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SELL DOW 12,000
“I’m not sure I want popular opinion on my side – I’ve noticed those with the most opinions often have the fewest facts.” ~~ Bethania McKenstry
Opinions are like noses: everyone has one. But a strange thing happened on the way to Dow 12,000 – the overwhelming majority of financial pundits sound like a broken record. Optimism is pervasive on Wall Street, yet some bulls, well aware of the laws of contrary opinion, claim too much pessimism as a reason to own stocks. The bulls cannot possibly be running confidently and running scared at the same time. What are the “facts” regarding investor sentiment?
Ten of our favorite sentiment indicators are, on average, in the 73rd percentile of bullishness versus readings over the past 10 years. Overall, 1996 to 2006 was a period of stock market ebullience, making the current level of enthusiasm all the more extreme. Meanwhile, the Soft Landing crowd continues to turn a blind eye to a credit bubble about to go into an uncontrolled spin. Since this rally began in mid-July, the Philadelphia Bank Index (BKX) looks exhausted, capturing just 54% of the gain of the S&P 500.
Never confuse a stampeding herd with the facts. Only in a bubble can the majority – utterly intolerant of dissent – delude itself into believing it is in the dissenting minority. We are not sure whether such behavior is disingenuous or simply dysfunctional. Perhaps the old saw applies: “When everyone is thinking alike, no one is really thinking.”Link here.
NOBODY SAW THIS COMING
Earnings are soaring, the few remaining bears have been discredited, the stock market has been making new highs, the housing bubble is headed for a “soft landing”, and Goldilocks does not have a care in the world. To top it off, BusinessWeek is reporting, “U.S.: A Do-Nothing Fed Is Looking Less Likely”. Various Fed members have been stressing the need to closely monitor inflation - just as they were back in May 2000. Over the next 18 months, the CPI dropped from 3.1% to 1.1%, the U.S. went into a recession, and capex spending fell off the cliff. Nobody saw it coming, and by the time they did, it was too late to do anything about it.
“Yields are heading up,” said BusinessWeek. Is BusinessWeek looking at what I am looking at? Here is the yield curve as of October 31, 2006. Hmmmm. Is that a 54-basis-point inversion between the 5-year and 6-month Treasury? Hmmmm. Is that a 69-basis-point inversion between the 5-year and the fed fund rate? Consider TLT, the 20+ year Lehman bond fund. Given that TLT rallies when long-term yields collapse, it seems to me that the Treasury market sees “something” is coming, and that something is not Goldilocks. Could it be the Treasury market sees rising foreclosures, rising unemployment, a falling CPI, and a slowing worldwide economy?
RealtyTrac is reporting, “U.S. Foreclosures up 43% From 2005”. Even though interest rates were hiked 17 consecutive times (a new FOMC record), and even though it was widely understood that $1 trillion in mortgages would reset in 2007, and even though the bottom fell out on credit standards, I am quite sure that nobody could see this coming.
As preposterous as that might sound, I have proof. The Bloomberg article, “UBS Reports 21% Decline in Profit on Trading Slump” reports: “UBS AG, Europe’s biggest bank by assets, said third-quarter profit fell 21 percent, missing analysts’ estimates after trading revenue dropped at its securities unit ... ‘Nobody saw this coming,’ said Florian Esterer, a fund manager at Swisscanto in Zurich, which oversees about $40 billion, including UBS shares. ... At UBS, proprietary trading revenue fell, in part because the bank was ‘incorrectly positioned’ in the Treasury market, the company said. Treasuries posted the biggest gains in four years in the third quarter on speculation a slowing economy would reduce the likelihood of further Federal Reserve interest rate increases.”
UBS was “incorrectly positioned” in the Treasury market, huh? Fancy that. I am quite sure we are going to see a lot of “incorrect positioning” going forward. This is simply the way it HAS to be. Before a deflationary credit crunch can set in, bears have to embrace the rally (and except for a few die-hards, they have), the masses have to embrace the Goldilocks scenario (and they have), housing has to look like a soft landing is possible (and most think so), and the Fed HAS to seem more worried about inflation than deflation (and without a doubt, it is).
In 2000, the Fed was worried about inflation right at the outset of the dot-com bust. In 2002, the Fed was worried about deflation in the aftermath of the dot-com bust. The Fed lowered interest rates to 1% even though consumers never stopped spending and housing was going strong. It was the wrong fear at the wrong time. In fact, those actions by the Fed set in motion the very thing they feared: a deflationary bust, not of dot-coms, but of housing, something far, far bigger. In 2000, the Fed was worried about inflation right at the outset of the dot-com bust. In 2002, the Fed was worried about deflation in the aftermath of the dot-com bust. The Fed lowered interest rates to 1% even though consumers never stopped spending and housing was going strong. It was the wrong fear at the wrong time. In fact, those actions by the Fed set in motion the very thing they feared: a deflationary bust, not of dot-coms, but of housing, something far, far bigger.
In 2006, the Fed believes a soft landing in housing is coming, inflation risks are to the upside, and wages and jobs are picking up nicely. The stage is now set for a massive number of “nobody could possibly have seen this coming” proclamations. When they come, please point them here.Link here.
CONQUISTADOR SILVER – OURS FOR THE TAKING
If I asked you what happened in the year 1492, you woul probably say, “Columbus discovered America.” But have you stopped to wonder why the queen of Spain was financing expeditions to the West at that time? It was not because some watery-eyed Italian named Columbus told her the world was round. Indeed, it is a tale of God, glory, and gold ... lots and lots of gold – and even more silver. What is more, mines that the Spanish discovered and worked in the New World are still being worked today. In fact, some of the most undervalued silver mines in the world are in Mexico, and still bear the marks of the conquistadors.
