-made euphemisms such as “multidisciplinary company”. As author John Brooks has observed, “Conglomerates, like prostitutes, had from the first a sufficiently shaky moral reputation to call for the use of euphemism.” As in politics, coining new buzzwords like these gives the illusion of newness to old tricks.
The idea behind this was fairly old. While most companies followed the respected dictum that a shoemaker should stick to his last, there were a number of exceptions by the time the 1920s rolled around. DuPont, for example, had largely confined itself to making gunpowder. But in the 1920s, it added a number of unrelated businesses, becoming a sort of pioneering conglomerate. The early forays were more a matter of contingency than an express corporate philosophy. Ironing out that philosophy would be the work of Royal Little, often seen as the father of the conglomerate concept. Little turned American Woolen, a textile company, into Textron – a company that was engaged in selling almost everything, including golf balls, life insurance, helicopters, cement, pens and much more.
Little fleshed out his ideas for posterity in his autobiography, How to Lose $100,000,000 and Other Valuable Advice. His strategy, he thought, would help insulate companies from unpredictable business cycles by giving them a firm foundation in many unrelated businesses. He also thought it would alleviate the often ruinous temptation to expand into losing businesses. Since the management team would have different lines of business to expand into, it could pick the strongest performers. Perhaps there was a kernel of a good idea in Little’s model. Textron would go on to have successes. In fact, in the roll call of “new age” conglomerates of that era – Gulf Western, Litton, LTV, National General, Northwest Industries, Norton Simon and others, Textron remains as one of a few survivors.
I think it was Benjamin Graham who made the paradoxical observation that it was not your bad ideas that do you in, but your good ideas – the idea being that people, especially on Wall Street, have a tendency to overdo what looks like might be a good idea. That is exactly what happened in this case. Wall Street and investors fell in love with the conglomerate idea, and the conglomerates were rewarded with high price-earnings ratios. This fueled the boom and would ultimately carry it to its inglorious end. In 1968 alone, 26 of America’s 500 largest companies were acquired in conglomerates mergers. Moreover, 10 of the nation’s largest 200 companies were conglomerates.
In the end, the holes in the conglomerate idea were too large for most to overcome. Management teams skilled in one industry had little expertise in others. The businesses under a conglomerate’s umbrella started to suffer and decline. This put more pressure on the conglomerates to do more acquisitions. Eventually, they started to stumble. First it was Litton, one of the granddaddies, who reported earnings substantially less than expected. The selling began in earnest. The stock prices of other conglomerates soon followed Litton down the proverbial drain. Then came the investigations and the exposure of faulty reporting and misleading practices – a snowball effect of bad news overwhelmed them. The conglomerate boom came crashing to a halt.
What insights does this history provide us with today? I think there are several: Relying on acquisitions for growth is usually a bad idea, for a lot of reasons. Lollapalooza-like combinations are rare and hard to achieve. Bad ideas sometimes begin life with the kernel of a good idea. Or what starts out as a good idea can be overdone. Too many transactions spoil the broth. Finally, I think this story holds an important warning for investors in today’s market: A flurry of merger and acquisitions in an industry that has already seen its stock prices rise for an extended period of time can be a sign that sector is getting a bit overheated. Especially, I should add, if the acquisitions are being financed with stock.Link here (scroll down to piece by Chris Mayer).
TECHNICAL ANALYSIS IS VITAL VOO-DOO
In response to a question about moving averages from a reader last week, I thought it would make sense – and, perhaps, cents – to present a brief discussion of technical analysis. But, first, does it make sense – and cents? Proponents of technical analysis believe that by analyzing a stock’s chart, they can pick up patterns that can predict future price movement. “Poppycock!” – or something like it – counter the naysayers. Benjamin Graham, the “Father” of value investing and author of, The Intelligent Investor, numbers among the naysayers:
“The one principal that applies to nearly all these so-called ‘technical approaches’,” writes Graham, “is that one should buy because a stock or the market has gone up and one should sell because it has declined. This is the exact opposite of sound business sense everywhere else, and it is most unlikely that it can lead to lasting success in Wall Street.” Bill Gross concurs, as does Dr. Burton Malkiel, Chemical Bank Chairman’s Professor of Economics at Princeton University, and author of A Random Walk Down Wall Street, also pooh-poohs technical analysis. These are some pretty damning assertions from some pretty smart people. But other smart people eagerly take the other side of the technical analysis debate.
