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I still like North American energy on a 2-to-5-year time horizon. But in the shorter run, crude oil prices and energy stocks are extremely vulnerable beyond the unfolding bear market. Sell these now and buy them back later when they are cheaper. Their vulnerability stems from the excess liquidity that has sloshed around the globe in recent years. That results from the appreciation American homeowners have extracted from their abodes, from the huge U.S. current account deficit and from excess corporate cash. If you thought the speculative climate died in the 2000-02 bear market and 2001 recession, you should take another look. It survived on massive Federal Reserve easing, huge tax cuts and leaps in military and homeland security spending. Speculation simply jumped from stocks to real estate, emerging markets and commodities.
Oil in particular. Investors became convinced that growing global demand for energy, the industrialization of China and India and the lack of spare production capacity would keep crude prices surging ever upward. They have bought oil for delivery many months hence in the futures market, pushing those prices above spot levels. Institutions have sunk a net $80 billion into oil futures funds since 2004. The futures price for December 2006 is now $4 a barrel higher than the price for immediate delivery.
This condition, colorfully called “contango”, is not how the futures market usually works for oil – and it will not last. Normally, when oil prices are rising, futures contracts for crude cost less than spot prices, a phenomenon called backwardation, because oil further out is typically seen as less valuable than oil that is available today. But now oil producers can lock in a profit by selling future production (or selling what they now hold in inventory) in the futures market. They have become hoarders. The consequence of that contango has been a completely logical, if highly unusual, climb in crude oil inventories occurring at the same time that prices skyrocketed. Inventories are now back to the peak levels of 1998, just before oil prices collapsed in December of that year. Abroad, there is talk that Iran has chartered 20 huge tankers to store excess oil that would total 40 million barrels, or half a day’s global demand. That is a lot. And you can bet that old tankers on their way to the scrap yard are getting reprieves to serve as floating storage.
Futures contract holders are very vulnerable. Prices have to rise $4 per barrel between now and November 17, when the December contract expires, just for owners of December crude oil futures to break even. It will take a lot more Mideast turmoil for that to happen. What is clear is that the oil price spiral will end. Maybe the market will run out of buyers. Maybe energy prices will get so high that demand is curtailed. If nothing else, the ongoing collapse in housing prices and the global recession to follow will slash energy demand as well as stocks.
Speculators will bail out, and distant futures prices will collapse. That in turn will kill the desire to hold inventories. The contango will revert to backwardation. Producers and refiners will dump inventories on the market. Crude oil price declines of $30 to $40 per barrel from the current $75 can be expected. True, that would carry them below equilibrium levels, but markets overshoot on the downside just as the oil market has done on the upside. Oil prices held up relatively well in the mid-May through mid-June recession-anticipating debacle in gold, base metals, emerging markets and other speculative areas. In the face of high inventories, they will not keep doing that for much longer.Link here.
Let us take the very rosiest assumptions for corn ethanol, from the paid PR flacks who lobby for the subsidy. They claim that it takes 35,000 BTUs of energy to make 77,000 BTUs of ethanol from corn. No one else gets a ratio anywhere near that good. Some calculations show that corn ethanol actually costs energy to make. But even this most unrealistic case assumes that about half the energy in a gallon of subsidized ethanol has to come from somewhere else. For comparison, it takes around 22,000 BTU to make a gallon of gasoline. Gasoline contains about 114,000 BTU per gallon, so there is a clear energy profit.
Looking at market price instead of BTUs, on June 6 wholesale cost for ethanol was around $2.67 per gallon, vs. 2.09 for gasoline. Even cheating, corn ethanol still is not as good as gasoline. And mixing the ethanol in to make gasohol adds further refining costs. So, the ethanol programs force us to pay more per gallon for a diluting fuel additive that gives only 2/3 the miles per gallon. This means more gas station stops, more wasted time and gas. And the ecological effect of each fuel?
Oil-based gasoline comes from very small drill holes in deserts, tundra, and sea bottoms. U.S. ethanol is made from corn, grown in large dusty monoculture fields that must be covered with pesticides and herbicides. Ethanol programs subsidize soil destruction, deforestation, habitat destruction, and bunny-killing. All so-called “biofuels” are a step backward ecologically. 59% of the northeastern U.S. is now forest. The eastern U.S. has more forested acres now than in the mid-1800s. This reforestation is due to our replacement of biofuels with higher-tech oil, gas, and nuclear power. If we allow the market to improve our technology, eventually we would only use “biofuel” for grilling our salmon.
Not too many people are in favor of cutting down forests, polluting streams, and exterminating wildlife for money-losing programs that make us all worse off. So why has welfare for corporate moonshiners lasted since 1980? Some say that it is because these programs transfer billions to a few powerful people, while inflicting only a few hundred or perhaps a thousand dollars in damage on each American. Thus the concentrated interest has incentive for rent-seeking campaign contributions, while the burden on the average worker is lost among all the other taxes and government-sponsored cartel and monopoly exactions.
But there is also another ecological factor here: infosphere pollution. Those who benefit from multi-billion-dollar subsidies will spend tens of millions to spew polluting memes into the media. Thus, false science and economic fallacies fill up our hard drives and our minds, outcompeting the unsubsidized species. Can we overcome infosphere pollution? Or are we doomed to pay for the destruction of our own environment, because the majority of media is produced specifically to confuse us into supporting parasitic special interests?Link here.
A WAREHOUSE OF VALUE
The chief virtue of industrial REITs: They tend to weather bad times well.
Bustling office towers, lively shopping malls, thronged hotels: All have done well in recent years for the real estate investment trusts that own them. With their nice yields and fat rent rolls, REITs in general have easily outpaced the S&P 500. Collections of properties that kick off rental income, REITs have clocked an annual 24% total return – appreciation plus dividends – over the past three years, versus the broad stock index’s 7.5%.
There is a strong case to be made that REITs are a good thing to have in your portfolio long-term. But inevitably they will skid, especially during an economic downturn, when demand flags for those offices, malls and hotels. A possibly safer alternative: industrial REITs. These entities, which mainly own warehouses, do not have quite the glamour of other REITs. (Ever hear of a Frank Gehry-designed warehouse?) But their tenants stick around. In the 2002 recession year industrial REITs sported a 17.3% total return when many other sectors were down. Offices, the largest REIT type, lost 6.8%.
Thus far in the still-healthy economy of 2006, warehouses have been trailing in the real estate category, with an 8.8% return (versus 13% for REITs collectively). Office REITs are way up, 20%. Even that longtime laggard, apartments, is surging as demand rises, because mortgage payments are climbing, discouraging home buying. Nonetheless, REIT research firm Green Street Advisors expects industrial development to quicken in the second half of the year. A key strength for industrials is that they are better at avoiding oversupply – the bane of real estate – than the others. Warehouses take only six months to erect, so industrial REITs can quickly turn off the development pipeline. Another strength of industrials is that even if the economy slows, their corporate customers still need logistics. And that often involves consolidating from small warehouses to larger ones, the province of industrial REITs.Link here.
BUY CLOSED-END FUNDS FOR INCOME
Income investors need not be slaves to the Federal Reserve Board. You can get steady cash from a portfolio without owning Treasury bonds. Diversify across the stock market, real estate and oil and gas. A good way to accomplish this is with closed-end funds. Two years ago I recommended buying closed-ends to get their high income, income that was derived in part from leverage. The funds borrowed short term at low rates and invested the money long term at high rates, pocketing the difference, a maneuver called “the carry trade”. A year later I called for selling closed-ends because the Federal Reserve’s rate-hike policy was punishing funds reliant on leverage. Now it is time to get back in.
For the moment leverage provides a fund no advantage because the yield curve is close to flat. That is, there is no spread to pocket between short- and long-term rates. But I expect the curve to steepen over the next 12 months. When it does, leverage will magnify the return from a portfolio of bonds and preferred stocks. Right now not a lot of investors are foolish enough to keep playing the carry trade. Fixed-income funds are borrowing short term and channeling the money into short-term instruments in a sort of holding pattern. That obviously does not make them much money. But they keep going in this circle because they do not want the source of their short-term money, corporate lenders, to dry up. Restarting when the time is right would be a hassle. They want to be ready to go.
With exchange-traded funds now the fad on Wall Street, you may be asking why I still favor old-fashioned closed-ends. There are three reasons. One is that ETF offerings in the bond sector are still somewhat limited (albeit getting better by the day). Next, ETFs generally do not use leverage. Third, you cannot get an ETF at a discount to its net asset value – the whole point of the ETF structure is to keep the shares trading almost precisely at NAV. Closed-ends are often available at a discount. This discount enhances your yield, offsetting the closed-end’s expenses (which are higher than expenses of an ETF).
If you are buying in a taxable account, look for a preferred stock fund paying mostly dividend income that qualifies for the 15% federal tax rate. For tax-deferred accounts, a fund offering fully taxable interest income provides a better yield. If you want some exposure to a rising stock market, get a closed-end that owns convertible stocks and bonds. If, on the other hand, you think the stock market is going nowhere for now, you can enhance your income by buying a fund holding a stock portfolio that writes call options against it.Link here.
THE SHORT, SHARP SHOCK
There are corrections, and there are bear markets. What we are experiencing right now is a correction. Know the difference. As this column went to press, the Morgan Stanley World Index had fallen 11.5% from its May 9 peak to its June 14 bottom – and then risen. The damage may not be over, but it is not the beginning of a sustained bear market. You should be buying stocks now. There is more bull market ahead before any real bear market. What makes me confident that the decline will be short and small? Corrections and bear market beginnings act very, very differently. Having the one means not having the other. And this decline has the distinct fingerprint of a correction.