In the old days, the Spanish/Mexican miners would only mine the visible silver. They did not realize that the black rock around them was thick with silver ore! Plus, many of Mexico’s silver mines fell into decline. In the 20th century, as political winds shifted, as the price of silver cratered, it often became more trouble to mine the metal than it was worth. But now the price of silver is rising again. And the Mexican government and people alike are eager to work with companies that will reopen and recapitalize the old mines.
And I believe this is a great time to buy silver. The metal is well off the highs it hit earlier this year, but its bull market is still intact. It has gone through a consolidation that is a normal and necessary part of any bull market. If you look at a chart of silver, you can see that it is coiling up like a spring. A big breakout should come next. I believe there are many forces driving silver higher. The supply of silver from mines has not been able to meet demand for years. There are new silver mines coming online, but they will probably be playing catch-up for quite some time to come ... potentially for years.
For real outperformance, I look to the small-cap mining stocks themselves. Three things I look for in miners are large resources, near-term production, and great management. You can find a bunch of incredible bargains south of the border, including silver mines. Interestingly, many of them are mines owned by Canadian companies, because that is where a lot of the mining industry’s talent and entrepreneurial spirit is. And some of them even list in the U.S. An example would be Silver Wheaton Corp. It is a Canadian company that also lists on the NYSE under the symbol SLW.
Silver Wheaton is the purest silver producer in the world. It does not own any mines of its own – thus, it does not have to deal with the cost of plants or equipment. Instead, it has silver purchase agreements with three mines around the world, including the Luismin mines in Mexico, which are operated by Goldcorp. Through contracts like the one with Luismin, Silver Wheaton produced 2.7 million ounces of silver in the most recent quarter, at an average cash cost of $3.90 per ounce. Silver Wheaton’s production should exceed 15 million ounces in 2006 and hit 20 million ounces in 2009. SLW has other projects in the works that could add hundreds of millions of ounces to its resource base.
I have no doubt that silver will be breaking out to the upside soon – and stocks like Silver Wheaton could lead the way.Link here.
THE GREAT DEBATE
Once again, financial markets are agonizing over the U.S. economic growth outlook. A weak third quarter GDP report, paced by an ongoing housing recession, and in conjunction with tentative signs of further softness in October, has all the trappings of yet another soft patch. Time and again, a Teflon-like U.S. economy has bounced back smartly from these periodic downshifts. Is another such bounce in the offing, or is this slowdown for real – the beginning of the end for a five-year expansion?
The Morgan Stanley Economics team does not take this debate lightly. Both points of view are well represented in our internal discussions and our published work. Steve Roach and Dick Berner, friends for more than 30 years and whose offices share a common wall, do not share much else in common these days insofar as the macro prognosis is concerned. But they both thought it would be an opportune moment to thrash out their differences in the exchange that follows.
Roach: The housing downturn is a very big deal for the U.S. economy. The way I see it, there are three macro impacts to consider: a contraction in construction activity; collateral damage on industries such as furniture, appliances, real estate brokers, and mortgage finance; and negative consumer wealth effects. So far, we have seen only the early stages of the first impact. While residential construction activity fell at a 14% average annual rate in the two middle quarters of 2006, as a share of GDP it has only reversed 27% of the record run-up that occurred over the past decade. Given the magnitude of the building boom and the associated surge in home prices, in conjunction with a still huge overhang of unsold homes, is it not a bit premature to conclude that the worst is over for the housing recession?
Berner: It may come as a shock to you, Steve, but I agree, it is a big deal and I do think that the housing downturn does have a long way to go. That downturn clearly creates the potential for collateral weakness in the areas that you enumerated. Indeed, some of the softness in manufacturing activity is directly traceable to housing; output in the appliances, furniture and carpeting grouping in industrial production fell at a 2.3% annual rate in the three months ended in September. But we have taken that into account in our forecasts. I take your points about the housing downturn seriously, but I think you are seriously underestimating the potential for a two-tier economy – housing in recession, the rest of the economy doing much better – to outperform your bearish expectations.
Roach: Well, I am certainly not a compartmentalist – I am more of a spillover kind of guy. So let me get to the real punch line of this story – the potential impacts of yet another post-bubble shakeout on the asset-dependent American consumer. 6½ years ago, after the bursting the equity bubble, the American consumer pulled back and the U.S. economy slipped into, yes, a mild triple-dip recession. I fear a similar outcome this time as well. In my humble opinion, consumer spending and saving is even more asset-dependent today than it was when the equity bubble burst.
Berner: As long as we are revisiting history, let’s get it right, not rewrite it: The mild downturn of 2001 was the product of the bursting of a capital-spending-cum-hiring bubble in Corporate America. We spent the first three years of this expansion cleaning up those excesses. With those extremes well behind us, and labor markets firm, the income-generating capacity of the economy is actually improving, not weakening. Thus, I think that the real question is whether consumers will have enough wherewithal both to maintain moderate spending gains and rebuild saving. Where we most strongly disagree, however, is on the housing wealth-consumer spending link. You side with those who think it is all about Mortgage Equity Withdrawal – that even a deceleration in housing wealth and thus declining MEW will cripple consumers. Unless it is different this time, my view is that the wealth-consumption connection is no more than 1/5th or even 1/10th as big as feared.
Roach and Berner: There are two main bones of contention between us: Roach worries much more about the post-housing wealth effect and Berner is banking more on energy-augmented income support. Where we both agree is that a sharp upsurge in personal saving could derail the soft landing the markets seem to be banking on. Roach is clearly in the growth recession camp and worries that another shock at any point in the next 6-9 months would spell outright recession for an increasingly vulnerable U.S. economy. Berner stresses resilience and soft landing. The market implications from these contrasting scenarios could not be more different. Steve is in canned milk and bonds, while Dick still likes riskier assets.