Enter William Brock, Josef Lakonishok, and Blake LeBaron (BLL), whose 1992 study, “Simple Technical Trading Rules and the Stochastic Properties of Stock Returns”, contradicted the notion – and a slew of previous studies – that technical analysis was futile. They analyzed moving averages and trading-range breaks on the Dow Jones Industrial Average from 1897-1985. Signals to buy or to sell were generated whenever long (50-day, 150-day, and 200-day) moving averages intersected with short (1-, 2-, and 5-day) moving averages. Buy methodically buying breakouts and selling breakdowns, the study’s authors discovered that buy signals produced an average annualized return of 12% over the ensuing 10 days. Sell signals produced an annualized 7% decline over the ensuing 10 days. Net-net, the authors concluded that the results were “consistent with technical rules having predictive power.”
Technical analysts hailed the results as vindication, but it is important to note that returns were computed based on a 10-day holding period, hardly long-term, and even the authors cautioned that their “analysis focus[ed] on the simplest trading rules” and that “transaction costs should be carefully considered before such strategies can be implemented.” The study was itself the subject of a study by Ryan Sullivan, Allan Timmerman, and Halbert White (STW) in 1999. The authors found that the robust results of the BLL study appear to be the result of data snooping. “The superior performance of the [BLL] trading rule is not repeated in the out-of-sample experiment covering the period 1987- 1996,” Sullilvan, Timmerman and White conclude.
But weep not for technical analysis. It boasts many fans. Technical analysis has its defenders, and their faith is not completely for naught. Over a narrow time span, stocks do tend to adhere to a trend. A million people can be wrong. But a million people being wrong at the same time and in the same way can exert a substantial influence. Technical analysis, at a minimum, provides a real-time picture of the behavior of millions of investors. That has gotta be worth something, especially when “herds” of investors can sometimes trample all over a stock’s fundamental attributes.
So even if technical analysis is flawed, it still provides insights of “value”. Investors who fail to acquire at least a working knowledge of technical analysis and charting tools, therefore, risk investing in ignorance of important market influences. A working knowledge of technical analysis becomes increasingly important as market capitalization decreases, which makes it particularly important for us small-cap investors.Link here.
THE PROPHETS OF DOOM AND GLOOM
“The people that once bestowed commands, consulships, legions and all else, now concerns itself no more, and longs eagerly just for two things – bread and circuses.” Juvenal made this very pertinent social observation in the first century AD, but it was another 300 years before the Roman Empire totally collapsed. Moreover, the empire experienced repeated periods of glory and power – among others under Trajan, Hadrian, and Marcus Aurelius – until its final collapse, in the fifth century, at the hands of Visigoths, Ostrogoths, and Vandals. Despite the up-and-down nature of its fortunes, the value of its currency was in a continuous steep decline. The Denarius, which under Nero, who carried out the first debasement of the currency, still had a silver content of 94% had declined by AD 268, under Claudius Gothicus, to a negligible 0.02%!
I mention this because a recent report by my friend Peter Bernstein entitled “Cheers”, begins with the following paragraph: “The prophets of gloom and doom are increasingly prolific and apocalyptic. As we admitted in our June 1 issue, this publication has contributed its fair share to this process. But the dark voices we hear are always the same dark voices, and the sheer volume and lack of variety in argument has begun to dilute their impact on us. The sound of impending disaster is now so deafening, in fact, that we have been seeking for any rays of sunshine we could spot, if only to relieve the monotony and perhaps to find something substantive that might counter the deep pessimism flooding our mailbox.”
Now, I suppose that Peter also had me in mind when he talked about the “prophets of gloom and doom.” However, I consider that, at least by my standards, I have in recent times been relatively cautious about expressing negative views of the U.S. stock market. This is largely because printing money, as the Romans did 2,000 years ago, enables economic policy makers to keep the party going for longer than would be possible under a rigid gold standard.