Corrections are preceded by spike tops. You see a rally (such as we had in the first four months of this year) followed by a sharp cliff that takes the market down 10% to 20% in a very short time. The retreat is over very quickly, in one to four months. Usually, there is a story to go with it. In the correction of 1999 the explanation was the upcoming Y2K crisis, which did not happen. In the current spill a common rationalization is that the new Federal Reserve chairman, Ben Bernanke, is bad news for equities. It reminds me of the five-week 10.4% correction of 1979 that accompanied Paul Volcker’s ascension to that job. The Bernanke scare is just another one of those silly stories that accompany corrections. In time the explanation wears thin and the bull runs.
The adage is true: “Bull markets die not with a bang but with a whimper.” The crash of 1987 is the last century’s only real exception, and in many ways it was simply an oversize correction. It was big, fast and over fast. By contrast, the bear market of 2000-2002 accumulated slowly. For 11 months around the market peak in March 2000, the Morgan Stanley World Index never wandered outside a 9% band. But that slow and painful downturn was the prelude to much worse. At the bottom the world index was off 51% from its peak. Buy stocks now, before it is well understood that the recent correction is a short-lived phenomenon.Link here.
COMPANIES TANGLED IN SARBANES-OXLEY PROBLEMS CAN OFFER PROFITS FOR THE PATIENT INVESTOR
Bearingpoint is the former consulting arm of accounting giant KPMG. So it was particularly embarrassing last year when it got embroiled in an accounting mess that forced it to stop issuing financial results – a condition Wall Streeters call “going dark”. In April 2005 the firm told investors they could no longer rely on the filings it had made in the past. Within two days the stock was down to $5.28 - half of what it had been the year before. Investors, including Fidelity Investments and Hotchkis & Wiley, unloaded millions of shares … while other investors jumped in. Glenview Capital, a New York hedge fund, amassed a 7% stake in stock and convertible bonds. Ariel Capital, a Chicago value fund manager headed by Forbes columnist John W. Rogers Jr., bought 29 million shares for a 15% stake.
Call this the Sarbox Effect. Any hint of accounting irregularities, for which the Sarbanes-Oxley Act imposes dire penalties, causes corporate managers to freeze up and conservative investors to head for the exits. Scavengers like Glenview come in. BearingPoint (NYSE: BE) shares have recovered to $8.15. Hanging over BearingPoint’s head are a failed accounting system and possible violations of federal antibribery laws. The firm has yet to announce when it will begin issuing financial filings again. But this does not mean that an Enronesque collapse is imminent or even that its business – advising companies on computer installations, including accounting systems – is weak. It may reflect no more than overcaution as the financials are redone.
Sarbox provides a powerful incentive for management to move slowly and carefully. Under the draconian law, passed in 2002 and taking effect in November 2004, officers risk jail if they certify numbers that turn out to be false. The irony here is rich, says Eugene Fox, a portfolio manager and analyst at Cardinal Capital in Greenwich, Connecticut. “Sarbanes-Oxley was supposed to increase the flow of information to investors,” he says. “It’s done the opposite.” Sarbox victims suffer in the market from more than a dearth of information flow. They are barred from doing many things involving their stock, from buying back shares to redeeming options. Sometimes their shares are delisted from the stock exchange. Big institutional investors may sell because their policies forbid them to own stock in a company that has become an enigma.
But some money managers see bargains among Sarbox victims. “Once we looked past the shorter-term Sarbox issues, we saw [in BearingPoint] a company that would recover and thrive,” says Ariel analyst Kenneth Kuhrt. With new management and a strong government business, he says, BearingPoint can generate solid earnings once it stops spending so much money on lawyers and accountants. Not all Sarbox victims are winners, of course. Advanced Marketing Services “went dark and never came out,” says Fox, who owned the stock for a while but sold it when the company failed to unravel the accounting problems.Link here.
CENTRAL BANKS LOOKING TO EXIT THE DOLLAR
I have often mentioned the inevitable move by central banks to diversify their reserves out of the U.S. dollar. Apart from the current situation, there is no precedent for any non-redeemable paper currency being held as the primary reserve of the world’s central banks. That diversification out of the dollar, with a lot going into gold, has begun. A regime change is afoot – although few have yet recognized it.
Recently, Russian President Vladimir Putin ordered the Russian central bank to raise the gold share of its foreign reserves from 5% to 10%. That is no small matter, given that Russia’s reserves have surged to $247 billion. Accomplishing the shift to 10% gold would require purchasing 21 million ounces of bullion, which is about one-quarter of the world’s annual mine production. And thanks largely to oil exports, Russia is accumulating additional foreign currency reserves at a rate of about $100 billion per year.
Meanwhile, in China, Monetary Committee member Yu Yongding is not alone in calling for Beijing to diversify its $875 billion reserves into gold to protect against a tumbling dollar. More recently, Zhao Qingming from the Chinese central bank’s Financial Research Institute and Luo Bin from its accounting department wrote in a note published in China Money Market that using some of China’s forex reserves to buy gold could “maintain and raise the value of China’s dollar holdings.” That conclusion seems questionable, but the important thing is that more Chinese officials are jumping on this bandwagon.
Given the trillions of U.S. dollars washing around the world’s monetary system, these are not inconsequential developments. They greatly favor gold and other tangibles. What is the alternative for a dollar-heavy investor or central bank? The Who-Owes-You-Nothing euro? Or the yen, which is the proximate cause of the current bubble? How about the Zambian kwacha or the Vietnamese dong? I think not.
As I have explained previously, thanks to the traditional seasonal pattern, gold buying will pick up in August, which should kick gold solidly back into gear. After that, as the wheels start to come off the global economy, I expect gold to gain serious upside momentum. That is not to say there will not be corrections, even substantial ones, along gold’s trek to $2,000 and beyond. There will be. But the trend for higher gold prices is firmly entrenched. While there are many reasons for that trend to accelerate, the most important is the desire to hold the metal. That is why it is so significant that investment demand for gold is up 37% over the past year. Demand will only rise as the months go by and everyone from central bankers to oil sheiks to hedge fund managers to everyday Joes piles into gold out of distrust of the U.S. dollar – and of the government that purports to stand behind it.Link here.
THE MARKET’S ETERNAL SPRING
The advance second quarter GDP estimate, released by the Bureau of Economic Analysis last week, showed the quarter’s growth at 2.5%, lower than expected, while the price index for gross domestic purchases increased at a 4.0% annual rate, higher than expected. The market responded by soaring into the stratosphere, in the belief that the lower GDP growth would cause the Fed to pause in its rate tightening. Hope really does springs eternal in the stock market’s breast! On closer inspection, the details in the BEA release confirmed pessimism, not optimism. Real GDP figures for 2002-05 were revised down by 0.3% per annum, while the price index was revised upwards by 0.2% per annum – thus we were not as rich as we thought we were, productivity growth was lower than we thought, we were already suffering more inflation than we thought and monetary policy was in real terms significantly looser than we thought.
There is really no way to get around the fact that if inflation keeps on rising, interest rates will eventually have to follow, to a level high enough to bring that inflation down again, regardless of what the U.S. economy does. If the economy went into a severe recession, inflation might drop because the price of domestic inputs would decline (as would commodity prices if the world shared in the recession) but the experience of the late 1970s demonstrated pretty conclusively that even with quite a sharp economic downturn, if interest rates remained at a low level in real terms, inflation would rebound as soon as the economy stirred again into life. If as Wall Street seems to expect, the Fed pauses in its increases in short term interest rates, while inflation continues to ratchet upwards, the effect is a continuing loosening of monetary policy. However this will not produce continued economic expansion.
A reason is that after several years of loose money and proliferation of private equity funds and hedge funds, all aggressively seeking deals, some of the investments that have been made with the readily available money will turn out to have been turkeys. Like the overexpansion of telecom bandwidth in 1999-2000, let alone the dot-com speculations of those years, the turkeys will take some time to reveal themselves, but as expansion continues, the rate of turkey production will increase until, even without monetary tightening, the collapsing turkeys will produce an overall loss of confidence.
The rise in nominal interest rates the Fed has already implemented represents little or no monetary tightening in real terms. Although in real terms a 7% home mortgage with inflation at 5% is no more burdensome than a 4% home mortgage with inflation at 2%, in cash flow terms it is far more difficult for a borrower to handle, since the required monthly payment (including principal repayment) is about 40% higher. Over a long period, inflation increases the borrower’s income and maybe the value of the property, but in the short term the burden is considerably increased, maybe to the point where it is unmanageable. Thus even if real interest rates remain low, the affordability of housing decreases, and demand for housing diminishes. Given the aggressiveness with which speculative building has taken place, this can only result in a housing glut, and at least a moderate fall in house prices, which will in turn produce defaults and bankruptcies of its own. Even loose money cannot sustain a housing bubble forever.
As well as the downbeat GDP figures, and the widening of a new war in Lebanon, the other major event that might have been expected to have an effect on the market was the final collapse of the Doha round of trade talks, and their supposed replacement by a spaghetti of bilateral trade agreements. When there are no worldwide pressures for freer trade, it is clear from the 1930s experience that subsidies, non-tariff barriers and special politically-motivated deals multiply, to the great detriment of world prosperity as a whole. The Doha trade negotiations themselves were far more valuable than any outcome of freer trade that might eventually have emerged from them.
