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The Dow ended the year down 0.6%, with the S&P 500 up 3.0%. 10-year Treasury yields rose only 14 basis points over the past year, with benchmark 30-year mortgage rates up about 40 basis points. U.S. and global growth was solid – not too hot, not too cold. Core inflation was sanguine. It is, then, tempting to view the year as relatively uneventful and benign. It was anything but.
The story of 2005 is one of an unrelenting and expansive U.S.-based credit bubble and the prolific global liquidity glut. The inflationary benefits to the U.S. economy and markets notably waned, especially relative to others. Coming into the year, a dollar crisis and/or spike in U.S. market yields appeared leading candidates to finally force a reining in of excesses and the commencement of long-overdue adjustment. The global leveraged speculating community seemed poised to disappoint. There was palpable vulnerability with respect to the mortgage finance bubble. But financial crisis was not in the cards, not with the Fed’s pre-ordained interest rates and a financial sector determined to expand U.S. credit at unprecedented levels. At the same time, global central bankers remained acquiescent to rampant asset inflation and leveraged speculation, and very much still content to balloon their balance sheets with American securities.
Rather than one of tightening financial conditions and the risk of dislocation, the financial backdrop developed into only greater – manifestly unprecedented – accommodation. The emboldened and now firmly Global Wall Street Finance Liquidity Machine was left to its own devices, and the results were spectacular. Unparalleled global credit inflation provided a powerful allure of easy profits for speculators, dealmakers, lenders, investors and businesses the world over. Credit and speculative excess ran to new extremes and enveloped markets across the globe.
Here at home, non-financial debt growth rose at the strongest rate since the mid-1980s. The year will see new records set for both new and existing home sales. According to the Financial Times, companies around the world signed M&A deals worth $2,900 billion in 2005 – a 40% increase over 2004. A small jump in deal activity had been expected in 2005, but the extent of the recovery was a welcome surprise to many on Wall Street and in the City of London. Global private equity deals are said to have reached a record $494 billion. Yet nowhere is the global liquidity glut more conspicuous than with 2005’s global equities performance. Leading European equity indices enjoyed a stellar year. Gains were generally greater in Eastern Europe. Liquidity indulged both Asian markets and economies, with the unrelenting Chinese economic boom and reinvigorated Japanese equities major 2005 developments. Japanese stocks generally enjoyed their strongest gains since 1986. With Asian demand more than partially responsible for crude’s 40% gain this year, the already rampant flow of liquidity to the Middle East turned into a gusher. Saudi Arabia’s major equities index surged 104.1%, as a historic mania took hold. loser to home, Canada’s TSE Composite index jumped 21.9%. Liquidity gushed into Latin America as well.
U.S. equities badly lagged the global boom. Our stocks clearly suffered from the heated competition from scores of hot asset markets overseas. Moreover, the U.S. services-based economy is relatively underexposed to companies and industries benefiting from the world-wide inflationary boom in energy and commodities. At the same time, we have some key industries – autos and airlines, to name two – that are on the losing end of newfound inflationary manifestations. Additionally, U.S. equity valuations increasingly suffer from the nature of intransigent credit bubble financial excess. U.S. stocks may appear cheap relative to ballooning earnings, but certainly not on a risk-adjusted basis.
Ten-year Treasury yields ended the year at 4.39%, a one basis point inversion from the two-year’s 4.40%. Traditional pricing signals provided by the shape and steepness of the yield curve cannot be expected to operate in today’s most atypical environment. The marginal buyers of Treasury and agency securities these days are foreign central banks deluged with dollar liquidity (and insignificant funding costs). There is also the key issue of global leveraged players tapping inexpensive funding sources, such as borrowing in yen, euros and francs. Surely, today’s 2/10 Treasury “inversion” is symptomatic of the global liquidity glut, providing little in the way of relevance for economic analysis.
As for economic analysis, the fourth quarter provided further evidence that Europe and Japan are emerging from their respective malaise. Concurrently, perceptions hardened that the U.S. housing market was softening. The risk of over-heating and the necessity for problematic Fed tightenings have apparently abated. Energy prices are generally thought to have peaked. But this sanguine view downplays global liquidity glut dynamics. The global monetary system has completely lost its bearings, and such a circumstance is not known for sanguine outcomes. The unbalanced global economy is more energized today than it was one year ago, while financial conditions are more accommodative. It is conventional wisdom that U.S. markets and the economy are now several years into a post-bubble recovery. The past year has provided convincing evidence that the protracted U.S. bubble has become only more unwieldy and global in stature.Link here (scroll down to final section of article).
A NEW YEAR RISK ANALYSIS FOR YOUR PORTFOLIO
By building the “Maginot Line” France invested very heavily, if not very cleverly, in its future security. This line of forts was so strong that the French thought they would repel any future German invasion from the east. In a sense they were right, because Hitler did not take it on. Instead he blasted through Belgium, and Paris was taken in a few weeks by an attack not from the east but from the north. The Maginot line held out magnificently unscathed, but entirely irrelevant.
A large global business – the insurance industry – now sells us our own safety, and most of us seek some personal financial security through it. We build our own little line of forts, to secure ourselves and our families against future financial onslaughts from, for example: premature death, becoming permanently unemployable. having a house destroyed, or being found liable for huge damages by a court of law (e.g., after a car accident). But are our forts in the right places? How many wealthy people could identify a risk which is statistically many times more likely than the listed disasters, which would be financially ruinous, and which is widely uninsured? Probably no more than 1 in 10 could identify the risk. Probably less than one in 10,000 has covered it.
The risk is loss arising from the collapse of a large part of the financial system. The Maginot line of peoples’ private insurance arrangements has been built. But the most likely case is that their financial destruction is threatened not from the east, through the relatively improbable and isolated disasters which befall individual men and women, but from the north, from where comes periodically the cold wind of general financial chaos, which destroys almost everyone’s finances at the same time.
When instead of being private the disaster is public, and financial, the number of victims can easily grow by a thousand times, or even a million. The UK Lloyds of London debacle ruined tens of thousands of Britain’s wealthy. The Argentinian collapse ruined millions of scrupulous and trusting savers, as did the stock market crash of the early seventies, and the bursting of the worldwide dotcom bubble at the end of the nineties. Meanwhile the Great Depression wiped out the financial fortunes of tens of millions of industrious and successful citizens of the world. Nothing like these numbers of wealthy people have ever been affected by all the insured premature deaths, house fires, personal injuries or liability claims of the twentieth century put together. Yet all these financial disasters, and many more like them, have occurred within the last 100 years. The fact is that big financial crises are really quite common, and the seed-corn of these accidents is that the victims suffer a collective memory failure which sets up the circumstances.
Against this backdrop look at how most wealthy people have secured their accumulated capital. They have already bought a nice house, and their surplus is invested in deposits, stocks, bonds, mutuals, property, or whatever else their private investment preference dictates, which together yield a few percent of their current annual outgoings. All of this wealth is at risk in a general financial crisis. In a financial collapse almost nothing can be sold. Profits fall. Dividends are cut. Banks cannot pay back depositors and government deposit guarantees become hyperinflationary and are worthless. This happens in at least 1% of years – ordinarily in circumstances not so dissimilar to those around us now.
Fortunately the insurance needed to defend against that type of problem is just about the cheapest form of insurance it is possible to buy. The reason for this is because – necessarily – it does not involve any insurance companies or other financial organisations. In a world of financial crisis gold bullion held legally and offshore regularly holds and multiplies its value. This is why people are buying gold. You can already see in its price that growing numbers are rediscovering the painful lessons of history.Link here.
DEATH CHANTS, BREAKDOWNS, AND FORECASTS FOR 2006
Mercy Otis Warren on the ratification of the U.S. Constitution in 1788: “When fortune throw[s] her gifts into the lap of fools, let the sublimer characters, the philosophic lovers of freedom who have wept over her exit, retire to the calm shades of contemplation, there they may look down with pity on the inconsistency of human nature, the revolutions of states; the rise of kingdoms, and the fall of empires.”
We warn our dear readers. What follows is more of a churlish lament than a real forecast. As we have confessed more than once, and proven more often, we get the news no sooner than anyone else. Still, we have two advantages over most forecasters; We know our limitations, and we do not watch television. So, today, we begin by describing the world, not as it will be, but as we think it is. It is a world where individuals who mind their own business can live better than at any time in history. Painless dentistry, air-conditioning, automobiles, the Internet – we are humbled by the majesty of our own creations. Year after year there are more of them. Now we can eat pineapple in London in the wintertime. We can read books written by dead Chinese scholars in our native languages. We can chat with a friend on the other side of the globe, at almost no expense. And we can have an erection where and when we want one (so we are told), thanks to the wonders of modern biochemistry, rather than the mysteries of old-fashioned hoochie coochie. The thought of it is almost too much for us. We swoon, and ask the gods, what next?
While the progress of the world swells up before our eyes, we turn our eyes to the newspaper and wonder what has gone wrong, for there is a story of 100 dead in Iraq. Reading more carefully, we find that the news from Iraq could have been written 100 years ago, when the British Empire was fighting insurgents in the area. It could have been written nearly 1000 years ago, when Baghdad was under assault from the Great Khan. We also might have read it 2,000 years ago, when similar battles were fought with the Romans. Has nothing changed? Why is our own Texas Tiberius repeating the errors made by virtually every empire that ever was: pushing beyond the limits of its resources, until it finally falls apart? And he does so at the very moment when life seems so sweet in so many ways. We Americans can barely brush our teeth often enough.