I have not quoted Peter Bernstein in order to defend my not so-rosy views about the economies of the U.S. and Europe, but because – unlike his mailbox – both my post mailbox and mye-mail inbox are overflowing with rather positive comments about the U.S. economy and the financial markets. The positive sentiment and almost total absence of negative views is most apparent from investors’ intelligence sentiment for stocks. Bullish sentiment remains above 50% while bearish sentiment hovers around record low readings. Moreover, since 2003 the Bulls-to-Bears Ratio has only occasionally dropped below 2.
Another symptom of investors’ complacency and confidence is that the volatility index for both bonds and stocks hovers near record lows – hardly a sign of excessive bearishness. Still, Peter makes a very good point that the stock market may now be less overvalued or, as some observers will argue, even undervalued following the collapse of bond yields. At the same time, it is also true that the corporate sector is at present highly liquid. The question, however, is not so much about the present as about the future. Are the current low interest rates sustainable? Also, why are corporations in such a great shape financially, while the debts of the household sector have been mushrooming? Is this situation sustainable? Finally, equity prices may be reasonably priced or even inexpensive when one only takes their earnings yields compared to bond yields into account. But, as I have tried to show in recent reports, macroeconomic, geopolitical events, natural disasters, or possibly soaring commodity prices (energy) could, some day, overwhelm in terms of importance the pure U.S. equity earnings yield and bond yield comparison and make both U.S. stocks and U.S. bonds unattractive.
In short, all the pros and cons of U.S. equities must be dealt with, and they should be compared with alternative investments, such as foreign equities and other asset classes. After all, U.S. equities could be a bargain compared to U.S. bonds, but in a world of “inflated asset values” both could conceivably be in fantasyland at the same time.Link here (scroll down to piece by Marc Faber).
HEDGING FOR DUMMIES
An online trading platform wants you to stop griping about skyrocketing gas prices and start trading. HedgeStreet operates a kind of futures exchange in which customers can take a position on where they believe gas prices, mortgage rates and inflation, and other indicators are headed by buying contracts called “hedgelets”. As its name suggests, HedgeStreet aims to provide tools for investors to hedge, or reduce risk, in their portfolios. For instance, if your daily commute requires you to fill up at the pump often and you want to reduce your exposure to rising gas prices, you can take a “yes” or “no” position on whether gas will exceed, say $2.32 a gallon by the end of the month. If you make the right call, you take home a fixed payout of $10 for each hedgelet you own; if you make the wrong call, you lose your original investment.
Some experts say such contracts can be dangerous for those who do not understand the principles of investing. But according to Mark Longo, a trader and former member of the Chicago Board Options Exchange, these products offer everyday investors insurance against market risks, such as a housing bubble or interest rate hike. “In many ways, it is making a bet, but it is a very specific tool really meant for specific people to hedge products,” Longo said.Link here.
THE 5 MOST OUTRAGEOUSLY OVERPAID CEO’S
All is fair, they say, in love and war. Not much is out of bounds when it comes to executive pay, either. Consider Michael Ovitz. Although stockholders sued, the one-time Hollywood superagent gets to keep the $140 million he was paid for 14 months of work as president at Walt Disney. A Delaware judge ruled in mid-August that Disney’s board did not breach its responsibilities in awarding the huge severance package. While the Ovitz payout may have been legal, it is the type of corporate behavior that costs investors millions of dollars every year. And it is not just a few spendthrift companies throwing good dollars after bad leaders. We scoured corporate regulatory filings and found plenty of examples of overpaid underachievers in executive suites. Ultimately, we came up with a list of the five most overpaid bad chief executives, and another of the five most underpaid good execs.
Top honors go to Gary Smith at Ciena (CIEN). His shareholders have been virtually wiped out – losing 93% in the past four years. His compensation over that period: $41.2 million. Sun Microsystems (SUNW) paid Scott McNealy, its CEO, chairman and founder, $13.1 million a year over the past four years, even as Sun’s shareholders lost 76% of their money. It is getting worse, by some measures. The ratio of CEO compensation to pay for the rank and file was roughly 200-to-1 in the early 1990s. Now it is more than 450-to-1, says David Lewin, a professor at the UCLA Anderson School of Management. Worse, many average workers are now paid partly through bonus systems and stock options, meaning their livelihoods are tied to often-volatile company stocks. Many executives have similar incentives, but at a vastly greater scale. They win almost regardless of how their stocks fare.