Under Doha’s predecessors, tariffs throughout the world were lowered dramatically from 1948 to 1994, resulting in a revival of world trade to its pre-1914 levels and since 1980 a surge in world economic growth that has missed only the heavily protectionist continents of Africa and Latin America. The alternative policy now to be pursued by the U.S., bilateral trade agreements, is directed by politics rather than economics. The Doha round offered only a modest chance of engendering a world of low and uniform tariffs and no non-tariff barriers or subsidies, but they did at least offer some hope of a reduction in the world’s greatest economic distortion, agriculture subsidies – just as the 1994 Uruguay Round of trade talks has finally, more than a decade after it was signed, more or less disposed of textile quotas. Thus the collapse of this generally benign system is an economic disaster, which is likely to reduce world economic growth by a measurable percentage, thus losing us all hundreds of billions of dollars. Most likely, the most visible effect of the protectionism will come in higher inflation as prices are propped up by producer-oriented deals and cartelization, while price-reducing trade enhancements like the opening of the world textile and garment markets fail to appear.
This week thus contained important bearish news, both for the short and long term. However over the week as whole, the Dow Jones Index had its best week since November 2004. The Efficient Market Hypothesis states that stock market prices include the effects of all information, short term and long term, to produce a valuation that is minute by minute rational, so that it is impossible to achieve superior returns through superior understanding. Once again, we have had a week that proved what utter twaddle this is.Link here.
WAR AND THE FINANCIAL MARKETS
Generally, people think that war and violence make the public feel worried, depressed, and angry. First comes war, then comes the negative reaction in social mood. But the opposite point of view makes even more sense. That is, first people feel angry, and then they make war. The corollary is that when people feel happy, they make peace. This formula is a 180º turn from the normal idea about which came first. But if this different perspective sounds right to you, then you might also like to know that a good way to take the measure of a nation’s social mood is to look at its financial markets. Bull markets signify a positive social mood, while bear markets signify a negative social mood.
The longer a bull market goes on, the more positive and happy the populace feels and the more it works together on social goals. The longer a bear market goes on, the more negative and unhappy people feel and the more they become polarized from one another and want to fight over issues. Bob Prechter of Elliott Wave International has developed this theory, which he calls “socionomics”, based on patterns of the human herding instinct. Since financial markets record the bullish (positive) and bearish (negative) moods of millions of people, they turn out to be a useful measure of social mood. That is why back in 1982, Prechter was able to predict that with a bull market in full swing – and there to stay for a while, according to his technical analysis at the time – there would be “no major international war for at least 10 years.” And there was not. In fact, the euphoria of the bull market lasted until 2000.
But, you might say, the bull market during the 1950s and ‘60s was not exactly a total love-in. What about the Cold War? Prechter says that was a perfect example of the kind of conflicts that take place during bull markets: “Bull-market hostilities mean you don’t fight”q he says. “The Cold War was a phenomenon of a bull market. Hot wars happen in bear-market trends.”
Which leads us to the state of martial affairs in the world today. Although the world’s financial markets are not out-and-out bear markets now, the trend lately has been more sideways and down than up. Many hit multi-year highs two months ago. Social mood could be turning from the powerful pull of positivity to one of negativity. From the looks of the warlike world around us, it seems that people have become less likely to want to work out solutions to conflicts together and more likely to start shooting and ask questions later. It looks – and feels – like fear, anger, terrorism, fighting, missile launching, and belligerent behavior are on the ascendancy. If the markets rise again along with a more positive social mood, however, we may see the leaders of some nations decide to back down or find a way to conciliate their differences. But if the markets continue to fall, as Prechter predicts via Elliott wave analysis, then the world could be heading in the other direction toward a more dangerous and longer-lasting conflict, maybe even a return to the “Eve of Destruction”, Barry McGuire’s anti-war song from 1965.Link here.
FOUNDATIONS OF U.S. HOUSING MARKET START TO LOOK SHAKY
Not so long ago in parts of the U.S., new homes were often sold before their foundations could be laid. But the home boom is now showing clear signs of waning – and analysts say that has worrying implications for consumer spending in the world’s largest economy. Most economists agree that housing demand is likely to slow further in coming months, after recent interest rate hikes and soaring energy prices. But few are predicting the abrupt bursting of an overly inflated bubble. In the past week, a government report highlighted that the number of unsold new homes on sale across the country swelled to a record high of 566,000 last month. And an IMF report said that U.S. property prices were “overvalued”, just one of the headaches facing Federal Reserve policymakers.
Homeowners have benefited from double-digit annual rises in their property values to go on a credit-fuelled spending splurge. But now the picture is changing. “Many individuals, who signed a (purchase) contract in what they had believed was a booming housing market, may now be backing out of those contracts,” said Phillip Neuhart, an economic analyst at Wachovia Securities. “Thus, the new home market is likely weaker than new home sales reflects,” he said. The Commerce Department last week said sales of new U.S. homes declined 3% in June to a weaker-than-anticipated annualized rate of 1.131 million units. News of the latest sales downturn, and the record number of new homes that are languishing unsold, followed an industry report that showed existing home sales fell 1.3% in June.Link here.
Nominal U.S. house prices to dip for the first time ever.
Jan Hatzius, economist at Goldman Sachs, said, “The risk is rising that nominal U.S. home prices may be headed for an outright decline in 2007. It would be the first decline in national home prices ever recorded, at least in nominal terms.” In real terms, prices have declined during several periods, including a 9% drop from 1979 to 1984.Link here.
The slowdown is just beginning.
No matter how hard some people try, they cannot seem to float this housing bubble anymore. “Sales of previously owned homes in the United States fell in June for the eighth time in the past 10 months, reflecting a continued slowdown in the housing market, according to a report released today by the National Association of Realtors,” begins an article in the Washington Post.
Reuters followed suit with its own take, this one more upbeat and mixed with the latest consumer confidence results. “The pace of existing home sales fell … to the lowest rate since the beginning of the year, as sales of condominiums tumbled and price increases were the weakest in 11 years … Analysts had expected home resales to slow even further to a 6.58 million unit rate.” Existing home sales results were written off as if “beating the number” really had any bearing on the housing bubble at all. And because the mindset is that home values can never really go down, many people (especially realtors and anyone trying to sell a home) are saying that prices have “leveled off” and that the market is “returning to normal.”
What we are seeing in Baltimore’s housing market – and many others across the country – is a staggering increase in homes listed for sale. In fact, these high inventory numbers have not been seen since the early 1990s. During the frenzied buying we saw this time last year, one realtor told me the average house in the city was under contract within two days of being listed. Now we see this incredible gain in inventory, which boils down to more choices for potential homebuyers. We are entering a point where buyers are reluctant to offer as much for a home, and sellers are reluctant to drop their prices. But prices will have to eventually be adjusted. As Mike “Mish” Shedlock wrote last week: “As soon as someone drops their price by $100,000, every house in the neighborhood will be repriced. Comps will drop like a rock. Consumers used to seeing nothing but rising prices are in for a rude awakening. Their house will no longer be an ATM.”
But much of the damage has not yet been done. While foreclosures have risen in some areas, the consequences of irresponsible lending that has transpired during recent years have yet to really take their toll. And as the housing boom continues to unwind, payday lenders and loan collectors will prosper, especially since many homeowners have cashed out their equity and continue to live beyond their means. A little more than six months ago, I wrote about some businesses that could benefit when the effects of a stale housing market began to sink in. Now it is time to check in on these four companies’ progress this year:Link here.
Hamptons real estate sales slow as rising rates sideline buyers.
The highest interest rates in four years are sapping confidence in real estate, even for wealthy Hamptons buyers who typically spurn mortgages and pay cash for their waterfront mansions, said Judi Desiderio, owner of Town & Country Real Estate in East Hampton. People are concerned that house prices will fall as demand wanes, she said. “Wall Street bonuses traditionally fuel our market, but so far this year we haven’t seen a lot of that money spent on real estate. Everyone is talking about a bubble bursting as interest rates go up, so they’re waiting on the sidelines to see what happens.”
“The real estate market was on a five-year binge and now everyone has a hangover,” said Paul Brennan, regional manager in the Hamptons for Prudential Douglas Elliman Real Estate. “The frenzy is gone and the fog is clearing as we deal with Iraq, gas prices and higher interest rates.” Average prices for a Hamptons home broke $1 million for the first time in 2005, more than doubling from $499,194 in 2001. In the first six months of this year, the average price was $1.26 million, up 21% from a year earlier.Link here.
Inflated appraisals bungle refinancing.
As the housing market cools, Americans are confronting a problem that was easy to ignore during the boom: Inflated appraisals of home values. Critics inside and outside the appraisal business have long warned that many appraisals are unrealistically high. That is partly because generous appraisals help loan officers and mortgage brokers, who often choose the appraiser, complete more deals. If a home is appraised at less than the buyer offered, the deal is likely to fall through.
Inflated appraisals did not matter much when home prices were rising at double-digit rates, since market values would quickly catch up. Now, however, prices are leveling off in many places and falling in some. Some homeowners are finding that the market value is below what past appraisals led them to believe. For sellers, that can mean being forced to drop their asking prices. Some people hoping to refinance, meanwhile, may be unable to lock in new loan terms because they have less equity in their homes than they thought. Lenders and mortgage investors, too, could take a hit if it turns out the collateral backing their loans is worth less than expected.