Alas, dear reader, while we enjoy real progress in matters of technology, in matters of psychology we remain the same as we always were: prone to panic, backsliding and humbug. Which is why we expect little from 2006. Technology improves with the passage of time, but psychology oscillates like the seasons. While we are sure that the year will bring marvelous new gadgets, we doubt that it will bring marvelous improvements in our mental state. We have enjoyed a long season of calm, comfort and conceit. Bitter weather must follow, as it always does.
We have no opinion on sectors, markets, or individual stocks. But our opinion of our fellow man is that he is given to fits of desperate sanity. And our instinct is that he is getting close to one now. He will look at his dollars and realize that they are nothing more than pieces of paper. He will look at his stocks and wonder why he ever thought they were worth 20 times earnings. He will look at his house and will not be able to believe that someone would have willingly paid him so much for it … and that he, damned fool, did not take it!
All of that is in the future. How far in the future, we do not know, but we are happy to own gold while waiting for it. Gold, any broker or financial planner will tell you, is nothing but a “risky speculation”. In our opinion, it is one of the few places you can put your money that is not a speculation. It is there when your neighbors are happy. It will still be there when they sad. It there when the empire is riding high. It is still there when it doth lie so low. We hold onto it now, because we expect an extraordinary change … as the U.S. empire sinks, and your neighbors start to growl. Gold should not merely stay there, but go up.Link here.
REAL ESTATE GAME THEORY
[Note: Game Theory is a branch of applied mathematics that studies strategic situations where players choose different actions in an attempt to maximize their returns. … In other words, game theory studies choice of optimal behavior when costs and benefits of each option are not fixed, but depend upon the choices of other individuals.]
Year-end stock market rally? Well, no. Not yet anyway. Perhaps it was the New York Transit strike and the traders were simply too wiped out to trade after they finished walking to work? There has to be some reason. Alternatively, perhaps it is simply that the market has topped out. Perhaps, deficits really do matter when one considers the enormous government debt, moreover, the current account deficit which continues to break high ground and swelled to a percentage of GDP unprecedented in history.
Perhaps it is a market top because the fabled consumer (who keeps the economy alive) is feeling tapped out, gorged and maybe just a wee bit concerned over adjustable rate refinancing (ARMs) and home equity lines of credit (HELOCs). ARMs are beginning to reset and bringing reality to the realty, the housing market. We are seeing it every day in real estate, lower sales volume, still higher prices, more unsold inventory. Yet, in fairness, this is the seasonally slow year-end. Moreover, HELOC loans are resetting monthly in accordance with the consistent rise in the prime rate, leaving some homeowners cowering and muttering: When will monthly increases end? Will they ever end? Well yes. But, you may be renting by then.
Perhaps it is an equity and housing market top because those in the know on Wall Street realize that the wild turkey – liquidity in the markets, particularly mortgage markets – may come flying home to roost. This is a huge, massive turkey. It can crash where it wants to, and sometimes even when it does not want to. Kind of like that 800 pound gorilla named “Real Property” over in the corner that is going to come out one day, stare at that turkey and say: “Mincemeat. Mine.” If they battle, they will likely kill each other. Perhaps, it is an equity and housing market top because of underreported inflation, which is a cancer growing, growing, growing on the economy, even though Economist Priests maintain that inflation expectations are “manageable”.
Perhaps it is an equity and housing market top because energy is rising, forcing the growth of that inflation cancer, and those Inflationists (central bankers and their Financials ilk) do not have an adequate response to growing inflation, which exacerbates items mentioned above. They can print more money as they have always done, but, but, but, that devalues the dollar and forces interest rates up which smacks down home values. Not a Greenspan conundrum, a vicious self-perpetrating cycle-circle, as the Credit Bubble/Mortgage Bubble Cycle may have replaced the historical Business Cycle. That may be at the bottom of the problem. If so, you may have a good clue as to why Greenspan claims he cannot figure out the long bond Conundrum. He probably knows this too, but, he will never ever tell, even if he writes the book for his historic pretensions, perhaps as a get-back at those who dare to impugn his Oracular Wisdom as he becomes widely discredited over time. Perhaps … perhaps … perhaps.
We will nearly close with the unremarkable news that more and more major U.S. corporations are starting to pay dividends and buy back stocks. (They do what Wall Street, Structured Finance, Hedge Funds recommend they do. Or else.) This is terrific for the pocketbooks of Wall Street Financial entities, and pretty darn terrific for the corporate officers, and maybe, they strongly argue, for shareholder value. Today. Not someday. Today. Someday might never come. Unfortunately, if the companies are not making productive investment, then we as a nation might as well just hand over everything to Wall Street, and ask them (please, please, please) if we can stay in our former homes with a real low rental for just a few more months while we get back on our feet. While they are not likely to feel our pain, they may be surprised to discover that there are no more buyers for our former homes at today’s inflated values.
No problem. Since they are not actually holding our mortgages, and neither are the original lenders, because so many of the vulnerable ARM type mortgages were packaged up as Mortgage and Asset Backed Securities (they have all these Greater Fools, like pension funds, desperately seeking – coerced by the Hedge Funds – high yields who buy this sub-prime, high risk paper) they will likely recommend the liquidation of home values. Fed keep raising rates. The new low appraisal price will be based on 2006-07 value which may be (we argue) 50% less than the same home appraised for in the famous Summer of 2005, which really was the top of the market. The early bird seller gets the worm. The late seller will get wormed. Beware.
Have a Happy New Year. Be safe and resolve to lose the debt.Link here.
The other shoe just dropped.
In our report dated 5/27/2005 we reported that the Federal Reserve was trying to slow the housing market by tightening lending standards on mortgage lending. We stated that, “There is evidence that the Fed has begun to move to contain the housing bubble using credit standards in place of interest rates.” The report mentioned the joint memo dated May 16, 2005 entitled “Agencies Issue Credit Risk Management Guidance for Home Equity Lending”. This memo cautioned lending institutions on home equity lines and loans to consumers. It was the opening salvo by the financial regulators to tighten lending standards on homes.
The other shoe to fall was dropped on December 20, entitled “Federal Financial Regulatory Agencies Propose Guidance on Nontraditional Mortgage Products”. The memo’s proposed guidance targets nontraditional mortgages such as “interest-only” mortgages and “payment option” adjustable-rate (ARM) mortgages. As the memo states, “The proposed guidance discusses the importance of carefully managing the potential heightened risk levels created by these loans.” The federal authorities are clearly concerned the lending standards have gotten lax during the recent real estate boom. The concern has reached the point that Controller of the Currency John C. Dugan recently stated, “And are lenders really prepared to deal with the consequences – including litigation risk – of providing such products in markets where real estate prices soften or decline, or where interest rates substantially increase?” The concern with these mortgages is two-fold: How will they hold up if interest rates move higher and/or if real estate declines over time? And do consumers really understand the risks of these loans?
The housing boom has been brought about by the confluence of two major trends in the financial markets. The first is the Federal Reserve’s decision to lower the Fed Funds Rate and thereby short-term rates to an historic 1%. Lesser understood is the explosive growth of the home mortgage lending market. The development and mass marketing of more exotic loans such as the “interest-only” and “payment option” loans have transformed the housing market. Together these two trends provided the liquidity surge that ignited the housing bubble in many markets in the U.S. “Interest-only” loans accounted for over 30% of all new mortgages in many cities in 2005. This is up from less than 5% as recently as 2001. In San Diego, Atlanta and San Francisco they were over 45% of the market in 2004. Many people are now using these loans to buy more home than they can afford. These exotic loans coupled with over-borrowing are very reminiscent of the Savings and Loan problems that plagued the county in the 1980s.
We believe this latest memo is part of a major campaign to tighten lending standards and there by cool the housing markets. In same way you would cool a stock market bubble by raising margin requirements. When the Fed makes it known that they are out to change something the generally stick to their guns and do it. We believe the Fed is concerned about the residential real estate bubbles and this is how they will cool the markets off. This should result in a major slowdown in the housing market for 2006. A major slowdown in consumer spending will be one of the results of the busting of the housing bubble. The other thing to watch for as the housing market weakens is to look for the Federal Reserve to react quickly to lower short-term rates to cushion the decline.Link here.
ARE BEARS ROAMING BROAD & WALL?
The first week of January is a storied week on Wall Street, deemed so important that some say the week’s results can forecast the gains or losses for an entire year. But with no Santa rally and questions lingering over what the inverted yield curve means, investors may return from vacations next week in a bearish mood, analysts said. Many traders had hoped for a Santa Claus rally in the final week of the year. But it fizzled last Friday before the old boy could even blow into town. Instead, thin volume led to volatile movements in stock prices, while crude oil futures climbed back above $60 a barrel, and the bond market began to behave as if the U.S. economy faces trouble.