No one is suggesting the companies on our top-five overpaid execs list are committing accounting fraud. But a few companies on our list get weak to lousy grades for corporate governance. Can investors do more than vote with their feet? Activist shareholders sometimes fight overly generous pay. Another approach is to simply look for companies that have great performance and reasonably paid leaders. That is a sign that boards and top managers feel a responsibility towards shareholders. Many of these companies are much smaller than the five on our worst-paid CEO list. So you might expect CEO salaries to be lower. But from an investor’s point of view, does that really matter when you are making 500% on a stock in four years instead of losing 93%?Link here.
FED OFFICIALS SUMMON WALL ST. FIRMS TO DISCUSS DERIVATIVES
Credit derivatives, which are linked to the probability of a company’s paying its debts, represent one of Wall Street’s fastest-growing businesses, with $8.4 trillion of these contracts outstanding at the end of last year, up from $919 billion just three years earlier, according to the International Swaps and Derivatives Association, a trade group. The meeting, which will be held on September 15, is being called three months after global stock and bond markets were rattled by fears that some of the largest banks were caught wrong-footed on some credit derivatives bets.
The worries, which surfaced in May after the credit rating of General Motors was cut to junk status and the prices of G.M. bonds fell sharply, turned out to be overblown. Still, the tumult drew attention to the rapid growth of the credit derivatives market, and raised concerns that participants did not fully understand the risks.Link here.
CZECH BANKS, AMERICAN MANIA LENDING?
Every financial mania has its pet slogan(s). “This time it’s different” and “Don’t fight the Fed” were the phrases of choice in 2000. Today it is “Real estate always goes up.” Words like these become a substitute for independent thought, and/or the pat reply to questions people would rather not discuss. The larger the crowd gets the stronger the psychology becomes, and the more each individual within that crowd becomes oblivious to facts. Every one of the millions of people connected to the real estate mania has heard the “bubble” talk, yet talk is all it is. You measure a mania not by what people say but by what they do.
How manic has the U.S. real estate market become? A recent story from a major Prague newspaper explains how banks in the Czech Republic are offering no-questions-asked “American mortgage” loans to Czech citizens, who use the money to go on vacations and buy expensive stuff.Link here.
HEAVY CLOUDS, NO RAIN
“Because the market has not dropped sharply, it will not drop sharply.” If there is one thought that will cost investors billions in the near future, it is this one. The price action of the major U.S. indices over the last year appears to have anesthetized investors into a lethargic state making it improbable that they will prepare their investments before the next major move. I am not talking about hundred point moves on the Dow, but thousand point moves. Why is this happening? Why is this lethargy so instinctive in our behavior?
First, let us start with the human brain and how we are wired as human beings. Robert Prechter’s book, The Wave Principal of Human Social Behavior and the New Science of Socionomics, allowed me to understand why all investors, including myself, have such a difficult time preparing for future investment opportunities and spend most of their time reviewing the most recent numbers on their quarterly statements. We actually have three connected minds: primal, emotional, and rational. The basal ganglia controls the brain functions that are instinctive, such as the desire for security, the reaction to fear, the desire to acquire, the desire for pleasure, being accepted in our social circles, and even choosing our leaders. More pertinently, this area of the brain controls behaviors such as flocking, schooling, and herding. The limbic system is the seat of emotions and guides behavior required for self preservation. It operates independent of our reasoning capabilities, and therefore, has the capacity to generate out-of-context, affective feelings of conviction that we attach to our beliefs regardless of whether they are true or false.
These feelings are not isolated to the small, naïve investor, but affect the vast majority of professionals as well. And, what about the neocortex? It is in a far inferior position. The neocortex is involved in processing ideas and using reason. However, it is trumped by the limbic system in that the limbic system is faster, controls the amplitude, or intensity of emotions, and unfortunately has no concept of time nor learns from experience. Truly, for the afore mentioned reasons, we are not hard wired to make good investment decisions. Since herding is a natural instinct, and money decisions are one of the most emotional charged areas to handle, then it only makes since that, without understanding the power of these instincts, investors are not even aware of their incapacity to take action to prepare for a sharply declining market.