How to choose? Keep your eye on the American consumer. A disappointing holiday selling season could turn a pause into a more serious problem, triggering the cumulative forces of outright recession. An inflation surprise could also be decisive. If prices accelerate significantly further, requiring a more aggressive Fed and triggering a dramatic backup in yields – read 100 basis points or more – ironically, Steve could also end up being right. In contrast, the moderate further cyclical inflation pressures Dick expects could underwrite a more benign outcome. In any case, an important test is undoubtedly close at hand.Link here.
We are all data junkies. When a number comes out that supports our position, a rush of self-gratification courses through the veins. That is true of investors looking at earnings reports, as well as economists looking at economies. Never mind that the data, by definition, offer backward-looking insights into forward-looking views. Never mind the quality of the data either – an increasingly serious problem with today’s information flow. In the mark-to-market world, when the screens flash with a new piece of information, we react first and ask questions later. It is the reality TV of world financial markets.
This is less of a gripe and more of a plea to take a deep breath. Deciphering the incoming data flow is as much art as science. Yet, for those of us wedded to an analytical approach, only the data check can keep us honest. My own approach continues to stress two key issues in the global macro debate – America’s post-housing bubble shakeout and China’s lack of policy traction. On both counts, the latest data depict “growth friendly” outcomes. Yet in each of these cases, the analytics still provide considerable pause for thought. One way or another, I suspect these disconnects should be resolved in the year ahead.
Most bulls on the U.S. economy – with the notable exception of Dick Berner – have concluded that the worst is now over for America’s housing recession. Former Fed Chairman Alan Greenspan, who has a fair amount of reputational skin in the game in this one, has recently led the charge in that regard. September’s bounce in housing starts and home sales offers a couple of data blips in support of that conclusion. But with inventories of newly sold homes still 14% above year-earlier levels, that conclusion may be a bit premature. In fact, I would argue that the recession in homebuilding activity has only just begun. As existing projects are completed, I suspect there will be a sharp fall-off of headcount in this once frothy industry – with important implications for the state of the overall labor market, income generation, and personal consumption.
The employment response of the homebuilding sector is a microcosm of a key macro characteristic of the U.S. economy – that the hiring shoe is typically the last to fall in a cyclical adjustment. Businesses are slow to rehire in an upturn and equally reluctant to reduce headcount in a downturn. Current employment trends reflect just such a recognition lag. The disconnect comes when financial markets treat the lags as a counter-trend. That has certainly been the case in the aftermath of the past two labor market reports – weak preliminary estimates of hiring in both September and October, accompanied by massive upward revisions to earlier months. In my view, either one of two explanations to the data-analytics disconnect is possible: The GDP is dead wrong and will be revised sharply upward from the sluggish 2.1% average annual pace of the two middle quarters of 2006, or it will just be a matter of time before this growth-recession-like outcome elicits the typical lags of the hiring response. My sympathies are with the latter line of reasoning. I do not believe that businesses are suddenly throwing caution to the wind and loading up on high-cost labor at precisely the point when the cyclical debate is more contentious than ever.
Halfway around the world, there is another very important disconnect – Beijing’s response to a runaway Chinese investment boom. For the fifth time this year, the People’s Bank of China has followed the conventional counter-cyclical stabilization script and tightened monetary policy in an effort to cool off a white-hot economy. The approach is not working. The growth rate of fixed investment still speaks of a China that is headed toward massive capacity overhangs, with attendant risks of deflation.
There are two dimensions of the China disconnect – the first being a policy strategy that is at odds with the structure of the Chinese economy. The central bank has not achieved policy traction, in large part, because its actions do not filter down to the provincial and village levels, as well as China’s modern-day central planners. A second aspect of the China disconnect comes in the form of its implications for the rest of Asia and the broader global economy. Once again, the unflinching vigor of the Asian economy is being taken for granted. The same is true of the commodity super-cycle. In my view, these conclusions are highly conditional on the Chinese growth outcome. If Beijing finally delivers on the slowdown front, I suspect there will be a quick and severe markdown of the economic outlook for Asia and the commodity complex. The case for a cooling off of the Chinese economy remains compelling: Ever-mounting imbalances in an investment- and export-led economy raise the odds of the dreaded hard landing that would seriously threaten the most important objective of China’s reforms – social stability. I continue to believe that the Chinese leadership is about to up the ante on its cooling-off campaign.
Disconnects always seem to have a way of coming full circle in resolving the macro debate. This is where the analytical approach has the advantage over the data-dependent approach. Notwithstanding the risk that we get the analytics wrong – or that old relationships are rendered inoperative by new developments – I still think it pays to focus on America’s post-housing bubble shakeout and on the staying power of the Chinese investment boom as the two most important moving pieces in the global economy. If both of these engines slow, as I suspect, a year from now the world will be in a very different place than it is today.Link here.
FED: OOPS! WE KEPT MONEY CHEAP TOO LONG
We are all human. Everybody makes mistakes. It is just that some people’s mistakes are, well, more consequential than others’.
Exhibit A for that point surfaced last week, when the president of the Federal Reserve Bank of Dallas gave a speech containing what has to rank as one of the biggest “oopses” of the decade. Speaking to a group of New York economists last week, Richard W. Fisher acknowledged that some bad data on inflation caused the Fed to hold interest rates too low for too long, fueling the house-price bubble of the last few years. As a consequence, Fisher said, “today ... the housing market is undergoing a substantial correction and inflicting real costs to millions of homeowners across the country.”