Dubious appraisals are a risk for the hundreds of thousands of people who in the past few years have bought homes with little or no down payment, or owners who used almost all of their home equity to finance home improvements or other types of spending. That has left these people with little financial cushion to deal with rising interest rates. “Now it’s pay-the-piper time for people, and they’re finding out they don’t have the value in the house they thought they had,” says John Taylor, president of the National Community Reinvestment Coalition, a Washington-based nonprofit group that supports low-income housing.
Appraisals are only opinions, and appraisers often disagree on the value of a home. No one can say how many appraisals are unreliable. Still, Iowa Assistant Attorney General Patrick Madigan, who coordinates with law-enforcement officials from other states on mortgage-related issues, believes the deliberate inflation of appraisals is “widespread” among loans to subprime borrowers, or those with flawed credit histories. Jacquie Doty, an executive at Freddie Mac, predicts that inflated appraisals will lead to more foreclosures.
The appraisal system has a built-in conflict of interest. Appraisers often are hired by loan officers or mortgage brokers, whose compensation depends on how many loans go through. Appraisers, dependent on loan officers for their livelihoods, say they often feel pressure to come up with a number that will allow a home purchase or refinancing to proceed. Eric Randle, an appraiser in the Los Angeles area, says he frequently receives faxes from loan officers asking whether he could appraise a specified home at a certain level. The implication is that an assignment will be forthcoming only if he was willing to hit the desired number. Randle says he declines to work on those terms.
Even when all parties want an honest appraisal, that can be hard to achieve. In making their value estimates, appraisers rely heavily on “comps”, or prices paid recently for similar homes nearby. But those prices may be misleading. For instance, builders of new homes sometimes include in the sale prices such items as landscaping or contributions toward loan fees or settlement costs. Such “concessions” are rarely broken out in the sale price listed in public records, though. So the resulting inflated price can become a misleading “comp” for nearby homes.Link here.
The flip side of wealth creation.
If you believe Larry Kudlow, first of all turn off your computer before you respond to any emails from Nigeria. Second of all, if you believe Larry Kudlow, then a new era of wealth creation is upon us, thanks in part to a housing boom that has made everybody rich, but not so rich that the boom can be called a “bubble”, a term that indicates that the current environment (or at least the environment of a few months ago), is unsustainable.
Certainly more and more money has been steered toward the housing market and all things housing related for the past several years, and certainly prices of houses have been climbing higher and higher thanks to the ingenuity of mortgage bankers, the eagerness of mortgage borrowers and the dream-fulfilling skills of realtors. Whether this is “wealth creation” or merely “collateral for more borrowing creation” is a matter of opinion. Certainly no wealth has been created for those standing outside the circle of fun with a downpayment in one hand and a sheet of real estate listings in the other. For those first time homebuyers, prices of homes have gone up faster than the money accumulating in their savings accounts. Even with tricked-up mortgages, the average monthly principal and interest payment was 24% higher in 2005 than in 2003.
That bit of mortgage trivia comes straight from a National Association of Realtors survey released in June. The survey results, certain never to be mentioned on Kudlow’s program, reveal a few of the drawbacks to running out and buying the biggest house you can (almost) afford. The most eye catching of the results, in part because they are presented in the first sentence of their press release, reveal that one out of three Americans worries that rising monthly payments will force them to sell their home and buy a less expensive one. One-third! And surprisingly, these skittish homeowners are not worried so much about escalating mortgage rates as are they are about rising property taxes and energy costs.
And then there is the term used in the survey that describes the kind of home Americans might want to buy – a “less expensive” one. That is a phrase linguists thought had disappeared from the English language long ago, along with “cell phone etiquette”. Imagine millions of Americans even thinking such wealth destructive thoughts. So what would happen if Americans bought fewer or less expensive homes? Who knows, but look at the brightly colored chart below and see how the money associated with purchasing a home exploded in recent years. The chart illustrates “transaction” value, which is simply the number of existing and new homes sold multiplied by the average price those home sales. A rising line only requires rising home sales or rising prices. A sharply rising line requires both, which has been the case in spades since 2000.
An accompanying table presents some of the metrics of giant homebuilder, D.R. Horton. Those numbers not only reflect management’s ability, but in them we can also see the rising homeownership rate, slouching lending standards, and home price inflation that helped to triple the net income of this particular business in just three years. But what happens if fewer homes are sold or if home prices stop increasing? If, e.g., the number of homes D.R. Horton closed falls by 10% and – with inventories of unsold homes rising, it would not be unreasonable to see – home prices fall 10%, then the company’s gross profit margin falls to 20%, a figure that has occurred previously, and gross profits would fall by a third. This is no news to investors in stocks of homebuilders. What would be news, however, is if all the wealth creation since 2000 is not a reflection of a new financial era, but sort of what you would expect when lots of people are loaned lots money.Link here.
It has not burst, but the housing bubble is real.
When it comes to bubbles, the ironies tend to emerge in hindsight. Looking back, the book Dow 36,000 marked the top of the bubble hysteria in 2000. For the housing bubble, the equivalent could be last year’s Are You Missing the Real Estate Boom?, re-christened this year as Why the Real Estate Boom Will Not Bust – and How You Can Profit from It.
The biggest argument against labeling the housing bubble for what it is, is that it has not burst. Therefore, any who have suggested its existence must be crying wolf. But there is a reason the bubble has not burst yet. Bubbles do not burst without a pinprick. David Rosenberg, Merrill Lynch’s chief economist, was the first on Wall Street to call it a bubble, in August 2004. He predicts the pinprick will be oversupply. “That has inevitably unwound every bubble back to the tulips in the 17th century.”
Although it may redeem Mr. Rosenberg and this columnist in the end, neither of us is glad that the oversupply has officially been documented. It is not enough to say that new and existing home inventories are at a record .That has been the case for a long time now. At 4.3 million units, the combined number of homes for sale is up nearly 40% from one year ago. One year ago, as I wrote about the disturbing build in inventories, readers wrote to reassure me that buoyant sales would work to keep supply in balance. Today, existing-home sales are running 9% lower than a year ago. This has pumped up supply to 6.8 months’ worth, from a cycle low of 3.7 months in January 2005. On the new-home side, things appear a bit better thanks to incentives. Supply remains at 6.1 months, up from 3.5 months in August 2003. Oversupply is most rampant in the condo market, where supply is at a record 8.0 months, up from 3.1 months in June 2004. The catalyst is a 15% sales decline over the last year.
The best news for Dallas is that inventories are not yet as bad as they are on a national level. Existing-home inventories are at a 6.2-month supply, and condos are at 7.6 months. And local sales are still up on the year. But then, we are the caboose on this deflating bubble train. Sales in the South are down by the mildest 5.5%. In the Midwest they are down 6%; the Northeast, 10% and the West, 17%. In California, sales have gone for a 26% free-fall.Link here.
IS THE FED IRRELEVANT?
This post is a continuation of “Lights out in Georgia”, the saga of Sonnypage, an Atlanta-area real estate broker. He concludes his recounting of the dismal current conditions in the residential real estate selling industry with this assessment: “Bernanke faces an interesting dilemma. Does he continue to raise rates to keep inflation in check and defend the dollar? Do that and you get, IMHO, a catastrophic housing-related recession in this country, and very soon, at that. It may already be baked in the cake. If he pauses in August, and continues to pause, does the dollar fall, perhaps precipitously? That will indeed generate inflation, because the cost of imports, including oil, will rise. I am very long gold.”
Reality has set in for Sonnypage. To his credit, he is not denying the truth. What supposedly could not happen in Atlanta seems to have happened, and like a shot out of the blue, too. The best year ever that Sonnypage had in January and February may turn out to be one of his worst years ever. So what happened?
There are probably several other ideas people could add to that list, but I can sum it all up in two words: Psychology changed. Perhaps a better way of expressing that idea, for the Austrian economists tuning in, is time preferences changed. The reality of that has yet to be factored into the stock market. Sonnypage said the Fed faces a dilemma. Unfortunately, “dilemma” does not remotely begin to describe the problem Bernanke faces. Back in May I wrote, “Bernanke is trapped in ‘Wonderland,’ but, unlike Alice, has no way out. Bernanke gets to choose between hyperinflation and deflation. The moment he cannot run fast enough, the U.S. economy will implode. If he runs too fast, the value of the U.S. dollar, as well as the Fed’s power, will both come to a very abrupt stop. … In effect, Bernanke is in zugzwang, and he does not even know it. Eventually, Bernanke (like the Bank of Japan) will have to choose deflation. The reason is simple: Hyperinflation will end the game, which in turn would eliminate the wealth of the Fed, as well as all of its power.”
The Fed is no longer in control of this economy (not that it ever really was in the first place). The U.S. consumer is in control (in conjunction with global wage arbitrage and other global factors, such as foreigners being willing to finance our debt, and at what interest rates). Simply put, if people decide to stop buying houses, there is nothing the Fed can do to make them. The Fed can encourage, but not force, speculation.
I believe we reached near-universal sentiment this year on two myths that are about to be shattered:
Those beliefs are about to be sorely tested. What can Bernanke do about it? The answer is nothing. Oh, sure, he can cut the fed fund rate, but long-term mortgage rates have not really risen that much – perhaps a point or so. Is a pause, or even a one-point cut, going to be enough to get people to buy overpriced houses when real wages are falling for the masses? Of course not. Psychology (time preference) has changed.