For the final week of 2005, all three major U.S. stock indexes fell. The blue-chip Dow Jones industrial average finished the week down 1.52%, while the broad Standard & Poor’s 500 index slipped 1.61%, and the tech-laced Nasdaq Composite Index fell 1.96%. “If Santa Claus should fail to call, bears may come to Broad and Wall,” the Stock Trader’s Almanac says, referring to the site of the New York Stock Exchange in lower Manhattan. That adage suggests that if a Santa rally, which typically occurs in the last five days of the year and the first two days of January, does not materialize, stocks will fall in the coming year.
“The time to be bullish was back in mid-October, when you had a 26-session buying stampede,” said Jeffrey Saut, chief investment strategist of Raymond James Financial Services, in St. Petersburg, Florida. “Since then, I haven’t seen a real easy way to make money” in the market.Link here.
WHY SO BEARISH?
As 2006 begins, I am at the bottom of the barrel, bringing up the rear, and the proverbial low man on the totem pole … and I am not talking about being in the doghouse with the Mrs. for excessive partying on New Year’s Eve. Rather, I refer to having the very lowest market prediction – and by more than 2,000 Dow points (!) – in the 2006 Business Week market forecasts. In this column and one to follow, I will describe my top down, macroeconomic process, and how I derived my improbable forecast. I will also review some market history and explain how, after all the arguments have been made, these long-term charts reveal the most compelling reason to be cautious on U.S. equities into 2006. If I were a weatherman, my forecast would be 50% chance of heavy showers.
As part of their strategic planning, the Pentagon plays out various military scenarios. I used similar war-gaming techniques to consider what might happen next year. Only instead of nuclear conflagration, I think about consumer spending, corporate expenditures and hiring. What might happen to real estate prices, and how will that impact other elements? Will the demand for commodities continue to increase? Will Asian growth stay strong? What will Congress do: taxes, spending, deficits, politics? What are the political wild cards? I wonder how inflation will impact all of it, and what the Federal Reserve might do, including the expected – and the unexpected.
While doing all this war-gaming, one scenario kept coming up repeatedly: The slow-motion slowdown. It starts with the consumer, who after years of spending, finally tires. Soon, it infects corporate revenue and profits. Slowly, it cascades its way across different sectors: housing, durable goods, discretionary spending, entertainment. Eventually, the decay spooks the markets.
The Business Week survey reveals one group of bullishness. When I made my guess, I never figured I would be the outlier to the downside. Silly me. Most of the surveyed group is clustered between 11,000 and 2,000 (about plus 5%-10%) on the Dow, while advising a 40% to 75% U.S. equity exposure. But its not just the pros. A WSJ.com poll of more than 5,000 people taken on Dec. 30 shows 46% expect the same thing in 2006 as the market gurus: between Dow 11,000-12,000. Just 11% believe the Dow will drop below 10,000. This means 89% of these WSJ readers do not believe 2006 will be a substantially down year. Note that the crowd is not extremely bullish, however. It will take one more rally toward 11,000 to get investors to breathlessly embrace the market. Then the trap door gets sprung.
I understand why the crowd is so bullish. The past few years have seen terrific data points. Despite all of the favorable elements, the markets are essentially unchanged. Look at any U.S. index for the past one or two-year period – or even four or five – and there has been very little progress made. Except for the pre-Iraq war selloff and subsequent snapback, and the rally from the October 2005 lows, there has not been much of a market gain. Are you not curious as to why that is?
Imagine the markets as a four-engine jet. Let us name the four engines M&A, buybacks, dividends and earnings growth. Our jet is cruising along at … oh, let’s say 10,847 feet. All four engines are at full throttle. Yet for some reason, the plane cannot seem to make any altitude. Every time it gets near 11,000 feet, it seems to stall. Once or twice, it even swoops down to gain some speed but still cannot seem to break that altitude. Mind you, all four engines are working at peak efficiency, and have been burning high-priced jet fuel prodigiously. The pilot and crew are experienced, and everyone wants the jet to go higher. Yet it cannot seem to make any upwards progress. Odd, is it not?
Now consider this: What happens if something goes wrong? What if one of the engines flames out? What if we start running low on fuel? Or if there is a human error? This does not mean the plane will plow into the ocean – but it is likely to lose some altitude. That is the situation we have found ourselves in.Part I.
American consumers have happily charged yet another banner holiday season to their credit cards and now, some analysts warn, they could face a hangover in the new year. A combination of higher interest rates, bigger home heating bills, and a slowing housing market could make it more difficult for people to pay down their balances or meet minimum payments on their credit cards, analysts said.
Over the past two years, the quality of consumer credit has steadily improved driven by a stronger economy, rising employment and a booming housing market that has encouraged a growing number of people to use home equity loans to pay down credit card debt. As a result, payment rates – the measure of how fast credit card balances are paid off – are at record highs, and consumers continue to charge away. Last week, Visa USA said that holiday shoppers charged $232 billion on its credit cards, an 18% increase over the same period a year ago, roughly Oct. 31 through Dec. 25. Sounding a note of caution, some analysts warn that consumers will be in for a rougher ride in 2006.
Of course, pundits have been predicting a slowdown in consumer spending ever since the economy went into a post-Sept. 11 tailspin. Yet, save for an initial pullback, consumers have remained surprisingly resilient – so much so that spending in recent years has grown more rapidly than after-tax income. “That by itself is reason enough to expect slower growth in consumer spending next year,” said John Lonski, chief economist for Moody’s. But, Lonski continued, there is another metric that proves a far better predictor of the financial health of the American consumer: unemployment. In October, for instance, consumer credit card delinquency rates fell to 3.3%, the 27th consecutive monthly decline. The drop mirrors a dip in the unemployment rate to 5% in October from 6.3% in June 2003.
Economists predict the unemployment rate will fall further, to 4.9% by the fourth quarter of 2006. “If that forecast holds true, then we ought to avoid a deterioration of consumer credit that is severe enough to substantially slow consumer spending,” Lonski said. Moreover, he added that the recent flattening of the yield curve could cause the Federal Reserve to halt its policy of interest rate hikes. But even Lonski concedes that the housing market remains the big unknown.Link here.
MIDDLE-CLASS JOB LOSSES BATTER WORKFORCE
Many of the country’s manufacturing workers are caught in a worldwide economic shift that is forcing companies to slash payrolls or send jobs elsewhere, leaving workers to wonder if their way of life is disappearing. The trend in the manufacturing sector toward lower pay, fewer benefits and fewer jobs is alarming many of them. “They end up paying more of their health care and they end up with lousier pensions – if they keep one at all,” says Michigan AFL-CIO President Mark Gaffney. As wages and benefits drop, “it’s the working class that’s paying the price.”
West Virginia steelworkers are all too familiar with the problem. The former Weirton Steel, which 20 years ago had some 13,000 employees, today has just 1,300 union workers left on the job. The steel mill has changed hands twice in two years, and just last month, Mittal Steel Co. told the Independent Steelworkers Union it would permanently cut the jobs of 800 people who had been laid off since summer. Abby Abdo, 52, of Weirton, said workers once believed that if they accepted pay cuts and shunned strikes, they would keep their jobs. Not anymore. “Once they get what they want, they kick us to the curb,” he said. “There’s no guarantee anymore. No pensions. No health care. No job security. We have none of those things anymore.”
Dan Fairbanks, of GM’s Lansing, Michigan plant, said the changes are going to force a lot of people to retrench to deal with the new economic reality. For some, it will make it harder to send their children to college or be able to retire when they want. For others, it will mean giving up some of the trappings a comfortable income can bring. “You’re going to see lake property, you’re going to see boats, yo’qre going to see motorcycles hit the market,” he said. “People get rid of the toys.”
Economists agree the outlook is changing for workers who moved from high school to good-paying factory jobs two and three decades ago, or for those seeking that lifestyle now. “It was possible for people with a high school education to get a job that paid $75,000 to $100,000 and six weeks of paid vacation. Those jobs are disappearing,” says Patrick Anderson of Anderson Economic Group in East Lansing, Michigan. “The … low-skill, upper-middle-class way of life is in danger.”
Dick Posthumus, a partner in an office furniture system manufacturing company in Grand Rapids, Michigan, says that “basic, unskilled manufacturing is going to be done in China, India, places like that because we are in a global world, and there’s nothing anyone can do about that.” His company, Compatico Inc., buys much of its basic parts from South Korea, Taiwan, Canada and China, where Posthumus has toured plants he says rival modern manufacturing plants in the U.S. But the company still saves its sophisticated parts-making and assembly for its Michigan plant. “The manufacturing of tomorrow is going to look somewhat different from the manufacturing of yesterday,” Posthumus says. “It doesn’t mean that we no longer manufacture … [But] it’s going to be a painful adjustment.”Link here.
THE WISDOM OF WALL STREET? SOMETIMES IT’S WRONG
As 2006 begins, the great American housing boom is going to weaken, if not collapse. But that will not hurt the economy very much, and growth will continue at a good pace. Or so goes the conventional wisdom. Mortgage applications are down, and surely home sales will follow. Homes in many markets are far less affordable than they were a few years ago. There is a lively argument as to whether prices will fall sharply in some markets or simply level off for a few years, but another record year for the housing industry seems out of the question.