The problem began in late 2002, which you may recall as a time when things looked pretty bleak. The 9/11 attacks were still a fresh memory. Enron and other corporate scandals had shaken the markets. It was not even clear that the economy had emerged from the recession that began (and ended, as it later turned out) in 2001. For the Fed, which lives to worry about inflation, it was unfamiliar territory – so much so that its analysts and prognosticators began talking about the opposite problem: deflation. Such a decline would likely mean a prolonged economic slump, if not a new Depression.
So the Fed studied ways to prevent it. Interest rates were already low, but now the central bank pushed them even lower. By mid-2003, its overnight-bank-loan rate was all the way down to 1%. The so-called fed funds rate stayed there a full year before the central bank began raising it, gradually, to the current 5.25%. “Determined to get growth going in this potentially deflationary environment, the [central bank] adopted an easy policy and promised to keep rates low,” Fisher said. But, “A couple of years later, we learned that inflation had actually been a half point higher than first thought.”
That may not sound like much, but at a time when one percentage point meant the difference between inflation and deflation, the margin of error shrank as well. And in Fisher’s view, the result was an easy-money policy that encouraged speculation. Investors borrowed cheap, and bought assets such as gold, crude oil and real estate. Ordinary people did the same to bid up for houses. Prices soared – and now we are seeing the consequences.Link here.
GLOBAL ECONOMIC TRAIN WRECK
Bloomberg reported, “U.K. Third-Quarter Personal Bankruptcies Reach Record”. Bankruptcies are soaring, but the response by the biggest lender in the U.K. was to increase loan amounts “because of continuing gains in house prices.” Even as home prices in the U.S. are collapsing, lenders in the U.K. somehow think home prices can keep rising orders of magnitude faster than wages and rents. This same situation is playing out in Canada, Europe, China, and, obviously, the U.S.
According to S&P, “U.S. Credit Quality in 25-Year Retreat Toward Junk”. [See “Ratings: A 25-year march to junk” below.] Among the highlights are that “Shareholder-friendly activity, such as share buybacks, restructurings, and leveraged buyouts, have all increased debt burdens and lowered credit quality.” Buybacks at these levels are NOT shareholder friendly. Headed into an economic slowdown, corporations should be hoarding cash, not squandering it. To make matters worse, corporate insiders are bailing on their own shares by the bucket load as fast as they can. S&P says that “an aggressive financial posture is necessary for survival in a stiff globally competitive environment.” Of course, that is absurd. Unless you are a lemming, you should not have to follow the competition over the cliff. Besides, the idea of lemmings jumping off a cliff as pictured in the 1958 Disney nature documentary White Wilderness is really just a suicide myth, in stark contrast to suicidal credit lending activities by corporations, which appear to be the real deal.
RealtyTrac is reporting, “National Foreclosures Increase 17% in Third Quarter”. Even as foreclosures skyrocket, corporate lemmings are doing everything they can to keep the machine greased and the wheels spinning. I guess the theory must be that as long as the wheels keep spinning faster and faster, they will not fly off the axle. That theory is about to be tested.
Some responses to my blogs blamed the “gold standard” for the Great Depression, while others were arguing that the expansion of credit by GSEs proves we need more government regulation, not less. Those arguing for more government controls are, in effect, arguing in favor of Russian-style communist government central planning that is now thoroughly discredited everywhere. The free market is the answer, not more ridiculous central planning. Government setting interest rates is a problem, not a solution. Government-mandated programs of all kinds at every level are a huge problem, not a solution. Growth in government employment is a problem, not a solution. The government has no business setting prices for orange juice or mortgages. We do not have a free market here, not with 300 government programs promoting housing. The free market did not cause this housing bubble. Stupid government policies did.
Those blaming the “free market” for problems should really be blaming “central planning”. It is ironic to find people arguing for MORE communist central planning, because the current communist central planning (CCCP) is not working. What we really need is a free market, because the markets we have now are anything BUT free markets. As far as the gold standard being the cause of the Great Depression, people simply do not know what they are talking about. Those who think like Bernanke does (the Fed did not cut rates fast enough or soon enough) do not know what they are talking about, either. To dispute the myth that the gold standard is at the root of the problem, let me refer everyone to Murray N. Rothbard’s A History of Money and Banking in the United States:
“Recessions unhampered by government almost invariably work themselves into recovery within a year or 18 months. But the United States, Britain, and the rest of the world had been permanently seduced by the siren song of cheap money. If inflationary bank credit expansion had gotten the world into this mess, then more, more of the same would be the only way out. Pursuit of this inflationist, ‘proto-Keynesian’ folly, along with other massive government interventions to prevent price deflation, managed to convert what would have been a short, sharp recession into a chronic, permanent stagnation with an unprecedented high unemployment that only ended with World War II.”
A list of key government policies and interventions from the 1920s parallels nearly exactly what is happening today. In fact, it is downright eerie. This is not a rerun of That 70’s Show, but rather a rerun of the roaring ‘20s. Keynesian folly by the Fed and this administration in cooperation with foreign central banks everywhere have put the global economy on the brink of disaster. There is no way out. All that remains to be seen is the tipping point that sends this global train on a “23 Skidoo” over the cliff.Link here.
BUYERS BACK OUT OF HOME DEALS IN RECORD NUMBERS
A little over a year ago, buyers could not wait to sign contracts to purchase homes. Now, many cannot wait to get out of them. With real-estate prices falling around the country and even pro-industry trade groups predicting further declines over the next year, buyers are backing away from deals in droves. Economists have reported that contract-cancellation rates for big builders were running around 40% – about twice as high as last year’s levels. Anecdotally, real-estate professionals say they are seeing a similar dynamic in existing-home sales.