I am aware that I am prone to herding instincts as well. It is the way we are made. We are not robots; we are humans that enjoy encouragement and acceptance. However, when it comes to looking at some of the best minds of investing, my research continues to show the same pattern over and over again. One must allow their neocortex to override the basal ganglia and limbic system. Or, more simply, we must be ultra logical and unemotional. John Templeton states, “To buy when others are despondently selling and to sell when others are greedily buying requires the greatest fortitude and pays the greatest potential reward.”
This fortitude, to drive past the emotions and noise of the herd, was seen in Warren Buffet as well. “By the end of 1973, the market value of Berkshire’s portfolio, which had cost a total of $52 million, had sunk to only $40 million. His paper losses worsened significantly in 1974. His net worth, as measured by Berkshire’s prices, fell by half. Yet it seemed to dampen his spirits not at all. In the sixties, when he had been making tons of money, he had been full of fearful prophecies. Now, with his portfolio underwater, he was salivating.” Buffet’s painstaking preparation ultimately paid off. “By early 1986, over the last twenty-one years, Berkshire stock had multiplied 167 times, while the Dow had merely doubled.” (Buffet: the Making of an American Capitalist (1995) Roger Lowenstein)
While we can all read this article with our minds engaged, away from the distraction and noise of Wall Street and Washington, when we meander back into the milieu of daily life, it becomes very hard to prepare for something that appears as though it will not occur. Since no one desires to see the financial and social changes that accompany a bear market, it becomes even easier to push off until tomorrow what we do not want to address today. The more times we do not make a decision to change, the more we are emotionally rewarded with the fact that so far nothing happened. 50 point declines are met with 50 point rallies. The sky is blue. The grass is green. No rain comes.
Dr. Benoit Mandelbrot sounds a wake up call much like Buffet’s investments and real losses in 1974. Without moving ahead of the rain, there is no assurance that you will avoid the effect of the deluge. Dr. Mandelbrot, discoverer of fractal geometry, is known as one of the greatest math minds of the 20th century. While his work was not widely accepted through the 1960s and 1970s, after the crash of 1987, his work on fractals and market risk brought him to the forefront of the financial world. He has contributed greatly to Monte Carlo simulation models, which are used all over the world today. One aspect of his work was the discovery that sometimes markets, like nature, reveal patterns of movement that stay within a certain range – the “Joseph Effect”. There are other times when the data moves violently outside its normal range. These violent reactions, much like a tsunami or hurricane, are referred to as the “Noah Effect”.
While we can all see the Joseph and Noah Effects in weather patterns and other life experiences, amazingly, many in the financial world still espouse theories that focus only on the Joseph Effect. They assume that changes that occur from a Noah Effect cannot be seen ahead of time, and are thus to be ignored. They reason, that since no one can time the day and hour, the season becomes unimportant as well. The focus of all numbers becomes the “average”. Unfortunately, historical, real world losses are not as forgiving as the “average”.
Traditional asset allocation models deal with portfolio fluctuations only within two to three standard deviations. Traditional economic models hold that for an event to occur within a deviation of two means it occurs 95% of the time while a deviation of three would reflect events that occur 98% of the time. Mandelbrot notes two problems with this line of thinking. Moves beyond 2 and 3 standard deviations occur much more frequently in the historical record than allowed for in traditional models. And additionally, these extreme moves, accounting for large percentage changes in price, occur in miniscule amounts of time. So rather than a steady flow of asset prices, we see jerky action followed by stasis.
So, how frequently have investors seen changes beyond 3 standard deviations? Historical record shows that changes of more than five deviations happened 2,000 times more often than expected. Under normal rules such an event should occur only once every 7,000 years; in fact, it happens once every 3 or 4 years. Statisticians call this a “fat tail” … and it means the standard model of finance is wrong. The Crash of ‘87 one-day event took markets to a deviation of 22 – standard asset allocation models only address 2 to 3 deviations.
Are we as investors condemned to be blind sided by Noah Effects? Is the safest way to invest in these periods to follow the crowd and buy an index or basket of indices? History and science does not support this “random walk” mentality. If there are hundreds of logical arguments for the Noah Effect occurring in the markets today, why is it so hard to make changes now to address this issue? The Journal of Behavioral Finance had a great article recently called “Self is not Neutral”. In this piece the authors write, “Rationalization doesn’t mean, ‘acting rationally.’ It means attaching desirable motives to what we have done so that we seem to act rationally. In other words, people seek justification for their behavior. Rationalization makes people feel good.”