Sometimes, conventional wisdom proves correct, and a year from now that may be exactly what has occurred. But lately Wall Street’s consensus forecast has seemed more likely to miss than to hit, a fact that investors may want to take into account before they sell their homes and await the bargains that will inevitably follow in the great housing bust. A year ago, the one verity in market commentary was that the decline of the dollar was real and was going to continue. The U.S. was running a huge and unsustainable trade deficit, and the dollar’s 2004 decline was likely to accelerate. So what happened? China did grudgingly allow a small devaluation of the dollar against the Chinese currency, albeit one so small that it made no difference at all. But the dollar rallied against the other major currencies. It ended 2005 up 14% against the euro and up 15% against the Japanese yen.
A year earlier, at the end of 2003, market seers were united in expecting long-term interest rates to rise. The Federal Reserve was going to increase short-term rates, and virtually everyone was sure that long-term rates would follow. But they actually fell in 2004, and the yield of the longest-dated Treasury, which matures in 2028, fell again in 2005, although yields on the benchmark 10-year Treasury note rose 17 basis points, to 4.39%. That rate was, however, lower than the two-year Treasury yield, which climbed 133 basis points, to 4.41% during the year. That yield-curve inversion, as bond jargon terms it, set off talk of a slower economy this year.
If the conventional wisdom this year is going to be as wrong as it was the last two years, there are at least two ways for it to be wrong. One would be for housing to continue at an extraordinarily strong pace. An accompanying chart shows sales of single-family homes, both new and previously occupied, for 12-month periods over the last 20 years. But no sign of slowing is to be seen in those charts, and, as Robert J. Barbera, the chief economist of ITG Hoenig, notes, if the next move in long-term interest rates is down, sales could rise even more. The stock market clearly was forecasting a decline in the housing market a few months ago. The Philadelphia Stock Exchange index of housing sector stocks reached a record high in late July and by late October had lost 21% of its value, leaving it down a little for the year. But it rallied 11% by the end of 2005, as profits continued to be strong.
Another way that the conventional wisdom could be wrong is that the impact of a declining housing market could be less benign than expected. Most economists say they think that the U.S. economy will grow around 3.3% this year, a little, but not much, slower than the 3.7% estimated for 2005. If the housing market were to decline, that could be reflected not only in lower construction spending but also in some retrenchment on the part of consumers who suddenly felt less well-off.Link here.
DOLLAR DROP STILL COMING, BUFFETT AND BANKS AGREE
The investor Warren Buffett and the biggest banks in the currency market – Deutsche Bank, UBS and Citigroup – missed the dollar’s rally in 2005. But for 2006, they are standing by their old predictions. Buffett, the chairman and chief executive of Berkshire Hathaway, lost almost $1 billion betting on a decline in the dollar last year against currencies like the pound, which suffered its biggest loss since 1992. Analysts at Deutsche Bank, UBS and Citigroup predicted that the dollar would weaken to a new low against the euro, with the European currency rising to $1.40. Instead, the dollar rose 14.4% as the euro fell to $1.1838 at the end of the year. The dollar also ended the year at ¥117.945 in New York, up 14.7% against the Japanese currency.
These investors and analysts missed the gain by focusing on the U.S. trade deficit instead of a widening gap in interest rates in the dollar’s favor, driven by eight Federal Reserve rate increases. “Who cares about the current account now?” asked Christoph Suetterlin, a currency trader in Zurich at Bank Sarasin. “It’s a side issue. The dollar’s a good investment with rising interest rates, and it’s likely to stay that way.” Buffett and the analysts say they were not wrong, just early. Buffett, who has been selling the dollar since 2002, said the currency should fall because the trade deficit, which grew to a record $68.9 billion in October, keeps widening.Link here.
China hints at shift away from dollar.
China has indicated that it could begin to diversify its rapidly growing foreign exchange reserves away from the U.S. dollar and government bonds – a potential shift with significant implications for global financial and commodity markets. Economists estimate that more that 70% of the reserves are invested in U.S. dollar assets, which has helped to sustain the recent large U.S. deficits. If China were to stop acquiring such a large proportion of dollars with its reserves – currently accumulating at about $15 billion a month – it could put heavy downward pressure on the greenback.
In a brief statement on its website, the government’s foreign exchange regulator said one of its targets for 2006 was to “improve the operation and management of foreign exchange reserves and to actively explore more effective ways to utilize reserve assets.” The announcement came from the State Administration of Foreign Exchange (Safe). It gave no more details about whether this meant a big shift in the investment strategy for Chinese reserves, which according to local press reports reached nearly $800 billion at the end of last year and are expected by economists to near $1,000 billion this year. The statement comes at a time of growing debate in China on how the reserves are invested. Some economists have called on Beijing to use the funds to finance infrastructure investment and clean up state-owned companies, or to invest in higher-yielding assets rather than financing U.S. borrowing. According to Stephen Green, economist for Standard Chartered in Shanghai, although the language was “vague”, the statement was the first time Safe has publicly indicated a shift away from dollar assets.Link here.
SOMETHING A LITTLE OFFBEAT: FREEING YOUR MIND IN ORDER TO SUCCESSFULLY TRADE THE MARKETS
Here is a fascinating report about Emotional Freedom Techniques’ [Ed: A technology to clear oneself of negative beliefs, emotions, etc., which some of W.I.L.’s principals have found useful at times.] possibilities in trading the stock market, commodities market, etc. Before starting EFT, my occupation revolved around the stock market and thus I am quite aware of the potential rewards if one can “free their mind” and be “in tune with the markets”.
Along these lines, Steve Wells provides us with the experience of his client “James” with Australia’s “share markets”. Please note how many negative emotions and beliefs were handled by EFT before the financial success really unfolded.Link here.
COMMODITIES RISE TO RECORD ON SUGAR, COPPER GAINS
Commodity prices extended their 4-year rally by rising to a record, led by gains in copper, sugar and gold, amid concerns about supplies and the pace of inflation. The Reuters Jefferies CRB Index of 19 commodities rose to 338.49, after earlier reaching a record 338.78. The index has jumped 21% in the past year as demand for raw materials such as fuels and metals climbed, boosted by economic growth in China and the U.S. Sugar jumped to its highest price since 1995, after Brazil said its sugar-cane crop will be smaller than previously expected because of a drought. Copper, up 56% in the past year, rose to a record. Gold rallied for an eighth straight session, reaching the highest closing price since 1981.
“People have taken a look and seen how well commodities have done and don’t see any reason why fundamentally things should change,” said Robert Leary, a managing director at AIG Financial Products Corp., which makes markets in 30 commodities for institutional investors. Money invested in commodity indexes such as Goldman Sachs Commodity Index and Dow Jones AIG Commodity Index is up to about $75 billion, from $60 billion in May, Leary said. “It’s both new and old” investors from pension funds to money managers, foundations and endowments and individual investors, he said.
Some investors are buying commodities as a hedge against “rampant inflation”, said Marc Morgan, a copper trader at Triland USA Inc. in New York. “There is no concrete safe haven, other than the fact that you can go into commodities.” The dollar’s biggest 2-day drop against the euro in five years also may have sparked some buying of commodities, analysts said. Gold is up 25% in the past year and reached a 24-year high of $544.50 on Dec. 12. Gold prices are an indicator of future inflation, said Mike Armbruster, a broker and analyst at Altavest Worldwide Trading Inc. in Mission Viejo, California. “When gold starts making a big move, commodities across the board move higher as well,” he said. “It’s the inflation theme driving the market.”Link here.
DO BUY-OUT FIRMS DRAIN THE COMPANIES THE PURCHASE?
Private-equity firms are paying themselves lavish dividends and fees from the companies they acquire, loading up the acquired companies’ balance sheets with debt, according to a published report. The Wall Street Journal, citing statistics from Standard & Poor’s, reported that in the past two years, private-equity firms have paid themselves more than $50 billion from so-called dividend recapitalizations of the companies they acquired. Such dividend financings were virtually unknown just five years ago, according to the paper. It also reported that calculations by some private-equity firms show that as much as 50% of the returns that buyout firms have paid their investors in the past two years came from such dividends, which were financed mostly with new debt.
In the past, private equity firms made their money by restructuring the companies they purchased and then either taking them public or selling them to cash out their investment. But they are now seeing quicker returns through the cash payments that match or top their original equity investment while they still own the firms, according to the report. Some critics told the paper they are worried that the companies being acquired by the private equity firms could fail due to the enormous debt being assumed. Should it “be about how far you can push things or should it be about how much flexibility you give your companies to deal with the unexpected? You can see reason to worry in how much [money] they are pulling out,” Josh Lerner, a professor at Harvard Business School who has done research on the performance of private-equity firms, told the paper. But the private-equity firms told the paper that, in general, they are doing what they are supposed to do: make money for their investors.Link here.
PRUDENT BEAR FUND HEAD DAVID TICE’S VIEWS ARE BORN OF DISTRUST
Investment manager David Tice, who made a name for himself by staring down a revered U.S. corporation, attributes his maverick style to his Midwestern roots. The head of the $411 million Prudent Bear Fund raised eyebrows in 1999 when he was among the first to suspect accounting fraud at Tyco International, then a darling on Wall Street. “I’m from Independence, Missouri, the home of Harry Truman, so I’ve been an independent thinker for a long time,” he told the Reuters Investment Outlook Summit in December.