Some of the cancellations are by people who signed new-home contracts at one price months ago, have not yet closed, and are now stunned to see the builder drastically cutting prices on identical properties. Some are by speculators caught short by other investments they cannot unload. And some are by people trapped in a chain reaction: They cannot sell their old home, or the buyer has canceled the contract, so they are being forced to cancel the deal on a new house they are buying somewhere else. “There are a whole lot of people running from contracts,” says Alexandria, Virginia, real-estate attorney Beau Brincefield. He is currently representing more than 50 buyers who are seeking to get out of contracts on single-family homes, townhouses and condos, compared with none a year ago.
Even though it may mean losing a deposit that could run tens of thousands of dollars – deposits typically range from 1% to 5% of the purchase price – many buyers are deciding that is less onerous than the alternative. With median new-home prices already 9.7% below last year’s levels, bailing out now may be less painful than committing to an expensive, and possibly depreciating, investment. It is a far cry from the home-flipping exuberance of the past few years, when rising home values fueled a buy-and-sell mentality among millions of homeowners, and trading up became a staple of reality TV and home-improvement shows.
Kickouts were high nationwide in the late ‘80s, and in California and New England in the early ‘90s, spurred by massive job losses. But until now there is never been a period where cancellations have spiked in the absence of a recession, according to Amy Crews Cutts, deputy chief economist at Freddie Mac. Ms. Cutts says the current jitters are largely a result of investors fleeing the housing market in the last few months, which “slammed (it) into reverse,” and consumers’ fears that the bubble had burst. Rising interest rates earlier this year also gave buyers who had not yet closed on their homes cold feet. The result is a huge backlog of unsold homes, which could further depress prices.
Buyer’s remorse does have legal consequences, but the laws vary from state to state and depend on how the purchase contract was written. Usually, a buyer who defaults will have to give up the “good faith” or “earnest money” deposit that was made when the contract was accepted. But typically there is also some wiggle room written into contracts that allows buyers to cancel without penalty, e.g., if they cannot get financing, if the home inspection uncovers defects that the seller will not correct, or if the seller does not make certain disclosures. Just changing your mind, however, is not a valid excuse to cancel. A court could find that a buyer who got cold feet is in breach of contract and liable for the seller’s expenses, plus damages – or could even force the sale.
Of course, it is better not to wind up in court. To keep deals from falling apart, builders are offering everything from free vacations and cars to help with closing costs and mortgage-rate buy-downs – and they are cutting prices, too. Most of these incentives are dangled to attract new customers, but nervous builders have also been quietly sweetening the pot for buyers they have already snagged but whose contracts have not yet closed to keep them from bailing out of the deal. Some are even offering to drop the selling price after contracts have been signed. Builders’ willingness to lard up their incentives is putting added pressure on sellers of existing homes to do the same. Many are finding it necessary to add thousands of dollars in upgrades to compete with what builders are giving away.Link here.
Steal of a deal.
Two years ago, Colorado issued a warrant to arrest Taiwan Lee, a state prisoner who had vanished on parole. He had not gone far. While police looked for him, he bought three houses at inflated prices in Arapahoe County with the help of lenders who put up the entire $1.9 million. After he was caught and jailed, he managed to buy two more. Until the foreclosures commenced, Lee owned five villas in an affluent gated community while living behind prison bars 150 miles away.
The cast of characters in this foreclosure tale includes drug dealers who went straight from prison to the home-acquisition business, a developer with ties to an international Christian group, a state-licensed real estate broker who saw nothing peculiar and an appraiser who has disappeared. Taiwan Lee is among a group of former inmates and others accused of buying 17 homes for inflated prices and taking $2.1 million from excess loan proceeds. His buying spree is an extreme example of something that happens every day in Colorado, the state with the worst foreclosure rate in the U.S.
Typically, in inflated home price schemes, a buyer asks the seller to raise the price and give back cash or other concessions at closing. The seller gets rid of the house. And a distant lender often supplies 100% financing, or more money than the house is worth. This kind of activity can damage a neighborhood in several ways. Inflated sales encourage neighbors to overestimate the values of their own homes and borrow too much against their equity. Assessors can be fooled and levy higher property-tax bills. And in many cases, the buyer never moves in, blighting a block with a vacant house. “We now see price puffs of 30 percent or more in amounts over $100,000,” said Jon Goodman, a Boulder real estate attorney.
Lenders supplied former inmates millions of dollars to buy homes that they never occupied at inflated prices. At The Villas at Cherry Creek in Aurora, a gated community overlooking Cherry Creek State Park, five former inmates bought 12 homes at inflated prices in four months. Neighbors noticed these homes remained strangely vacant – until 150 cars and hundreds of young people poured through the gates for a raucous party at one villa last New Year’s Eve. “I went to bed feeling sick and got up madder than hell,” said Carolyn Brinkmeyer, a homeowner who compiled a long list of suspicious neighborhood sales and persuaded law enforcement agencies to do something.
Beyond The Villas of Cherry Creek, inflated sales have led to dozens of foreclosures throughout the metro area. In Jefferson County, for instance, a house at 1350 Kipling St. went on the market for $238,000. Lisa Johnson bought it for $310,000 – $72,000 over the original asking price. In Arapahoe County, 911 Hanover St. was offered at $144,000. Johnson bought that one too – for $31,000 over the original asking price. In one summer month last year, she bought three Denver-area houses for a total of $910,000 and left loan closings with cash. On the Kipling house, “the check I got after closing was $72,000,” she said. A year later, Johnson has lost them all and “totally ruined my credit.” She also waged a legal battle against a former partner who helped her acquire them, with each blaming the other for the debacle that added more houses to Colorado’s long list of foreclosures.