If Bernanke starts slashing rates, is there any guarantee that long-term rates drop? I think not. It is even possible there is a revolt of some kind on the 10-year note and long rates go up. Even IF long-term rates come crashing down, does that necessarily mean that mortgage rates follow? They always have. But once again, I think not. I suspect mortgage rates will be reluctant to drop quickly because of rising defaults and foreclosures. Perhaps the best fixed rates will go only to those that can make a substantial downpayment. If so, first-time buyers may be shut out of this market for years to come simply because of affordability issues. Who does not already have a house that wants one and can afford one?
In theory, the Fed can create hyperinflation by dropping money out of helicopters. In practice, the Fed is constrained by the ability and willingness of consumers/corporations to take on more debt, the ability and willingness of banks/credit companies to extend more credit, and the unwillingness of the Federal Reserve to print itself out of power. There just is no plausible scenario under which the government would bail out consumers at the expense of banks and creditors. The Bankruptcy Reform Act should be proof enough of that statement.
Given that housing and consumer spending make up well over three-fourths of the economy (heck, consumer spending alone is about 70%), I fail to see what can possibly replace housing as a jobs engine. Multitudes of those dependent on the real estate bubble look destined to tighten their belts or go under or both. How long did it take to flip the “lights out” switch in Atlanta? Based on Sonnypage’s posts, it is instantaneous. If it is happening in Florida, Atlanta, Phoenix, Boston, Las Vegas, San Diego, and D.C., exactly what is going to stop it from spreading elsewhere?
The California Department of Real Estate recently reported that the total number of agents in the state passed 500,000 in May for the first time – a staggering one agent for every 55 adults in the state. How many of those “employed” real estate agents are actually making any money? Yet all those self-employed agents will show up as “employed” in the “Household Survey”. How many additional “self-employed” are trying to make a living on eBay or via “home networking” scams? As a practical matter, the reported unemployment rate is now totally out of whack with reality. Meanwhile, homebuilders keep building houses no one can afford, and banks (for now) are still willing to lend them money to do so.
It seems reality has finally sunk in for Sonnypage, even if it has not yet sunk in for the masses. Most people are still in denial over housing, and most still seem to think the Fed is some all-powerful economic force. Unfortunately, the damage caused by poor economic and political decisions over the last 20 years is simply not reversible by the Fed, or anyone else. The Fed is not really in control of our economy, but it sure wants you to believe it is. All things considered, the Fed is basically irrelevant. I wonder how long that bit of reality will take to set in, not just for the masses, but for the Fed itself.Link here.
ANXIETY RISES AS PAYCHECKS TRAIL INFLATION
Last week, as the Chicago City Council prepared to vote on a bill that would impose a $10 minimum wage on the city’s big-box retailers by 2010 and require them to pay health benefits as well, the big guns came out to defeat it. Mayor Richard M. Daley said the bill was tantamount to redlining, because it would keep stores and jobs out of black neighborhoods. Andrew Young, the 1960’s civil rights leader, traveled to Chicago and chided black leaders who supported the bill. Around the city, Chicagoans could see a “Don’t Box Us Out!” advertising campaign paid for by Wal-Mart, and editorials in both Chicago newspapers denounced the bill. But it passed anyway, with 35 votes in favor and just 14 against, meaning that even if the mayor uses a veto – something he has never done since taking office in 1989 – he may lose.
Meanwhile, in Colorado, Gov. Bill Owens signed a bill requiring people to prove that they are legal residents of the U.S. before they can receive government benefits or a professional license. The debate over the law has dominated the news in Colorado for weeks, a good indication that immigration will be a big issue in this year’s midterm elections and not just in border states. The common ingredient in Chicago and Colorado is not simply populist anger. It is a particular anxiety that people have about their paychecks. Whether the culprit seems to be Wal-Mart’s drive for profits or an illegal immigrant who takes someone’s else job, many families feel as if they are falling behind. They are right. While it can be dangerous to make too much of two isolated incidents, these seem like a signal that the politics of the American economy may be coming to a turning point.
Going back to the 1970’s, the single best predictor of the nation’s mood has been its collective paycheck. For all the other things that affect public opinion, like a war or a scandal, the power of wages jumps out at you when you look at broad polling data over the last 30 years. When pay has been steadily increasing, as it was in the 1980’s and late 90’s, optimism has surged. But when pay stagnates, pessimism about the country’s future inevitably takes over.
There have been only three periods since World War II when pay increases have fallen behind inflation. The first came in the 1970’s, after decades of healthy raises. The public malaise became so severe at the time that a sitting president was moved to say, “For the first time in the history of our country, the majority of our people believe that the next five years will be worse than the past five years.” A year later, that president – Jimmy Carter – was unseated by the Reagan revolution. The second period started at the very end of the 1980’s, and eventually forced the early retirement of the first President Bush and the Democratic leadership in Congress. The third period of wage stagnation is now. Since peaking in 2003, the real hourly pay of the median worker has fallen about 2%. The decline has been closer to 4% for people in the upper-middle part of the wage distribution and for those toward the bottom. In essence, most Americans have not been receiving cost-of-living raises, and the national mood seems to be shifting as a result.
Right now, Americans’ view of the economy is nowhere near as negative as it was in the early 1980’s or early 90’s, but there is a real anxiety about its direction. According to the University of Michigan’s consumer poll, a stunning 57% of Americans say they expect the next five years to bring periods of widespread unemployment up from 38% two years ago. The obvious analysis is that this will help the Democrats, the party out of power, and to some extent it probably will. Independent voters are now nearly as pessimistic about the economy as Democrats are. But the only solid historical conclusion is that falling wages will bring some kind of political turmoil. Moreover, the complex reality of a growing economy that is not benefiting most workers will tempt both parties in some dangerous ways. Do not be surprised if the local outbursts of anxiety in Chicago and Colorado soon go national.Link here.
WHY OPTIONS BACKDATING IS A BIG DEAL
A debate over its nuances misses the point: Incentive-based compensation is broken.
For the past several weeks I have been asking experts – lawyers – if they think the options backdating scandal is a big deal with major ramifications, a medium-sized brouhaha that will fade after the egregious abusers have been punished, or a tempest in a teapot we will have forgotten by Christmas. Wishful thinking aside, almost nobody believes it is Door No. 3, a scandal-of-the-day wiped out by the next news cycle. The question on backdating then remains: pervasive rot in the system or technical malfunction that needs to be cleared up?
My conclusion is the former. So first let us dispense with the pooh-poohers, those who would minimize the importance of this issue. And they are legion. Options backdating is something of a misnomer. At its worst, the practice is called backdating because an executive manages to move the date of a stock option back in time, presumably to when the stock price was lower. Stock options grant the recipient the right to buy shares at the stated price after a certain period of time has gone by. If the market price is higher than the so-called strike price, the employee makes money. Find a way to lower the price of the grant – by moving back the grant date during a rising market, for example – and the option is worth even more.
The scandal, however, involves far more shenanigans, and deeper nuances, than mere backdating. Forward-dating in the event of good news, holding open a grant to see where the stock goes and systematically picking dates that represent a low point in the stock are all variations of how the game is played. Some of the practices could be outright fraud. Some are perfectly legitimate. Sometimes it is just not clear. One of the few things that is clear is that regulators, prosecutors and companies’ own audit committees believe there is a problem.
If the subject is so complex, then why argue that the whole system is rotten? Consider this: Stock options were invented as a way to align the interests of employees with shareholders. The first time the system began to crack was in the 1990s, when companies with falling stock prices began to reprice their stock options in order to retain their employees. With a righteous fury, arrogant Silicon Valley executives in particular glared at anyone who suggested shareholders would benefit by ending a practice that would lead to losing valued employees. Shareholders, of course, did not get the opportunity to reprice their shares. The practice halted when rules changes required shareholder approval for repricing.
Since then, the system of awarding options has gone from an incentive program to an entitlement. Companies that cannot or do not offer rich options are at a disadvantage to those that do. Executives – with the complicity of their accountants, lawyers, compensation consultants and boards of directors – game the system to ensure not that employees are working for the shareholders, but rather that employees will make extra money in all but the gravest of circumstances. Options were considered so sacrosanct that Silicon Valley bigwigs fought tooth and nail to avoid having them accounted for as a compensation expense.
So here is a radical proposal: Scrap the whole system. Pay employees a competitive and living wage. Pay them more when the company does well but only after shareholders have been rewarded. Do that in the form of transparent bonuses and profit-sharing plans. Outsized riches should be reserved for the company founders, not the hired help, which, let’s face it, is what most executives are. But stop gaming the system and then complaining that the rest of the world (capricious regulators, dopey journalists, and so on) just does not understand.
True entrepreneurs, by the way, the kind that drop out of school, max out their credit cards, eat ramen noodles and risk everything for a dream, will not mind this at all. They do not need stock options to get stinking rich. They have the stock of the companies they start. True entrepreneurs do not need to play games to become wealthy. It is the executives – the people the shareholders hire to look after their interests – who have been reaping entrepreneurial returns that need to be stopped.Link here.
TO WEAR OR NOT TO WEAR (ANTI-INFLATION WOLF’S CLOTHING OVER A SHEEP HIDE)
Is the economic boom intact or beginning to rapidly unwind? Are inflationary pressures building, or have they instead peaked right along with home prices? Is the U.S. consumption-based economy at the edge of the proverbial cliff, or is it rather more a case of an inflationary bubble economy continuing to luxuriate in unprecedented credit and speculative excess? Is reduced liquidity an issue for U.S. and global markets, or is the liquidity backdrop as loose as ever? Has the Fed already overdone it, or is the Bernanke Fed about to make a serious policy error and acquiesce to an inflationary boom?