Tice, who as a short seller makes a living by betting on bad news, views his firm as a “truth squad for Wall Street.” He looks for companies to short by examining earnings quality, business fundamentals and earnings expectations that get ahead of reality. “We’re trying to find all kinds of reasons why favored stocks might decline,” Tice said. Short sellers are a small and often disliked group on Wall Street because they effectively bet against the future of a company. They borrow shares that they think will lose value, only to repay their loan for less and pocket the difference. Tice, 51, cemented his reputation in the small club of short sellers by calling Tyco’s accounting into question when all 26 Wall Street analysts following the manufacturing conglomerate had a “buy” recommendation on the stock. Tice turned out to be right, and then-Tyco CEO Dennis Kozlowski and former Tyco CFO Mark Swartz were each sentenced to 8-1/3 to 25 years in prison for stealing more than $150 million from the company this past September.
Tice started out in 1988 doing investment research for money managers in a spare bedroom with a screaming baby next door. He started the Prudent Bear fund in 1996 because he and his associates felt many stocks were overpriced. But in 2005, the fund, which is about 70 percent shorted stocks, lagged behind the broader market. Prudent Bear was up about 1.5% last year, compared with a gain of 3% for the S&P 500 stock index. Tice, who moved his firm from Dallas to the Virgin Islands a few years ago, now sees trouble ahead for the U.S. housing market. This in turn poses the risk of a long-term bear market for equities, he believes. As a result, the Prudent Bear fund has been short shares of Fannie Mae and is downbeat on the housing and mortgage business in general. “The excesses in mortgage finance are just astounding,” Tice said.
His bearish views on the housing market investing are rooted in the notion that the Federal Reserve has left the economy too dependent on easy financing, which has led to a “credit bubble”. “If you continue to goose the economy with more debt, more debt, it’s almost like keeping your 8-year-old on a sugar high,” Tice said. The Prudent Bear fun’qs other short holdings include struggling automaker General Motors and Plantronics Inc., which makes portable headsets. As a hedge to the fund’s short bets, Prudent Bear is long on a number of gold and precious metals equities. Surging gold prices, which recently neared a 25-year peak, are often a leading indicator of financial systems falling into disrepute. Precious-metals shares account for about 18% of the fund.Link here.
DEFICITS DO MATTER
One cannot argue a priori that a trade surplus is “good” and a trade deficit is “bad”. Much will depend on a country’s composition of imports. If a rapidly growing economy imports principally capital goods for the production of goods or pays patent fees for the application of some inventions, I suppose that a trade deficit can be justified as it relates to capital formation, which leads to investment-driven sound growth and, eventually, boosts households’ real earnings and their standard of living. However, when the trade deficit is linked to a sharp loss of competitiveness, over consumption and relates principally to the importation of consumer goods, I doubt that such a deficit will lead to a rising standard of living in the long term.
Temporarily, and in theory, there could be a rise in the standard of living when import prices decline sharply and allow households to buy a larger basket of goods, while the loss of employment in some industries may be immediately offset by employment in other industries that pay the same or even higher wages. But this does not seem to be the case in the Western industrialized countries and the U.S. where the median real household income has declined by 4% since 1999. This seems also to be supported by data from the Bureau of Labor Statistics and by a survey commissioned by the AFLCIO. According to this survey, which polled 805 working Americans and which has a margin of error of 3.5%, only 11% of the respondents – concentrated among families with annual incomes of $75,000 or more – consider their family income to be rising faster than the cost of living.
However, it is still possible that standards of living have been rising even though median real household income is down, as evidenced by rising debt levels, which have created asset inflation and the illusion of wealth. However, if standards of living have been rising as a result of higher debts leading to soaring household wealth, two points ought to be considered. The gains in household wealth have been unevenly distributed. Between 1983 and 2001, the top 20% of households in terms of wealth received 89% of total growth in net worth, while the remaining 80% of households accounted for only 11% of the growth in net worth.
I think it should be obvious even to a non-economist that when production and investments shift to a region, it creates employment in that region and, through various forms of multiple effects, leads to rising incomes and standards of living. It should not be forgotten, also, that when a manufacturer shifts its production to Asia or any other emerging economy, it is accompanied by a transfer of technology, knowledge, and ancillary services, which then boosts the educational and skill levels of the local population and brings numerous other benefits. In fact, it is wishful – if not arrogant – thinking to assume tha tall engineers, scientists, and inventors will be stationed in the West and that the “uneducated” Asians will be employed in low paying manufacturing and low-value added service jobs. Rather, my view would be that, in future, research and development centers will follow the migration of manufacturing to Asia, since the benefits – the cost advantages aside – of the proximity of manufacturing and product development would seem to be obvious. Given that, in 2004, China graduated around 500,000 engineers and India 200,000, compared to 70,000 in the U.S., and since a company can hire five chemists in China or 11 engineers in India for the cost of one engineer or one chemist in the U.S., it is only a matter of time until most R&D will be carried out in Asia.
The notion that the Western world has a huge technological advantage over Asia would also seem to be negated by the findings of ipIQ, an intellectual property consulting and service company based in Chicago. Using a proprietary patent database that goes back 30 years, ipIQ’s technology rating model tracks patent details and ownership transactions, and ranks companies based on the number of patents granted, including the number of previous-year patents and growth of patents year-over-year. In 2005, ipIQ found that among the 10 companies it ranked as having the highest-quality patents, based on the innovations’ impact on industry and scientific significance, six are based in Asia – supporting the view that the technological and scientific advantages of the U.S. and Europe are waning.
Economists may contend that the U.S. trade and current account deficits are sustainable ad infinitum, which in my view they are not, but very clearly it does not take much economic background to see that the decline in the U.S. balance on services and the explosion in the country’s deficit in its balance on goods indicates very clearly a loss of international competitiveness. This is best documented by a figure that Bridgewater Associates has compiled and which we have published previously, which shows how the United States has lost market share of export markets. When a company loses market share, it affects its profitability in the long term and can threaten its survival (witness GM), while when a country loses market share in export markets and has growing external deficits it will have a negative impact on standards of living and on its financial strength in the long term. However, temporary standards of living can be maintained or even boosted if such an economy goes deeper into debt, as is clearly the case for the U.S.Link here (scroll down to piece by Dr. Marc Faber).
A gallon of crude oil costs $1.45. A gallon of Evian costs $11.91. This simple observation led one successful investor to assert that oil is undervalued. We see things a little differently: Oil may be undervalued, but NOT relative to drinking water. In fact, the truth is exactly the opposite. For most of the world, clean drinking water is a far more precious commodity than oil. While water largely covers this hardscrabble little planet of ours, less than 3% of it is fresh water. And the presence of pollution and disease has made much of that water undrinkable. Unlike with oil, no amount of technological wizardry can replace water. Water resource enthusiasts, such as money manager John Dickerson, know these facts well. He is familiar with all of water’s charms – but the biggest is the simple scarcity of clean water.
There are few industrial countries in the world feeling that scarcity more acutely than China. Its water needs are more critical than its much ballyhooed power needs. I did not fully appreciate this until I visited China myself and talked to Chinese business people. Even Chinese officials – prone to covering up or understating the extent of problems – sound alarmist when it comes to water. One official recently said China’s problem is “more serious and urgent than [in] any other country in the world.” China’s rapid industrialization has outpaced its water infrastructure, which is on the verge of collapse. Two-thirds of China’s 600 largest cities do not have enough water; half of these cities have polluted groundwater. Less than 15% of China’s population has safe drinking water from tap. The recent spill in the Songhua River, widely covered in the media, only worsens the problem. For further perspective, consider this: China has about as much water as Canada, but a population 40 times as large. And nearly half of China’s population resides in the northeastern provinces, where only 14% of the water resources are located. These facts provide endless challenges for the Chinese. Water shortages are a serious threat to China’s booming economy.
The Christian Science Monitor in December 2004 contained a provocative article suggesting that we could see a cartel of water-exporting countries emerge over the next decade, in a style not unlike OPEC. “Water is blue gold; it’s terribly precious,” Maude Barlow, chairwoman of the Council of Canadians, told the Monitor, “Not too far in the future, we’re going to see a move to surround and commodify the world’s fresh water. Just as they’ve divvied up the world’s oil, in the coming century, there’s going to be a grab.” Whether or not you choose to believe Barlow, it is clear that the demand for clean water is real. In an attempt to avert crisis, China plans to build hundreds of new water treatment plants. But for now, bottled water is the preferred choice – even among the Chinese, at least among those who can afford it.
So how to play it? There are several interesting companies working on the water crisis in China. I will run through two of them below. These are not the only companies engaged in solving China’s water resource problems, but they were two of the more interesting stories I found. The largest water company in the world is Veolia Environnement, of France, and, oddly enough, a spinoff of entertainment giant Vivendi. Veolia has a 20-year deal to provide water to Tianjin as well as a bundle of other water and waste management contracts throughout China. Veolia currently serves over 14 million residents in China. Another company is Watts Water Technologies, which has been doing business in China since 1995. The company produced valves used in China’s Three Gorges Dam project on the Yangtze River. In November, the company increased its commitment to China by acquiring Changsha Valve Works.