Johnson, 36, said she had little income aside from an offer to help manage her partner’s properties when she started investing in houses. The extra cash was supposed to be “rehab money,” she said. Johnson said appraisals were inflated to support purchase prices. Her partner, she said, squandered the home improvement funds on “trips to Disneyland, car repairs, shopping sprees – gambling was huge.” She declined to name her former partner. But Jefferson County court records show Johnson was sued by Beverly Monaco, a mortgage broker and landlord who formed Homestead Properties Inc. with her last year. Johnson and her husband, Shawn, alleged that Monaco’s mortgage-broker files contain evidence of false loan applications – altered pay stubs, “cut and paste” W-2 forms and forged signatures. A call to Monaco was returned by her attorney, Jeffrey Keiffer, who denied the Johnsons’ assertions.
One woman says her health and retirement have been compromised by an ID thief’s buying homes in her name. In Longmont, Anita Jantz covers the walls of her suburban home with her own paintings – cheerful watercolors, mostly, of wildflowers, rocky landscapes and tree-shaded streams. She keeps evidence of the ordeal she suffered in a box stuffed with credit reports, ID-theft forms and letters from a growing list of mortgage companies. Jantz traces her troubles to the day in 2005 that she explored the idea of refinancing her home. She gave her Social Security number over the phone to several mortgage brokers whose offers sounded promising. “My big mistake,” she said. Jantz wonders how many more hours she will spend reclaiming her identity and why it was so easy for another woman to buy homes at inflated prices in her name.Link here.
Late-stage housing mania.
This stuff seems to happen at the top of every market mania – like part of the clockwork. Greed and excess breed deceit like swamps breed mosquitoes. The sheep will always be with us, and thus so will the wolves. In my opinion, stories like this are both mind-boggling and mundane at the same time. Mind-boggling for the obvious reasons: crazy plotlines, colorful characters, jaw-dropping stupidity. Mundane because the truly impressive rip-off happens day in and day out, behind the scenes, on a massive scale. When you can juice the money supply here and there, fish a few bucks from the pockets of every U.S. consumer every single month, walk away with tens of billions in inflated gains, and make the suckers pony up for your insurance to boot ... now that is some impressive fraud. Making the crime above board and culturally accepted is the coup de grace.
Check out this wry observation from Aldous Huxley. It is 60 years old, but could have been quoted yesterday.
“There is, of course, no reason why the new totalitarians should resemble the old. Government by clubs and firing squads, by artificial famine, mass imprisonment and mass deportation, is not only inhumane (nobody cares much about that nowadays), it is demonstrably inefficient and in an age of advanced technology, inefficiency is the sin against the Holy Ghost. A really efficient totalitarian state would be one in which the all-powerful executive of political bosses and their army of managers control a population of slaves who do not have to be coerced, because they love their servitude. To make them love it is the task assigned, in present-day totalitarian states, to ministries of propaganda, news-paper editors and schoolteachers ... The most important Manhattan projects of the future will be vast government-sponsored enquiries into what the politicians and the participating scientists will call “the problem of happiness” – in other words, the problem of making people love their servitude."Link here.
WHERE WERE THE AUDITORS?
It is pretty clear by now that the stock option backdating scandal is much more widespread than initially believed. More than 150 companies are either embroiled in internal probes or are now being investigated by the SEC for potential stock option backdating abuses. The deluge is growing daily, with a fresh batch of companies announcing stock option accounting problems with each passing day.
So where are all those expensive auditors who are paid a lot of shareholder money to catch such problems? Right now, just as in past accounting scandals, they are reverting to type. They are trying to run away, or at the very least, blame the accounting rules. Backdating involves setting the strike price of an option retroactively to a day when the stock traded less expensively. An option with a lower strike price is more valuable because it costs less to exercise and has a higher pop.
Jack Ciesielski, editor of the Analysts Accounting Observer, says the issue of auditors’ responsibility came up at a recent corporate governance conference. Ciesielski says the moderator queried Daniel Goelzer, a member of the Public Company Accounting Oversight Board (PCAOB), about whether the PCAOB will chastise auditors for failing to catch the backdating fiasco. Although the PCAOB is supposed to crack down on auditor problems, it seems even the PCAOB is giving auditors cover here. Ciesielski says Goelzer gave this telling reply: Since accounting rules for years did not require companies to book an expense for this compensation cost, why should auditors then be required to spend a lot of time and effort searching for malfeasance?
What about their audits of footnote disclosures (option footnotes have been a fixture of financials since 1996)? The footnotes could have uncovered contracts with incorrect dates. Ciesielski says Goelzer again replied most auditors might have had no reason to believe that the documents they were examining were false at the time. Ciesielski adds that another member of the panel said that auditors do not usually devote the same amount of attention to footnotes as they do to financial statement amounts (not at all comforting, Ciesielski notes, to investors who often rely on footnotes to value stocks).
However, Professor David Larcker, one of the conference organizers, reminded the panelists that since 1997, there has existed a body of academic literature showing opportunistic and thus potentially abusive pricing of options. Translation: There really is no excuse that overpriced auditors did not take note of these studies and laser in on potential option accounting abuse. Heck, even the SEC uses academic literature for sussing out problems, Ciesielski adds.Link here.
U.S. HEALTH COSTS ARE FUELING A FISCAL BLOW-OUT
When a friend recently told me he was paying more for health care for his small company than rent, it confirmed in my mind that medical expenses are stifling the U.S. economy. His is a common tale today. Elected officials, though, rarely talk seriously about health-care change, even though medical costs are ravaging companies – 46 million are uninsured and four out of 10 Americans have no insurance through their employer.