For me, if there were ever a befuddling backdrop beckoning for analysts to lean heavily on their respective analytical frameworks – that time is right now. To begin with, second quarter financial sector earnings reports offer scant evidence of any significant slowing of system credit growth. The major “banks” maintain an aggressive business posture, with robust growth in lending and capital markets activities. The push to satisfy Wall Street earnings growth demands is intense, and the ongoing huge stock buybacks are as well indicative of more aggressive lending and market activities to come. Financial conditions remain extraordinarily loose. Credit availability remains easy and marketplace liquidity abundant. It is worth noting that the NYSE Financials are up almost 7% y-t-d, outperforming the S&P 500 and most other indices.
I found Freddie Mac’s Mid-Year Economic Outlook (from a couple weeks back) quite interesting (and they do occupy an enviable catbird seat over the U.S. economy). Freddie economists forecast second-half consumer spending moderation and a general economic slowdown. They expect both 2006 housing starts and total home sales to decline 7% from last year’s levels. Home price appreciation is expected to slow to 7%, with mortgage originations falling 12%. All the same, “mortgage debt outstanding, supported by new construction and house appreciation, should grow by 13% over 2006 …” It is worth noting that bank real estate loans expanded at a 13.7% annualized rate during the second quarter (from Fed data), with what appears a major push to finance the commercial real estate sector. Estimates have second quarter bank loan growth as high as 11%, and it is simply difficult to envisage the economy faltering meaningfully in the face of such a rampant expansion of finance.
I am today mindful of the financial sector simply “redeploying” its lending infrastructure away from household mortgage loans to commercial real estate, corporate, energy, small business, education, etc. It is a central tenet of macro credit theory that if the financial sphere is willing to lend and there is a general expansionary/inflationary bias within the economic sphere, borrowers will be inclined to borrow and spend. Some now discuss a looming recession, although a disciplined focus on the credit system and financial conditions finds such talk premature. Clearly, an increasing number of strapped homeowners face a confluence of rising mortgage payments, surging energy costs, and some even declining home values. The Fed is clearly concerned, and I view this as the major impetus for the Bernanke Fed’s desire to wrap up the “tightening” cycle.
As always, the markets are keenly focused on the Fed’s focus, thus today overstating the immediate influence of household mortgage risk on financial and economic performance. The markets now assume there is sufficient evidence of household mortgage vulnerability to engender the Fed to imminently end rate increases, and all they (the Fed and markets) have been waiting for is some less robust economic data to justify a pause. Now they have got it. The inflationary backdrop is only important as a determinant of how much longer Dr. Bernanke must adorn himself stiflingly in wolf’s clothing. This Fed would surely rather tolerate inflation than risk a housing bust.
So, as we have done repeatedly over the past few years, we will again watch and wait to see what impact declining market yields have on U.S. and global financial markets, economic performance, real estate markets and “animal spirits” generally. From the Financial Times: “The [emerging markets] love affair is back on … immediate evidence is of excess cash, which is finding a home in [emerging market] assets.” Brazil’s Bovespa index is now up about 12% y-t-d, the Mexican Bolsa 14%, Argentina’s Merval 10%, Hong Kong’s Hang Seng 14%, Poland’s WIG 29%, Russia’ RTS 38%, and India’s Sensex 14%. Emerging debt markets have quickly returned to a boil. Gold prices are up 23% y-t-d, crude oil 20%, silver 26%, and copper 84%.
There should be little dispute regarding the acute global vulnerabilities associated with the leveraged U.S. homeowner here at home and highly leveraged and speculative markets here and across the globe. Yet there is a fine line between vulnerabilities that restrain risk-taking and those systemic vulnerabilities that keep timid central bankers adverse to the risk of taking away the punchbowl. As we are witnessing yet again, the danger of central bankers accommodating a long period of credit and speculative excess is that the associated fragility will only entrap them in perpetual accommodation.
The global sell-off that transpired during May and June is certainly at least partially explained by the fear – from highly speculative markets – that the Fed and global central bankers were increasingly compelled to tighten financial conditions. I do not buy into the notion that the Bank of Japan and other central banks were removing liquidity, although there was justifiable angst that central bankers were growing impatient with the sweeping surge in asset and commodities prices. But with the Fed now yearning to wrap things up, the BoJ poised to make Greenspan’s crawling “baby-steps” appear a brisk trot in comparison, the ECB likely not in a position to play the world’s sole responsible central bank, and the weak dollar pressuring the major central banks to limit their rate increases – there is today a definite risk that speculation returns with an emboldened vengeance.
Attempting to wind up with some analysis, I will suggest this: Global financial conditions remain problematically loose, a dynamic that will stoke those sectors, economies, and markets that have been demonstrating robust inflationary biases (including energy, metals, commodities generally, “emerging” markets, “developing” economies, and, importantly, global finance). Global imbalances have nowhere to go but to grow – and grow precariously they will. There should be no mystery surrounding the dollar’s recent poor showing. I have argued that the key issue is not so much bubbles in energy, emerging markets, metals, commodities, etc., but an intractable bubble of dollar liquidity inundating the world’s markets and economies.
If the allure of global markets and commodities again takes U.S. institutions, hedge funds, and investors by storm, the dollar’s fortitude will be tested. That U.S. securities markets are underperforming and the highly mal-adjusted U.S. bubble economy is in the earliest stage of what will prove a wrenching and protracted – and likely stubbornly inflationary – adjustment period bodes poorly for our currency. And considering the highly unstable and deteriorating geopolitical backdrop, it should not be consoling that the Chinese, Russians, and oil producing countries are these days accumulating the vast majority of bubble dollar reserves. This is not the “good old days” when our dear friends in Tokyo were accommodating our boom. And, by the way, what are the ramifications for a mixed-up world that increasingly despises us while stockpiling our financial assets?
Yet, fixating on every trivial piece of economic data, the bond market is all giddy with the notion of a sheepish Gentle Ben – yielding the warm and fuzzies for years to come. Well, I have my doubts that it will take much to incite another speculative run in energy, metals, commodities and emerging markets – in the process inspiring a run away from the dollar – for our spineless Fed to have to reluctantly squirm back into its foolhardy wolf outfit. One of these days, this whole charade just will not placate. One of these days the world will simply be Fed up.Link here (scroll down to last heading in page content section).
A credit machine running amok.
The Anglo-Saxon countries have been the high-growth economies among the industrialized economies. By definition, strong economic growth implies that domestic investment exceeds domestic saving. Actually, Mr. Bernanke and others have repeatedly justified the capital inflows with the fact that capital investment exceeds domestic saving. On the surface, this is true. But this description represents a grotesque distortion of the economic reality. What has truly happened in the U.S. and the other English-speaking countries is that private households, in response to inflating house prices, have slashed their savings even faster than businesses slashed their capital investments. As a result, minimal investment exceeds nonexistent domestic saving. This explains their stronger economic growth.
To illustrate this with a comparison: In France, the personal saving rate is hovering lately at around 11.4% of disposable income, literally the same level as in 2000. This stability in savings has prevailed despite sharp rises in house prices because everybody in France regards this as inflation, not as saving. Living systematically beyond one’s means is not a way of life in France and many other countries. In the U.S., personal saving over the same period has slumped from 2.3% of disposable income to negative 1.6%. The key point to see is that the stronger growth of the Anglo-Saxon countries had one single overriding reason, and that was to boost consumption at the expense of savings. If the U.S. had the savings rate of most European countries, it would be in depression.
Now to the U.S. economy. With zero savings and runaway credit expansion, the U.S. ought to have sky-high interest rates. Thanks to large bond purchases by the Asian central banks and the virtually limitless availability of carry trade in dollars and yen, implemented by the two central banks, U.S. long-term interest rates have held at absurdly low levels. On the surface, interest rates are determined in the markets. In these two countries, they are heavily manipulated by the central banks. Strikingly, the Fed’s 16 rate hikes over the last two years have done nothing to curb the recorded domestic credit expansion. Yet dollar carry trade, which also has played an important role in funding highly leveraged asset purchases, is dead in the water, simply because short-term rates have caught up with long-term rates. Astonishingly, the bond market has only minimally reacted.
Barely noticed, the U.S. credit machine ran amok again in the first quarter of 2006, revealing the Fed’s tightening as a farce. Nonfinancial credit expanded $2,914 billion, annualized, up from the prior quarter’s $2,434 billion. Together with an increase in financial credit by $1,479 billion, the total adds up to $4,393 billion. Compared with an increase by $827 billion in 2000, credit and debt growth has quadrupled. In a country without domestic savings, the money for such a runaway credit expansion must implicitly come from credit creation through the domestic financial system and foreign investors and lenders. They famous “conundrum” of stable U.S. long-term interest rates defying all the rate hikes is due to the fact that measured by the pace of the credit expansion, there has not been the slightest monetary tightening. Instead, the Fed has accommodated runaway and permanently accelerating credit growth.
Nevertheless, as explained, the rate hikes at the short end of the yield curve have cut off the dollar carry trade. But it has been replaced through sharply accelerating U.S. domestic bank credit expansion, and further highly leveraged carry trade in yen, but perhaps also in euro and the Swiss franc and bond purchases by Asian central banks. Of course, rate hikes are generally applied to put a brake on credit growth and price inflation. The fact that in the United States the credit expansion sharply accelerated exposes the rate hikes as an outright sham. The point is that the Fed kept the banking system liquid enough to continue an aggressive credit expansion.