There are two problems here. First, neither company does all that much business in China. Veolia’s contracts bring in only a small fraction of its more than $30 billion in sales. Watts’s China revenues represent only 3% of sales at this point. This is a common drawback in looking at publicly traded water companies (excluding micro-caps). If you want more concentrated exposure to China’s water crisis, it seems impossible at this point. The other problem is that none of these companies strike me as being particularly cheap. Still, they remain interesting companies to watch – we may get a chance to own them at excellent prices down the road. And as the Chinese water crisis unfolds, it may become clearer as to who and where the winners in this struggle will be. One thing seems certain: Clean drinking water will remain more precious than oil – especially in China.Link here.
A “watershed moment” has arrived! Literally. One of the most dynamic and profitable themes for the rest of this decade will be investing in water. Purifying, filtering, transporting, storing and bottling water will become increasingly important global businesses. Three months ago I wrote to you from Colorado, on the edge of the Great American Desert. This month, I am writing to you from another arid region, Australia. Yes, there is water in the tropical north. But most of the Australian landscape is as dry as Carry Nation. Clean, fresh water is not nearly as plentiful as most Americans seem to believe. We often take it for granted. But most of the world’s residents do not.
In mid-December, the premiers of Quebec and Ontario, along with the governors of eight U.S. states, signed a pact that will ban all large-scale water diversions from the Great Lakes basin. That will prevent fully 20% of the total fresh surface water of the Earth being exported by pipeline to thirsty states like California, Arizona, or Nevada. The eight states that border the Great Lakes – Illinois, Indiana, Michigan, Minnesota, New York, Ohio, Pennsylvania, and Wisconsin – have seen the future. And the future is that fresh surface water is going to be more and more valuable as it gets more and more scarce.
Investing in water has never been particularly easy. But it just got a little easier. PowerShares has come out with a new exchange-trade fund (ETF) based on water stocks. It is called the PowerShares Water Resources Portfolio (PHO). According to the prospectus, “The index seeks to identify a group of companies that focus on the provision of potable water, the treatment of water, and the technology and service that are directly related to water consumption.” There are a couple of things you should know about PowerShares ETFs that make them different from other ETFs on the market. But since Dr. Steve Sjuggerud beat me to the punch on the virtues of PowerShares compared with other ETFs, I will let him explain:
“PowerShares actually started out by asking, ‘What would the customer want?’ As the customer, I want broad exposure to a sector (maybe 30 stocks). Don’t mess with it too much … But, if you must mess with it, please kick out the ‘dogs’ every once in a while, and don’t just passively sit by and watch them go to zero. … [D]on’t load up on overpriced stocks simply because the market value of these stocks has gone up. … PowerShares fulfill both of these objectives. …
“Each PowerShares sector ETF actually contains 30 stocks. And most importantly to me, no stock can make up more than 5% of the portfolio. … Thankfully, the dogs can also be kicked out. … stocks that appear attractive (based on quantitative measures) can be let in … and the super-expensive stocks will still never make it to more than 5% of the portfolio. … [T]he PowerShares portfolio changes quarterly based on dynamic underlying indexes, called ‘Intellidexes’. PowerShares allow me to invest in sectors the way I want … where all 30 stocks in the fund actually affect the performance, which is exactly the diversification I expect from investing in [ETFs].”
The only drawback of the PowerShares method is that you will incur higher brokerage costs and taxable gains because the fund is actively managed. But for the better diversification and performance, your total return on the fund should be much higher, even after the additional costs. A full slate of water utilities are also included among the holdings, with other water treatment and service companies rounding out the rest of it. The intrepid investor may prefer to review each of the 35 particular holdings and construct a smaller portfolio of key water stocks to own for the next 10 years. But for the simplest way to be “long water” in 2006, this is it. The stock just launched in mid-December. By the end of 2006, water will not only be a major geopolitical theme, but also a major investment theme. Drink up!Link here.
MORE ON JOEL GREENBLATT’S “MAGIC FORMULA”
In some ways, the average investor is like a man looking for the right combination to get at the riches in a vault. Unlocking the market’s treasures – knowing which stocks to buy and sell – is a difficult mystery seemingly beyond his powers. If there were only a simple and reliable way to find great stocks, a combination to look for or a magic formula of some kind … something the average investor can use and depend on. One great investor seems to have cracked the code, or at least one of them. In fact, he even calls it his “magic formula”. You are probably skeptical of anything that smacks of a “magic formula”. Rightfully so. The stock market has more than its share of snake oil salesmen and carnies. Not surprising, given the amount of money at stake.
As someone who loves old books and old ideas, I can tell you the search for a “magic formula” is as old as investing itself. The reality is investors of all stripes have been tinkering with such ideas for a long time. The goal is to find a simple way to cull through thousands of stocks to arrive at a reasonable number of names that have a high probability of working out. If you have been reading my letter over the past year, you may remember me writing about Joel Greenblatt before. He is one of my favorites. He is the founder and managing partner of a private investment firm called Gotham Capital. Since its inception in 1985, Gotham, with Greenblatt at the helm, has compiled one of the most astounding track records in the history of investing. He has earned annualized returns of 40% since 1985. That is a truly ridiculous track record. Basically, a $10,000 investment in 1985 comes back as nearly $12 million by the end of 2004!
Greenblatt is one of the all-time greats, even though, strangely, he is not all that well known among casual investors. Certainly, his fame is nowhere near Warren Buffett’s or Peter Lynch’s. Yet his record speaks for itself. He has already written a good book on investing titled You Can Be a Stock Market Genius. Despite its clownish title, this was an important contribution to the investment literature, as it dealt with special situations – such as spinoffs – and showed how and why such investments often worked out. It fleshed out, and brought to a wider audience, a set of strategic options previously known only to Wall Street insiders and certain enthusiasts. Well, Greenblatt has done it again. This time in a new book titled The Little Book That Beats the Market. In it, Greenblatt divulges his own magic formula – a strategy that has, over the last 17 years, returned 30.8%, versus 12.4% for the S&P 500.
The basic goal of Greenblatt’s screen is to find good companies at bargain prices. To do that, Greenblatt relies on two basic ideas – both concepts used by value-minded investors for decades. The magic formula’s two simple ingredients are really just two ratios. The inputs are readily available on a company’s financial statements: The first is return on invested capital (RoIC) and the second is earnings yield (EY). The first is a measure of quality. When comparing businesses, all other things being equal, the higher the RoIC the better. Greenblatt puts his screen to the thousands of stocks on the market today and ranks them, highest to lowest.
We need something else to measure cheapness. We all know Microsoft or Wal-Mart are great businesses, but are they cheap? Just because a business is great does not mean its stock price will rise. That is where earnings yield (EY) comes in. The basic idea is to compare what a business earns with what its price is in the market (enterprise value). Enterprise value is the market cap of the stock less cash plus debt – basically how much, in theory, you would have to pay to buy the whole company at current market prices. The higher the EY, the more earnings for your dollar. It is like a more comprehensive price-earnings (PE) ratio turned upside down. So a business with a 25% earnings yield is like a company with a price-earnings ratio of 4. This is overly simplistic, because in Greenblatt’s formula, a number of adjustments to both the “P” and the “E” are made.
Greenblatt’s magic formula takes these two ratios, ROIC and EY, and screens thousands of stocks, ranking them from highest to lowest. As Greenblatt writes, “If you stick to buying good companies (ones that have a high return on capital) and to buying those companies only at bargain prices (at prices that give you a high earnings yield), you can end up systematically buying many of the good companies that crazy Mr. Market has decided to literally give away.” As noted earlier, Greenblatt’s magic formula stocks returned 30.8% over the past 17 years, compared with 12.4% for the market.
Ideally, formulas of any sort have to make sense intuitively and economically. The ROIC/EY combination is rooted in basic financial ideas that no one will refute. It is not like betting on some odd chart pattern or abstract macro theory. Also ideally, such a formula should be hard to stick with all the time. Otherwise, everyone would use it and the profits would soon disappear. Benjamin Graham’s net-net idea [buying companies selling at less than working capital minus all long-term liabilities] was like that. Most of the net-nets were troubled companies. Investors hated these companies, which is why they were trading where they were. And it is also why Graham’s formula was able to work. It goes against human nature. People read it, they understood it, but they could not follow it.
It is the same with Greenblatt’s formula. A lot of the companies you will find on the list are not popular names, and indeed, many of them have short-term clouds hanging over their heads. This makes sense, because it explains why they are so cheap. Still, these are tough buys for the average investor. And it requires patience to stick with Greenblatt’s idea, something else the average investor does not have a lot of – and that is being charitable. Graham warned readers not to lose patience with his beloved net-net’s if they did not immediately rise in price. He related his experience in holding a net-net for 3½ years and making 165% – a 47% annual return. But almost the entire gain occurred in the fourth year. There are times when a Greenblatt magic formula portfolio will lag the market. But this is a good thing, in a way, because such underperformance will tax most investors’ patience and they will abandon the formula before it really has a chance to work its magic.Link here (scroll down to piece by Chris Mayer).
Gold is not the only metal to stir the hearts of men with feverish dreams. Its long-running companion, silver, also possesses the power to enthrall, and we suspect it will continue enthralling, if not dazzling, investors throughout the rest of this decade. Gold and silver have both functioned as money for roughly 98% of recorded financial history, dating back to the Lydians in the 7th century B.C. But it was silver, not gold, that backed the world’s first reserve currency. Before the almighty dollar, there was the almighty pound sterling, medium of exchange for the British Empire – in merry old England, silver was plentiful where gold was scarce.