There is little chance for workers or employers to keep up with the rate of increase in health-care expenses. Although this year’s 7.7% gain in employer-sponsored insurance premiums moderated from last year’s 9% jump, wages are not outpacing these costs. With their earnings climbing at 3.8%, workers are falling behind. In the past six years, health premiums have risen 87%. If costs surge at a 10% average clip, they will double again in about seven years. It is economically unsustainable when health costs are rising twice as fast as wages and overall consumer inflation.
Escalating health costs have yet another social economic sting – lower retirement saving. In a survey conducted by the nonpartisan Employee Benefit Research Institute recently, more than half of the respondents who said their health expenses rose claimed they were saving less for retirement as a result. And the tab is mounting. Boston University economist Laurence Kotlikoff estimates that to cover the future health and retirement liabilities for 77 million retiring baby boomers may require a 109% increase in payroll taxes, a 91% cut in federal spending or a 45% reduction in Social Security and Medicare benefits. Or keep on selling U.S. government debt and saddle future generations with the repayments. Kotlikoff calls this endless borrowing “fiscal child abuse”. I call it a multigenerational taxpayer mugging.Link here.
ART AUCTIONS SET TO RAISE OVER $1 BILLION
Auction houses hope to raise more than $1 billion selling art in New York in the next two weeks, in what is expected to be a record season even as dealers and collectors express doubts that art prices can go much higher.
Several big private sales have called attention to the booming art market recently. David Geffen, an entertainment industry billionaire, has in the past few weeks reportedly sold three paintings for a total of almost $300 million. Most recently, he sold a Jackson Pollock painting for $140 million, which would make it the most expensive artwork ever known to be sold. It pipped the $135 million paid by Ronald Lauder a few months ago for a portrait by Gustav Klimt.
High prices have brought out many sellers, and the pre-sale estimates for the two weeks of auctions at Christie’s, Sotheby’s and Phillips are double the level of last year. The share price of Sotheby’s, which is publicly traded, has more than doubled in the past year as its business has flourished. The pool of potential buyers has grown, with Asian, Russian and even Middle Eastern collectors joining the traditional American and European collectors. Wealthy hedge fund managers have also joined the fray. Michael Moses, whose Mei Moses index tracks market prices, said that art prices overall rose by 22% from June 2005 to 2006 – more than twice the mean annual rise since 1961.
Among the highlights on the block this week are four works by Klimt which are expected to go for up to $90 million. Christie’s is also selling a Picasso, a blue period portrait of Angel Hernandez de Soto, for an estimated $40 to $60 million. Impressionist and Modern works like these still command the highest prices, but the biggest rises have been seen in contemporary art, especially in photography. Artprice.com reports that in the past decade, prices for photographs by artists born after 1945 have risen by an average of 260%.Link here.
RATINGS: A 25-YEAR MARCH TO JUNK
S&P says aggressive financial policies and rising demand for high-yield debt have pushed nearly 50% of companies below investment grade.
Spurred by strong risk appetite and ample liquidity, the universe of U.S. high yield bond issuing entities continues to expand, steadily inching the U.S. ratings mix toward a 50-50 split of investment-grade and speculative-grade issuers. The non-financial issuer universe is already 61% speculative grade. In Europe where firms are still predominantly investment grade. However, both regions have seen aggregate credit quality slip during the past decade, as the low interest rate environment and elevated investor risk tolerance have increasingly encouraged speculative grade firms to directly tap into extremely liquid financial markets, eschewing the more onerous bank lending route.
The high-yield investor base has also continued to broaden and deepen. Low long-term interest rates and a receptive market for long-term debt have allowed firms to lengthen the maturity of their debt and lock in low interest rates, giving them more flexibility over their balance sheets than before.Link here.
Bond funds push for bondholder protection against LBOs.
The world’s biggest bondholders are determined to make an example of Henry Kravis. Pacific Investment Management Co. and Advantus Capital Management, frustrated by the sudden losses caused by leveraged buyouts, are forcing companies to guarantee immediate payment of principal whenever the borrower is acquired by Kohlberg Kravis Roberts, Blackstone Group or any of the dozens of LBO firms that have ravaged the corporate bond market.
While this year’s five biggest LBOs afflicted bondholders with about $2 billion of losses, relief may be in sight. Owens Corning, the maker of pink insulation for homes, and Realogy Corp., the owner of the Coldwell Banker and Century 21 real estate franchises, are among the dozen companies since August that give investors protection from LBOs, which typically increase debt loads and lower credit ratings. “The risk of re-leveraging is real and investors are trying to protect themselves,” said Mark Kiesel, an executive VP who oversees $50 billion in corporate bonds at Pimco. “This is something that’s going to be with us for a while.”
Owens Corning sold $1.2 billion of 10-year notes and 30-year debentures, with a pledge to pay investors 101 cents on the dollar should the company lose its investment-grade rating in a takeover. Any buyer of the company would have to comply with that agreement, known as a “poison put”. Private equity firms splurged on a record $465 billion of deals this year. Kravis and officials at New York-based KKR would not comment. A Blackstone spokesman also declined to comment. KKR, Blackstone, Carlyle Group, Pacific Group and the rest of the buyout industry have borrowed $166 billion in loans and bonds to finance acquisitions in 2006, leaving 10 targets with lower credit ratings. The debt of companies owned by buyout firms totals 5.4 times their cash flow, the most ever, according to S&P.