But the most important credit source for economic activity during the past few years is running out of steam, not because monetary conditions have become tight, but because the delivery of collateral for higher borrowing against rising house prices has slowed sharply in line with their sharp slowing. Purchasing power currently spent comes from income or credit. In times of yore until 2000, U.S. private households got their purchasing power, like everywhere else in the world, overwhelmingly from current income, provided by increases in employment and real wages. Yet since the early 1980s, there has been a steadily growing resort by households to borrowing, as reflected in a steadily falling savings rate. After 10% of disposable income at that time, it was down to only 2.3% in 2000. From then on, the relationship between income growth and debt growth has radically reversed. Debt growth has escalated ever faster in comparison to income growth. This recovery of the U.S. economy since November 2001 has been dominated by an unprecedented consumer borrowing-and-spending binge.
American policymakers and economists find it convenient to speak of “asset-driven” economic growth, in contrast to the “income-driven” growth pattern of the past. But “asset-driven” is a euphemism for “bubble-driven”, because what matters is not the existence or creation of assets, but their soaring prices celebrated as “wealth creation”. The second utterly negative point to see is that this asset price inflation has been manifestly driven by ultra-cheap and loose money and credit, and not by saving and investment.
With short-term rates now up to 5% and the housing bubble slowing down, the possibilities of borrowing are bound to shrink. To nevertheless maintain further increases in consumer spending, much stronger income growth will be needed either through higher real wage rates or higher employment. What are the chances? In brief, employment and income growth are worsening. First of all, wage growth is barely matching the rise of the inflation rate. So everything depends on stronger employment growth. This, however, dramatically deteriorated in April and May. Even including 482,000 phantom jobs manufactured out of thin air by government statisticians, the reported figures are flat awful, implying further income stagnation, if not worse.
Looking at the monetary aggregates, something else strikes us as most ominous, and that is the difference between record-strong double-digit credit and debt growth and record-low growth of the money supply. M1 and M2 gained 3.2% and 4.9% over the last quarters. Adjusted for CPI inflation, this was close to zero for M1 and up just 1.3% for M2. We regard this as ominous because credit stands for debt, while money supply stands for liquidity.
Recently, we made an inquiry among American friends, posing to them the question whether there is any thought or talk in public of a possible U.S. recession. The consensus opinion, in particular on Wall Street, flatly discards it as a possibility – precisely the answer we had expected. It is a historical fact that American policymakers and conventional economists have never foreseen a recession. There seems to be a general conviction, cultivated not just by Mr. Greenspan, that the U.S. economy has become virtually immune to recession. It is widely seen as just a bursting of strength due to ingrained “flexibility” and “dynamism”. In addition, there is, of course, unbounded faith in the virtuosity of the Fed to avoid a serious recession with swift action.Link here (scroll down to piece by Dr. Kurt Richebächer).
WHAT IS THE REAL FEDERAL DEFICIT?
The federal government keeps two sets of books. The set the government promotes to the public has a healthier bottom line – a $318 billion deficit in 2005. The set the government does not talk about is the audited financial statement produced by the government’s accountants following standard accounting rules. It reports a more ominous financial picture – a $760 billion deficit for 2005. If Social Security and Medicare were included – as the board that sets accounting rules is considering – the federal deficit would have been $3.5 trillion.
Congress has written its own accounting rules – which would be illegal for a corporation to use because they ignore important costs such as the growing expense of retirement benefits for civil servants and military personnel. Last year, the audited statement produced by the accountants said the government ran a deficit equal to $6,700 for every American household. The number given to the public put the deficit at $2,800 per household.
A growing number of Congress members and accounting experts say it is time for Congress to start using the audited financial statement when it makes budget decisions. They say accurate accounting would force Congress to show more restraint before approving popular measures to boost spending or cut taxes. “We’re a bottom-line culture, and we’ve been hiding the bottom line from the American people,” says Rep. Jim Cooper, D-Tennessee, a former investment banker. “It’s not fair to them, and it’s delusional on our part.”
The House of Representatives supported Cooper’s proposal this year to ask the president to include the audited numbers in his budgets, but the Senate did not consider the measure. Good accounting is crucial at a time when the government faces long-term challenges in paying benefits to tens of millions of Americans for Medicare, Social Security and government pensions, say advocates of stricter accounting rules in federal budgeting. “Accounting matters,” says Harvard University law professor Howell Jackson, who specializes in business law. “The deficit number affects how politicians act. We need a good number so politicians can have a target worth looking at.”
The audited financial statement – prepared by the Treasury Department – reveals a federal government in far worse financial shape than official budget reports indicate, a USA Today analysis found. The government has run a deficit of $2.9 trillion since 1997, according to the audited number. The official deficit since then is just $729 billion. The difference is equal to an entire year’s worth of federal spending. Congress and the president are able to report a lower deficit mostly because they do not count the growing burden of future pensions and medical care for federal retirees and military personnel. These obligations are so large and are growing so fast that budget surpluses of the late 1990s actually were deficits when the costs are included. The Clinton administration reported a surplus of $559 billion in its final four budget years. The audited numbers showed a deficit of $484 billion.
In addition, neither of these figures counts the financial deterioration in Social Security or Medicare. Including these retirement programs in the bottom line, as proposed by a board that oversees accounting methods used by the federal government, would show the government running annual deficits of trillions of dollars. The Bush administration opposes including Social Security and Medicare in the audited deficit. Its reason? Congress can cancel or cut the retirement programs at any time, so they should not be considered a government liability for accounting purposes.
If Microsoft announced today that it would add a drug benefit for its retirees, the company would be required to count the future cost of the program, in today’s dollars, as a business expense. If the benefit cost $1 billion in today’s dollars and retirees were expected to pay $200 million of the cost, Microsoft would be required to report a reduction in net income of $800 million. This accounting rule is a major reason corporations have reduced and limited retirement benefits over the last 15 years. The federal government’s audited financial statement now accounts for the retirement costs of civil servants and military personnel – but not the cost of Social Security and Medicare.
Social Security chief actuary Stephen Goss says it would be a mistake to apply accrual accounting to Social Security and Medicare. These programs are not pensions or legally binding federal obligations, although many people view them that way, he says. Social Security and Medicare are pay-as-you go programs and should be treated like food stamps and fighter jets, not like a Treasury bond that must be repaid in the future, he adds. Tom Allen, who will become the chairman of the federal accounting board in December, says sound accounting principles require that financial statements reflect the economic value of an obligation. “It’s hard to argue that there’s no economic substance to the promises made for Social Security and Medicare,” he says.
If you count Social Security and Medicare, the federal government’s financial health got $3.5 trillion worse last year. Rep. Mike Conaway, R-Texas, a certified public accountant, says the numbers reported under accrual accounting give an accurate picture of the government’s condition. “An old photographer’s adage says, ‘If you want a prettier picture, bring me a prettier face,’” he says.Link here.
THE HERD CHANGES COURSE AND RUNS AWAY FROM S.U.V.’S
The herd instinct is as powerful in humans as in other animal species. Clearly, the herd instinct can lead us astray. For the most part, however, the impulse to emulate others serves us well. After all, without drawing on the wisdom and experience of others, it would be almost impossible to cope with the stream of complex decisions we confront. Economists increasingly recognize the importance of herd behavior in explaining ordinary purchase decisions. A case in point is the sport utility vehicle. Herd behavior helps us understand not only the explosive rise of this market segment in the 1990’s, but also its imminent collapse.
The Chevrolet Suburban (or, as Dave Barry called it, the Chevrolet Subdivision) has been produced since 1935, but it and other similar vehicles were originally used almost exclusively for commercial purposes. Before the appearance of the Jeep Wagoneer in 1963 and the Ford Bronco in 1966, the family S.U.V. segment essentially did not exist. As recently as 1975, it accounted for only 2% of total vehicle sales. In the 1990’s, however, it became perhaps the biggest success story in automotive history. From a base of only 750,000 units in 1990, annual S.U.V. sales reached almost 3 million by 2000. In 2003, 23% of vehicles sold in the U.S. were S.U.V.’s.
The conventional determinants of consumer demand cannot explain this astonishing trajectory. Cheap fuel was a contributing factor, but clearly not an adequate explanation, because fuel had also been cheap in earlier decades. Similarly, rising average incomes cannot have been decisive, because the pre-S.U.V. decades had experienced even more rapid income growth. In any case, it is not obvious why wealthier people would want to switch from cars to truck-based S.U.V.’s. Many engineers who helped design these vehicles expressed wonder that they have sold in such numbers. Early ads, coupled with names like Blazer and Pathfinder, stressed the vehicles’ off-road capabilities. But as one engineer quipped, the only time most S.U.V.’s actually go off the road is when inebriated owners miss their driveways. Nor can safety concerns explain the success of S.U.V.’s. – their poor handling, high propensity to roll over and longer stopping distances make them more dangerous, on balance, than cars. Nor, finally, is the greater cargo capacity of S.U.V.’s enough to explain their popularity, as minivans and station wagons offer similar capacity without the handling and mileage penalties.