With the millions of marketing dollars spent on teaching advisors how to help their clients “feel comfortable”, is it any wonder that so many investors and advisors, surrounded by the emotional comfort of the herd and blinded by what we want to see, would ignore all the warning signs of a Noah effect until after the event costs them dearly? My research reveals that there are a few managers and traders who have the incredible fortitude and exceptional skills to prepare ahead of an event. In so doing, they will not only be able to avoid the pains of the downturn, but will actually be positioned to profit from the Noah Effect. The good news is that there are individual and institutional platforms in place today, that purpose to profit when the next Noah Effect occurs.
In our current placid market environment, it may be tempting to dismiss this article for its “extreme views”. However, a study of history and science suggests that the longer the Joseph Effect continues, the more violent the Noah Effect will be when it occurs. As you put down this article and go back to your day-to-day life, I hope you will force yourself to override your emotions and logically consider your surroundings. Make sure you are thinking and preparing for future events and not rationalizing your ways to the “comfortable” music emanating from the Wall Street and Washington rhetoric.Link here.
GLOBALIZATION’S FIRST OIL SHOCK COULD HAVE GRAVE CONSEQUENCES FOR ASIA
This is the first oil shock in the modern era of globalization. That means its impacts are likely to be compounded by the cross-border linkages that shape the global trade cycle. In today’s U.S.-centric world, that spells unusual vulnerability. If higher oil prices take a toll on the over-extended American consumer, repercussions in the rest of an externally-dependent world will be all the more acute. That puts Asia, the world’s most rapidly growing region, right in the cross-hairs of the energy shock of 2005.
With real, or inflation-adjusted, oil prices having more than tripled since the last recession ended in late 2001, the vulnerability of the over-extended American consumer can hardly be taken lightly. That could well be a big problem for the rest of a U.S.-centric global economy. China is the most obvious case in point. Its oil consumption per unit of GDP was double that of the developed-world average in 2004. China, like many Asian countries, tends to subsidize the price of retail energy products. While that means the cost of higher oil prices is deflected away from Chinese consumers, the impact falls more acutely on its government finances. At the same time, in the face of soaring energy costs, China’s subsidy structure has already caused serious disruptions to retail supply – resulting in long petrol lines that are strikingly reminiscent of those experienced in the 1970s. Moreover, about a third of China’s total exports go to the U.S. That means one of China’s largest and most dynamic sectors is very much a levered play on the staying power of the overly-extended American consumer. That is a tough place to be for any economy in an energy shock – even China.
With the possible exception of Japan and India, the rest of Asia may not be in much better shape. Still lacking in support from domestic demand, most other Asian economies have become tightly integrated into a China-centric supply chain. A U.S.-centric consumption adjustment could well have powerful ripple effects on a China-centric production complex. Japan and India may fare a little bit better than other major economies in Asia. If Japan is able to sustain its recent improvement in domestic demand, that would tend to cushion any blow to exports that might arise from energy-related impacts on Japan’s major trading partners. Japan is also insulated by the extraordinary progress it has made in improving its energy efficiency since the oil shocks of the 1970s. Nevertheless, Japan would be exposed to a China slowdown.
For India, it is less of a China-centric connection and more a tale of inefficient use and pricing of energy. India’s oil per unit of GDP is like China’s – double the developed-world norm. Consequently, while Japan and India are somewhat less exposed to soaring energy prices than other Asian economies, they can hardly be expected to emerge unscathed. Globalization is a win-win for the world economy. But an unbalanced strain of globalization is a risky way to go – it has the potential to skew the impacts of any shock. Such is the case with the energy shock of 2005. If the over-extended American consumer gets hit as I suspect, Asia could be in serious trouble.Link here.
WHAT SHOULD YOU DO WITH YOUR REAL ESTATE STOCKS RIGHT NOW?
The “Most Viewed News” story on Yahoo.com last week carried the following headline from USA Today: “Home Prices ‘Extremely Overvalued’ in 53 U.S. Cities.” I mentioned the headline to my colleague, Steve Sjuggerud, and asked, “If it’s a USA Today headline, could it possibly be true?” Steve agreed with my sentiment, i.e., that any headline on USA Today should probably be taken as a contrarian indicator. In other words, the housing boom is not over yet. Steve added that house prices fall during recessions and when there is oversupply. Right now, we have neither of those two conditions. Even so, the housing market feels like its much closer to a peak in prices than to a low.