Pound sterling aside, silver has played second fiddle to gold for thousands of years. Yet silver has certainly had its moments, drawing the spotlight on more than one occasion. Most notably, the ill-fated attempt by Nelson Bunker and William Herbert Hunt to corner the silver market during the late 1970s. As the daring duo loaded up on silver, the price climbed steadily higher, ultimately spiking to $50 an ounce in 1980. But the gambit to corner the market failed and the silver price collapsed. (You may read all about the Hunt’s wild ride here.)
After the Hunt saga, silver languished for nearly two decades – climbing into the teens a time or two, but generally sliding lower. Over the course of the 1990s, the gap between silver supply and silver demand began to widen. The Silver Institute notes that “Mine production of new silver rose only 4% from 1990–1999, while total fabrication demand increased by 22% during the same period.” Yet, even as the supply/demand gap yawned, silver’s price continued snoozing … until 1997. As the year progressed, it became apparent that someone was buying silver in size. Had the Hunt brothers returned? No, it was someone with much more staying power: Warren Buffett. The Oracle of Omaha revealed an accumulation of 129.7 million ounces of silver dating back to July 1997. This was a real problem for the shorts. Against Buffett, the standard dirty tricks would not work. Apart from hope and prayer, the shorts were out of options. Fortunately for them, things held together. But for the first time in many years, the cracks were beginning to show.
So what did Buffett see to get involved with silver in the first place? Two immediate things come to mind. First, he saw that silver was a compelling value – a Buffett essential. Second, he saw a virtually risk-free hedge for the rest of the Berkshire Hathaway portfolio. The value argument was based on a simple understanding of supply and demand: Silver demand had been covered by drawdowns from existing stockpiles for many years, and supply was simply not catching up. And as a hedge for Berkshire’s equity holdings, silver’s utility was obvious: The same conditions that could produce a massive selloff in stocks and bonds could also produce a massive rally in silver.
When Buffett’s buying hit the newswires in February 1998, the media took an extremely short-term perspective. After noting that he was up 50% in a short time, The Economist wondered aloud whether Buffett would be able to sell out as secretly as he bought in. But chances are Buffett does not care about exiting secretly, and almost certainly does not care about a meager 50% return. It is more likely that his 129.7 million ounces will resurface when they can fetch a 5,000% return, at which point the shorts will be frantically scrambling for every available ounce of silver on the planet.
Silver is showing definite signs of life these days, but has not yet broken loose. Will we have to wait years more before the real fireworks take hold? Perhaps not. The streetTRACKS Gold exchange-traded fund (ETF) (GLD: NYSE), introduced in November 2004, has turned out to be a smash hit. Prior to the introduction of GLD, U.S.-based investors could only get exposure to gold through the purchase of futures contracts, which are volatile and expensive, or via the purchase of physical metal, which can be cumbersome. The gold ETF gives investors flexible exposure to the price of gold through plain vanilla stock accounts. This innovation has made it possible for millions to own gold more cheaply and easily than before, which in turn has significantly increased the demand for the physical metal. (When investors increase their purchases of GLD, the managers of the ETF have to make corresponding purchases of physical bullion.) The streetTRACKS Gold ETF has amassed more than 8.4 million ounces of gold – worth more than $4 billion at today’s prices. In other words, GLD has already pulled 8.4 million ounces of gold off the market. This investor demand will contribute to rising gold prices.
Given the success of the gold ETF, the natural next step is a silver ETF. But when Barclays Global Investors sought regulatory approval to launch a silver ETF, the Silver Users Association (aka mouthpiece of the shorts) loudly objected, on the basis that “it will ultimately be the economy that suffers due to the negative impact taking large amounts of silver out of the market will have on industry.” Well, cry me a river. For years, the shorts have been claiming that the price of silver is low because it deserves to be low. They have implied that silver is plentiful, as well as cheap. They have falsely portrayed the digital camera as an industrial death knell. They have discounted any shortfall between supply and demand. And now that their bluff is close to being called, they complain about a shortage. This tactic smacks of fear and desperation. As far as the silver bulls are concerned, the SUA’s mealy-mouthed warning is a bit like waving a steak in front of a pit bull.
Could this be the spark? If a silver ETF is approved, public demand for silver could explode. Millions of investors would see the wisdom of putting at least a small percentage of their investment portfolio in silver as well as gold. Some will see the wisdom of investing a large percentage and recognize the potential for silver to ultimately soar past gold in terms of total return. On the other hand, if the introduction of a silver ETF is stalled by backroom tactics, eager investors will demand to know why – and the bullish pressure will only increase. Either way, silver will not fail to enthrall and dazzle.Link here.
THE MESS GREENSPAN LEAVES
With Federal Reserve Chairman Alan Greenspan set to retire next month after more than 18 years on the job, it seems appropriate to summarize his performance. Before he became Fed Chairman, some believers in sound money thought Greenspan might push for a less inflationary monetary policy. They pointed to his past as a close associate of Ayn Rand and author of the “Gold And Economic Freedom” chapter in Rand’s Capitalism: The Unknown Ideal. In that chapter, Greenspan argued for a Misesian view of monetary matters, pointing to how monetary inflation lead to confiscation of wealth and destabilizing business cycles, arguing that only a gold standard could protect us from the predation of the state. This is why statists view gold as a “barbarous relic”. He also described the events leading to the Great Depression in much the same way that Murray Rothbard did in America’s Great Depression.
Murray Rothbard warned when Greenspan became Fed Chairman that we should not expect Greenspan to be any better than his predecessors, pointing to Greenspan’s previous record, including his support for President Ford’s imbecilic “Whip Inflation Now” buttons and his saving Social Security by raising payroll taxes. As it turned out, Rothbard was entirely right. When Congressman Ron Paul reminded Greenspan of “Gold and Economic Freedom”, Greenspan said he now realizes he had been wrong, and that as Fed Chairman he was able to pursue policies that mimic the gold standard. That however is a preposterous claim. The global supply of gold has historically tended to grow 1-2% per year. Yet between August 1987, when Greenspan became Fed Chairman, and November 2005, the monetary base rose from $233.5 billion to $782.5 billion, a 235% total increase or 6.8% at an annual rate. The M3 measure of money supply rose during the same period at a 5.8% annual rate. Money supply growth has thus been far in excess of gold standard conditions.
Greenspan has a record of repeated rescue operations during times of financial distress. From the stock market crash of 1987 to the S&L crisis of the early 1990s to the Asian crisis and the collapse of LTCM to the feared Y2K crisis to the bursting of the tech stock bubble, Greenspan has proven himself more than willing to bail out failed investors with additional doses of “liquidity” (the popular inflationist euphemism for inflation). The result of this has been to increase the willingness of investors to participate in speculative bubbles because they know that if things go wrong and they are unable to get out before the bubble burst, their good friend Alan Greenspan will bail them out and limit their losses. Greenspan has thus been responsible for bubbles like the tech stock bubble and the housing bubble both by suppressing interest rates and providing the “liquidity” needed to create the bubbles, and also by reducing investors fear of losses after the bubble bursts by creating the expectations that the Fed will bail them out.
The consequences of this have been great. Instead of falling as a result of increased production, the consumer price index rose nearly 74% between August 1987 and November 2005, an average annual increase of 3.1%. This, together with the even greater asset price increases means that the purchasing power of the dollar has been sharply reduced, something which in turn has constituted large scale “confiscations of wealth”, as the 1966-vintage Alan Greenspan described inflation. Moreover, the illusionary paper wealth created by Greenspan’s bubbles has in turn greatly encouraged people to reduce their savings and increase their debts. The gross national savings rate has fallen since 1987 from 16.5% to 13%, and the net national savings rate from 4.5% to 1%. This decline in savings has come entirely in the household sector, as the household savings rate has fallen from 7% to -1%. Similarly, the private sector debt burden has increased from 120% of GDP to 153%. Again, this increase has been concentrated in the household sector where debt has increased from 77% of disposable income to 121%. Mortgage debt in particular has increased, from 51% to 91% of disposable income.
Greenspan’s policy of inflating bubbles to counter the negative effects of the bursting of previous ones is like someone who remains on a sinking ship because he does not like to swim. We can see here how the policy of inflating bubble after bubble to avoid the recessionary implications of previous bubbles has resulted in ever greater imbalances, with the savings rate falling ever lower after each bubble and the debt burden growing ever greater. Some may believe that Greenspan has been overruled by the other members of the Federal Reserve board – that perhaps he has been pushing for sounder policies, but to no avail. But Greenspan has in fact been highly active in pushing the rest of the board into the various bail-out operations, and it was reportedly Greenspan, together with a certain Ben Bernanke, who claimed that the old economic laws have been repealed and that the Fed can and should “accommodate” the tech stock bubble. Greenspan has thus been responsible for today’s economic mess.
Apart from inflation and economic imbalances, the defining characteristic of the Greenspan Fed has been its dishonesty. We have already seen how Greenspan claimed to have mimicked gold standard conditions. Moreover, instead of admitting how he was responsible for the tech stock bubble through the creation of moral hazard and suppression of interest rates, he blamed the bubble on “irrational exuberance”. And instead of admitting his role in creating the housing bubble, he denied that there was such a bubble. Later, when he admitted that the housing bubble was real, he spoke out against it as if he had nothing to do with having created it in the first place. In his tenure as Fed Chairman, Greenspan has acted precisely like the central bankers he attacked in 1966. The enduring legacy of the Greenspan era will be the large-scale confiscations of wealth and economic imbalances – all of it blamed on others.Link here.