To understand the explosive growth of S.U.V. sales, we must look first to changes in demand caused by new patterns of income growth and then to how others responded to those changes in demand. Unlike the three post-World War II decades, when incomes grew at about the same rate for people at all income levels, the period since the mid-1970’s has seen most income growth accrue to the wealthy. In the 1992 Robert Altman film, “The Player”, the film’s lead character, the studio executive Griffin Mill (played by Tim Robbins), could have bought any vehicle he pleased. His choice? A Range Rover with a fax machine in the dashboard. An important feature of the herd instinct is that people are more likely to emulate others with higher incomes. Seeing a wealthy studio executive behind the wheel of a Range Rover instantly certified it as a player’s ride. As more and more high-income buyers purchased these vehicles, their allure grew. And when other automakers began offering similar vehicles at lower prices, S.U.V. sales took off.
But what the herd instinct giveth, it also taketh away. Even when gasoline was still relatively inexpensive, many urban motorists had begun to question the merits of owning poor-handling off-road vehicles that got only 10 miles a gallon. And with gas now selling for more than $3 a gallon, the cachet of S.U.V.’s has vanished completely. If driving one was once like having a T-shirt saying, “I’m a player,” it is now more like having one saying, “I’m a chump.” And that is a perception that no product can long survive. With unsold inventory languishing on dealer lots, prices of S.U.V.’s have been plummeting. The last of Ford’s mammoth Excursions rolled off the assembly line last September 30. And G.M.’s largest S.U.V., the Hummer H1, was discontinued in June of this year. With the herd now in full stampede, the era of big, gas-guzzling S.U.V.’s may soon be history.Link here.
HEDGE FUNDS ARE BACK (WERE THEY EVER GONE?)
The hedge fund party seemed to be quieting down not so long ago. Returns were flagging. Blowout start-ups were fading from memory. The hype and hyperbole are now back. Another star of finance is doing what all good stars do these days – start a really, really big hedge fund. In September, Jon Wood, a former top trader with UBS, will start SRM Global Fund in Monaco, with commitments of more than $5 billion and capital of more than $3 billion to start with, according to people briefed on the fund. That puts him close to the record, set by Jack R. Meyer, the former investment manager of Harvard University’s assets, who raised more than $6 billion for Convexity Capital earlier this year.
It was not long ago that a $3 billion start-up had jaws dropping – and calculators clicking. Hedge fund managers tend to make a 2% management fee and take 20% to 25% of profits; 2% of f profits; 2% of $3 billion is $60 million. Mega-start-ups, while less frequent, are arriving with a far bigger bang. While the stars seem to have no problems raking in billions, starting small is increasingly difficult, say people involved in fund-raising whose banks forbid them from speaking on the record. “Raising $15 million to $50 million is much harder than it used to be,” said one fund-raiser.
Pedigree helps. Mr. Wood made roughly $500 million for UBS every year for at least half a dozen years, said one person who worked with him. Marketing materials indicate he never had a down month. Mr. Wood is certain to be deluged by money coming from pension funds and endowments looking to get in hedge funds, and looking for a big name in particular. In the second quarter, investors gave hedge funds more than $42.1 billion, according to Hedge Fund Research, the highest level of inflows since the organization has been tracking flows. Returns, which soared in the first half of the year, have recently been rocky – down 1.54% in May and 0.15% in June. But for the year through July, the average fund is up 6.2%, compared with 2.7% for the S&P 500.
The case for hedge funds may get harder. Recently, noncorrelated asset classes have become correlated, like gold and stocks. Many hedge funds sank with the equity markets they invested in. Interest rates are headed north, which should make cash look more attractive since hedge fund performance has averaged 9% over the last two years. And yet, the money keeps coming in, inundating the established managers. To investors, these are hedge fund heroes, sent from Monaco, to return them to the days of over-the-moon returns. There will be more: Ralph Rosenberg, a former Goldman trader, is expected to start a fund, R6, this fall with at least $1 billion and two former Goldman traders are planning to begin Montrica in Britain. Expected size? More than $1 billion. Not so jaw-dropping anymore.Link here.
GOOD AS GOLD
“A man may buy gold too dear,” wrote the English playwright John Heywood (1497-1580) in his collection of proverbs published in 1546. Here is some almost classical food for thought, so let us discuss gold and Heywood’s famous saying about it.
If you attended the Agora Financial Wealth Symposium in Vancouver last week, you might not be inclined to believe Heywood’s advice. Not just now, anyway. None other than Richard Daughty, aka the Mogambo Guru, gave a powerful talk entitled, “We Are All Freaking Doomed”, in which he discussed the century-long history of debasement of the U.S. dollar at the hands of the Federal Reserve. And then Mogambo advised the audience to, as he so subtly put it, “Buy gold. Just buy it. Get up off your butt, and go out and buy gold. Stop staring at me like a bunch of idiots. Get moving. Go buy some gold.” Mogambo is what they call, in the trade, a “motivational speaker.”
I collared Mogambo later on, after his talk, and asked if he had any recommendations besides buying gold. He squinted at me and said, “You are not a federal agent, are you? If you are, I am asking you to tell me, and my lawyer says that you have to tell me or it is entrapment.” After I assured Mogambo that I am not a federal agent, he whispered to me, “Silver. Silver and oil. Gold, silver, and oil. Accumulate as much as you can. Get rid of those rotten, stinking, no-good, piece-of-crap Federal Reserve Notes. Buy gold, silver, and oil.” And then Mogambo added, “And buy brass. Lots of brass. Get it with the magnum load, hollow-tip.” So there you have it from the Mogambo himself. Buy gold. And silver. And oil. And buy brass, if you know what I mean.
So can you “buy gold too dear”? John Heywood lived in a 16th-century era of hard money, based on the gold and silver that was flooding into Europe from the Spanish mines of Mexico and Peru. So perhaps Heywood was referring to trading your gold “too dear” for other real assets. Heywood was cautioning people not to get swindled in their trades. If you look at many other of Heywood’s proverbs (see the P.S. below), he counseled patience and prudence in one’s dealings in both life and finance. Heywood did not live in a world of fiat currency that was steadily declining in value, such as is the case in our rather sordid economic environment of today.
Can you “buy gold too dear” in our current global monetary environment? Certainly, the spot price will trade up and down in the short term. Gold was trading for well over $700 per ounce on some days of May, and under $600 per ounce on some days of June. But there was a relative consensus at Vancouver that the value of the U.S. dollar is heading for a long-term decline. Hence the dollar-value of gold is due for a long-term increase. So if nothing else, by trading some of your green dollars for some of that yellow gold, you will, in all likelihood, preserve your current purchasing power. And as John Heywood said long ago, “This hitteth the nail on the head.”Link here.
THE HOLLOWED-OUT AMERICAN DREAM
“I sing of ARMs and the Man …” ~~ Virgil’s Aeneid
We do not really have that much more to sing about ARMs, but we just could not resist the headline. Still, now that we think about it, our cautionary tale is likely to end just as bloodily as any epic poem we have read. Imagine what would happen if mortgages were adjusted upwards to rates anywhere near 10% – or anywhere near where they were 25 years ago?
That is why the Bernanke Fed cannot really fight inflation or stagflation the way Paul Volcker once did. Too many homeowners would not be able to afford it. ARMS were meant to give marginal borrowers flexibility. Instead, they have locked both the borrowers and the Fed itself into … well, leg-irons. The borrowers have no margin. Most cannot afford even the slightest boost in their payments. And with such boosts now automatic, the Fed can only react to inflation threats by prevaricating.
According to David Rosenberg at Merrill, discretionary items are now rising at a 5% annual rate – far beyond Ben Bernanke’s target. But what can he do? ARMs were supposed to be a way to realize the American dream of home ownership. But, like much else in American life, that dream too has been hollowed out.
For two reasons. The first is “declining marginal utility”. The more you have of something, the less each additional unit is worth to you. A little defense is precious. But add more soldiers, weapons … more office workers, consultants, crony contractors and pension programs, the less real defense you get for your dime. And eventually, if you spend enough, you get a negative return, as we have in the Middle East today. There, once, only a few extremists hated us. Now, a couple of hundred thousand soldiers and two wars later, whole countries and civilizations hate us. And, we are less secure than ever. The marginal utility of defense spending has fallen below zero. The second reason for the hollowing of America is that aging institutions pick up the horde of parasites – managers, hangers-on, hustlers, opportunists – who pursue their own agendas, and subvert their clients’ goals.
And so it is with the American home. People fantasize about the peace of mind, the security, and the independence they will get from owning their own piece of earth. Home sweet home. But look what they actually get. Peace of mind? Security? Independence? Only if they are comatose enough not to notice the incessant barrage of property taxes, zoning laws, building codes, and mortgage payments that rains down on them from the first day they become owners. In fact, with today’s mortgages, they never actually own their house – it owns them! The kings of today's castles are not independent. They are chained to the grindstone of work to meet mortgage payments. The dream of free and clear ownership swings perpetually just beyond their grasp, like Tantalus’s grapes.
And well they know it. People may be slow to think, but they are fast enough to feel. In surveys of American attitudes, pollsters have discovered that people already have a vague feeling that they are not as well off as their parents, and that they expect to be even less well off in the future. Of course, social scientists and economists dismiss these sentiments in favor of the numbers. But behind the dissembling numbers are the sentiments that tell the truth. People feel worse off because their real quality of life is falling. Real earnings – after inflation and taxes – have been falling for the working stiff for the last 30 years. Highway traffic moves more slowly. It is harder to find a parking place. People spend more on education and health care – with less to show for it. They work more hours than before, only to have more shopping malls than high schools. They use vastly more energy than the rest of the denizens of the planet and make more per hour, but they live in a way scarcely better … and perhaps much worse.
All institutions age, decay, and collapse, we observe. Even the American dream …Link here.
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