The USA Today story discusses a study by Richard DeKaser of National City Corp. that examined about 300 metropolitan areas, representing about 80% of the U.S. housing market. According to DeKaser, four of the five most overvalued housing markets are in California. The fifth is in Florida. The cheapest are in Texas and Alabama. Then there is Chris Mayer over at the Fleet Street Letter. He is been talking with the folks over at SNL Financial. SNL follows 128 REITS. Only 17 are selling below their net asset values. Only five are more than 10% below their net asset values. Based on the above input from USA Today, Steve Sjuggerud and Chris Mayer, it sure looks like most real estate investments are better sold than bought.
Here in my local market of southern Oregon, prices have soared lately. Everybody and his brother is coming up from California to escape its high prices and the Draconian taxes and regulations that contribute to California’s high cost of living. I do not blame them. Buying a house here is a wonderful value proposition compared to the nearby alternative. There is no bubble here in Oregon, despite price increases of between 30% and 50%. Nevertheless, because of the nation’s soaring real estate prices and the attention they have been getting lately, I feel compelled to address the topic of what investors should do with real estate stocks I have recommended like Alexander & Baldwin, St. Joe, Tejon Ranch, and Consolidated Tomoka.
As far as the geography goes, they are all in bubbly-priced areas, except Alexander & Baldwin, which is in Hawaii. All four of those stocks represent outstanding decades-long business propositions, each one involving the development of at least 10,000 acres of land. I am not going to remove any of them from the Extreme Value Model Portfolio right now. As five to ten year investments, they are not overvalued. But I will say this: if you think you are going to do as well with these stocks over the next 2-3 years as you did in the previous 2-3 years, I believe the odds are way against you. Most of these land holding companies are up 150% or more in about 3 years.
Net-net, I would not try to stop anyone from taking some chips off the table, but I think there is plenty of value left in them. While we fear the frothy housing market, but we do not fear buying – and holding – undervalued real estate stocks.Link here.
IF “BUBBLE” BURSTS, LEGACY OF GREENSPAN MAY DEFLATE
As central bankers and prominent economists gather in Wyoming to assess Alan Greenspan’s 18-year stewardship of the U.S. economy, the Fed chairman is expected to win widespread plaudits for fostering solid economic growth while deftly managing several financial crises. But the final chapter of Greenspan’s legacy might be based on how well the central bank manages what many experts say is a crisis looming on the horizon: a housing bubble. Many experts say the nation’s real estate market draws disturbing similarities to stocks in the late 1990s – a market driven to unsustainable price levels by what Greenspan famously called “irrational exuberance”. They fear a similar ending: a sharp fall in prices that could bite the net worth of many Americans and trigger a recession.
And some experts say Greenspan deserves at least some of the blame for fostering housing market conditions that the Fed chairman himself has called “frothy”. The Fed, they say, has not done enough to damp real estate speculation, while maintaining cheap credit for too long. Although Greenspan has warned of the pitfalls of “interest only” loans and other riskier mortgages, the central bank should be doing more to tighten lending standards and discourage their use, these experts say. The issue of how the central bank handles any housing bubble is expected to be discussed at the 29th annual Fed conference in Jackson Hole, Wyoming. It will be the 79-year-old chairman’s last official appearance at the prestigious two-day gathering before his retirement in January.Links here and here.
Paul Krugman says housing bubble will burst.
Soaring housing prices in the United States have created a real estate bubble that will likely burst early next year, Princeton University economist Paul Krugman said. “I’ll give you a forecast which might very well be wrong, but I think it will burst in the spring of next year,” he said at a derivatives conference in Brazil. “I would be surprised if it doesn’t burst in the next three years,” he added. Krugman said skyrocketing U.S. housing prices were supported by large – and somewhat “odd” – capital inflows from emerging market countries, such as China, which has accumulated huge holdings of U.S. Treasury debt, helping keep long-term interest rates abnormally low. “Americans pay for their houses with money they borrowed from the Chinese,” he said.Link here.
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