PRICE DEFLATION: A GREAT IDEA WITH LOW PROBABILITY
The debate between those who predict price deflation and those who predict price inflation has been over two closely related issues: 1.) The likelihood of rising U.S. Federal debt to continue to rise, and 2.) the ability of the Federal Reserve System (“FED”) to continue to purchase as much of this rising debt as the Federal Open Market Committee (FOMC) decides is appropriate. The debate is basically over the debt clock vs. the money supply statistics.
Some deflationists might argue that the debt question is much broader than Federal debt. It also includes private debt. In response, the inflationist argues that the source of the debt is irrelevant for monetary policy, since the FED can legally monetize any asset, including privately issued debt. In the 30-year debate between those forecasters predicting more price inflation (99.99%) and those predicting price deflation (0.01%), three facts stand out: 1.) The deflationists have been incorrect every year; 2.) there is still a tiny niche market for newsletters predicting deflation, and approximately three editors have gotten rich by staking out this market; and 3.) those few subscribers who have actually invested for 30 years in terms of deflation have lost most of their wealth.
This niche newsletter market will continue. There is always a market for newsletters predicting the opposite of what most experts predict. Those same three editors will continue to live well and prosper until either death or Alzheimer’s brings their publishing careers to a close. One of them is a second-generation deflationist. I heard his father give a speech predicting deflation and recommending 100% of investors’ money in T-bills at the original gold conference in 1967. After having heard the man’s utterly preposterous arguments and comparing them with the other speakers’ case for gold, I phoned my parents and told them to invest 90% of their liquid wealth in American double eagle gold coins, which they did the next week. The British pound was devalued a month later, gold went up and continued to go up, and my parents made a lot of money. Those attendees who invested in terms of the deflationist’s scenario missed out on a great opportunity. Today, it takes almost $6,000 to buy what $1,000 bought in 1967. Use the inflation calculator here.
Still, thousands of unsuspecting, naïve, economically illiterate investors say, “Wow, this is HOT NEW STUFF!” and send in their subscription money to get a warmed-over plate full of the dead man’s arguments, which are re-packaged annually and sold by his son with the same enthusiasm … and also the same results the following year: price inflation. Like the little old lady who feeds the slot machine with another quarter, even though she has fed it for 50 years without a single win, the deflation-predictor answers, “My odds must be getting better after so many failures.” No, they are not. The machine has been rigged by the house never to pay off. The casino is owned – lock, stock, and barrel – by the Federal Reserve System.
The Federal Reserve System is a government-created, government-licensed, commercial bank-owned monopoly. The only thing that the government legally controls is appointments to the seven member Board of Governors. This is why the web sites of the 12 regional Federal Reserve Banks end in .org. Only the Board of Governors’ site ends in .gov. This is why the 12 regional Federal Reserve Banks must pay for postage, but the Board of Governors does not. The legal independence of the FED was announced by the Ninth Court of Appeals in 1982.
The FED has two primary tools of monetary policy: 1.) the sale (deflationary) or purchase (inflationary) of assets – mainly U.S. government debt, mainly 90-day T-bills – that serve as legal monetary reserves for American commercial banking; 2.) control over the legally mandatory ratio of reserves to deposits – reserves that commercial banks must put on deposit, interest-free, with the Federal Reserve, unless they hold cash in their vaults. Reserve requirements for most banks are low – about 10%. The ratios are lower – 3% or 0% – for smaller banks. So, there is not much that the FED can do with respect to altering reserve requirements that is not deflationary, i.e., raising reserve requirements, which the FED never does. The FED can also set the discount rate – the rate at which commercial banks borrow short-term money from the FED. Banks almost never do this because the FED then has the right to do a detailed audit of any banks applying for these subsidized loans. Instead, banks borrow from each other overnight: the federal funds market. This is governed by the famous federal funds rate, which the FED can influence through monetary policy: buying or selling assets.
Then what is the FED’s operational tool of monetary policy? Adding (buying) or subtracting (selling) from the banking system’s legal reserves, i.e., the monetary base. The legal basis of the world’s money supply is debt owned by central banks and commercial banks. A central bank increases the nation’s monetary base merely by adding to its holdings of assets, which are composed mainly of government debt certificates and, to a much lesser extent in practice, gold. Gold pays no interest. Government debt does.
The mindset of central bankers is tied closely to the interest payments received from governments. They want to preserve the value of the central bank’s asset portfolio. But the seven members of the Board of Governors do not own the central bank or its assets. So, their primary concern is to provide the American commercial banking system with security against runs against money-center banks. This is what the senior-level Rockefeller-employed and Morgan-employed commercial bankers wanted when they met secretly on Jekyll Island in 1910 to design what became the FED. The FED has never let them down. No New York City money-center bank has ever failed. The 6,000+ small banks, mostly rural, that failed in the Great Depression were forced to sell their assets to larger banks. The recipient banks continued to collect interest from the rural debtors. The debtors had lost all or most of their deposits when their local banks went bankrupt. What more could bigger banks ask for?
Secondarily, central bankers want to preserve the purchasing power of their nation’s monetary unit, in which government debt is denominated. Politicians also say they want this. So do commercial bankers. And they really do. The crucial question is: At what price? What they really want is this: general price stability at a discount price. They do NOT want it at these prices: 1.) An economic depression, 2.) runs on the banks by depositors, 3.) the bankruptcy of money-center banks, 4.) an inter-bank payments gridlock, 5.) the abolition of the Federal Reserve System, or 6.) a return to a market-created monetary system. So, year by year, the central banks create new money to buy more government debt certificates. The debt-sellers then spend this money into circulation. Prices rise.
The Federal Reserve System can create money. It can buy all the debt that borrowers are willing to sell at a market price, i.e., the prevailing rate of interest. Those forecasters – I hesitate to use the word “economists” – who have predicted deflation for over three decades have insisted that someday, the inverted pyramid of debt will collapse. They never say why or how. If cousin Sam wants to sell a million dollars of debt, nothing legally prevents a central bank from buying it. If Uncle Sam wants to sell a billion dollars of debt, nothing legally prevents a central bank from buying it. There are always people who are willing to issue more debt at some low rate of interest. The largest issuer of debt on earth is the government of U.S.
Deflationists argue that the day will come when debtors will not be able to find lenders. Deflationists do not explain in coherent language why the central banks of this world cannot buy this debt and lots more just like it. The deflationist scenario rests on the strange supposition that central banks will not buy debt from insolvent debtors. They do not argue that central bankers will NOT buy this debt. They argue that the sellers of debt will use the money to pay off debts, and the debt pyramid will collapse. There is nothing in modern history to indicate why this might be true. There is also nothing in monetary theory to indicate why this might be true. Those predicting deflation insist that someday, somehow, central banks will not be able to lend enough money fast enough to keep the fractional reserve banking system from producing bank failures, thereby producing a shrinking money supply. This assumes that the FED cannot monetize anything it chooses to monetize by buying ownership. But sellers who are in a squeeze are happy to sell to anyone who can provide them with enough money to meet their debts. Such a person exists: the legally constituted person known as the Federal Reserve System.
But, the deflationists insist, when everyone is in debt over his head, there just is not enough money in the world to fund the debt pyramid. They are correct; there is not enough money in the world to fund it. But there is more where that came from. When it comes to insufficient money in the world, central bankers have a solution. It is not a zero-price solution. The solution could lead to the depreciation of the monetary unit to close to zero. This has been done in the past in nations that have lost a major war: Germany and Austria, 1918–23; Hungary, 1945–48. But in industrial nations during peacetime, this has not taken place. Booms and busts do take place, but not the complete destruction of the monetary unit. Still, over time, the erosion of purchasing power continues.
“But what about Japan?” ask the deflationists. I hear this over and over. “Japan proves that a central bank can create money, yet prices fall.” Oh, yeah? How far have consumer prices fallen in Japan since 1992? Do you know? Probably not. You know who else assumes that you do not know? Any newsletter promoter who is selling a subscription based on a prediction of price deflation. Fact: in not one year since 1992 has the rate of price deflation in Japan fallen by as much as 1%. In half of the years, Japan experienced price inflation. In 2004, prices were flat. What does this tell us? It tells us that the deflationists have neither economic theory nor modern economic history on their side. In a productive economy, consumer prices would fall in a non-fractional reserve banking system. New gold from the mines might increase the money supply by 1% or 2%. New production might increase by 3%. So, there would be a steady, predictable fall in prices.
What is wrong with price deflation? Nothing that I can think of, assuming that people have correctly forecasted it, and assuming that it is not the result of prior monetary inflation by the banking system. What is wrong with this? In other words, what is wrong with increased production and a stable money supply – “too many” goods chasing “too little” money? Price deflation can and does come with monetary inflation, i.e., increases in the supply of gold. It can also come with the increase of fiat money. Here is the wonderful offer made by the free market: things may get cheaper, despite mild monetary inflation.Link here.
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