Bondholders consider themselves lucky if they manage to avoid securities of companies that get purchased by LBO firms, which typically borrow to pay for about two-thirds of any acquisition. Before August, just one bond sale for an investment grade rating contained a such a poison put. Owens Corning has several traits that are attractive to buyout firms, including a low debt burden, “significant” cash flow and an expected investment-grade rating of Baa3, according to a report Moody’s. In a typical acquisition, leveraged buyout firms assume the target’s existing debt. Because of the poison put, buyout firms seeking to acquire Owens Corning would have to come up with an extra $1.21 billion upfront to pay off the bonds. “Companies are now releveraging and that releveraging of corporate America is going to be happening for the next several years,” Pimco’s Kiesel said. “You want to be going up in credit quality and staying high in credit quality.”Link here.
European Central Bank fears decay in bank standards.
The ECB said that banks in the EU might be compromising their financial standards in order to win lucrative business from hedge funds. Banks reap large fees by lending to hedge funds and executing trades for them, but “intense competition among banks may have contributed to a certain erosion of standards,” the bank said in its annual report on the stability of the EU banking sector. The ECB said that some banks had assumed the role of both buyer and seller as they mediated transactions for hedge funds, effectively concentrating the risk for themselves. “From a banking sector stability point of view, it is important going forward that banks retain sound risk management practices vis-à-vis their hedge fund exposures,” the report said.
While the report raises the possibility that the large risks that hedge funds take could spill over into the banking sector, for now the ECB painted a picture of a European banking system that is hale and hearty. After a crisis early in the decade, banks have been recovering strongly since 2003. The ECB said that recent innovations, like the ability of banks to securitize loans and sell them to investors, had helped to curb the risks they contend with. But this practice has transferred the risk to other investors, notably unregulated hedge funds, making it harder to keep track of. “We do not know exactly where this risk is,” Edgar Meister, head of the ECB's banking supervision committee, said.Link here.
STRUCTURED CREDIT SQUEEZES BEARISH TRADES
The rally in European and U.S. credit derivatives markets may have its base in a better outlook for corporate debt, but it is the sudden hype generated by one new kind of structured product that has really caught traders off guard and put the squeeze on bearish positions. This product, which allows investors to make a highly leveraged bet on the credit derivative indices, did not exist until this year, and only came to light in August. Since then, ratings agencies say that almost every investment bank has been working on or selling these deals, known as constant proportion debt obligations (CPDOs).
According to Paul Mazataud, a managing director at Moody’s, such deals typically begin with leverage levels of 10-15 times, which means $1 billion worth of deals would add up to $15 billion worth of unexpected protection selling in the same time frame, putting pressure on spread levels. The effects of this can be seen in the main iTraxx Europe index of investment grade credit default swaps, which provides protection against default for a basket of companies. The spread, or protection premium, for a 5-year contract on this index has collapsed in the past month from just above 30 basis points to about 22bp, according to figures from Markit Group.
Andrew Whittle, a managing director in structured products at Barclays Capital, says the arrival of CPDOs in the market is as important as the amounts they trade. The arrival of these products had materially changed the factors at play in the indices, which meant that those who were taking a bearish view of credit through short positions had to adjust their trades, he said. Lisa Watkinson, head of structured credit business development at Lehman Brothers, said that, “... it’s probably the hype around these deals or the fear of a wave of protection selling that is moving the market.”
The CPDOs sold so far work by taking a a series of very large bets on CDS indices in order to quickly generate enough income to pay a coupon of about Libor plus 200bp annually over 10 years. Investors are exposed to the risks not just of companies represented in the indices defaulting, but also of sudden increases in the premium that the indices pay. And because the structure will increase leverage if there are losses in a deal, in order to generate higher incomes and try to recover those losses, they can behave like a gambler chasing bad bets.Link here.
A FIRM THAT IS HELPING 34 FORTUNE 100 CLIENT COMPANIES INCREASE PROFITS
You have heard of Citibank, Wal-Mart and Sony before. These are businesses are leaders of their particular industries, with solid brands, name recognition and loyal customer bases. But what if I told you there was one company that helped all of these businesses make money and keep their customers happy? This $248 million company has delivered more than 23,000 of its software systems worldwide, and its customers include 34 Fortune 100 companies. But this stock is completely overlooked by Wall Street, even though as orders for its products keep piling up.
Invervoice (INTV: NASDAQ) makes software that automates and personalizes access to information. Its software includes useful features like automated password reset, survey automation and authenticator – which is a voice authentication system for access to confidential information. Essentially, it offers an entire software suit for major corporate call centers around the world. Intervoice products help some of the biggest companies in the world provide better customer service, because a quality voice automation system takes the hassle out of customer calls.
And now, you have the opportunity to buy shares of Intervoice on the cheap. In September, Intervoice reassessed the status of a large project that was in process prior to the filing of the company’s quarterly report. The company’s backlog of $41.6 million at August 31, 2006 was revised up $0.6 million, while its Q2 earnings per share were revised down a penny to $0.04. Although this new information has affected revenues and costs for the quarter, Intervoice executives are still expecting third quarter revenues of $48 million to $53 million. As I mentioned above, the company’s backlog is growing. This is where the Street made its short-sighted mistake – shares of Intervoice are down more than 16% from just a few weeks ago. And more recently, the acquisition of Nuasis, a company that provides Internet-enabled customer contact software, for approximately $2.5 million in cash on September 1 has set Intervoice back. While the added products Nuasis provide should ultimately compliment Intervoice’s own technology, it will take a little time to properly integrate the operations.
Intervoice not only makes money by selling its software solutions, but also by managing its systems for its clients – which it records as recurring services on its income statement. In its most recent quarter, Intervoice’s recurring services sales of over $26 million topped its $24 million in product sales. For every new customer Intervoice gets, it brings with it the promise of continued business. This year has also been a transition for Intervoice because it is implementing a new company-wide enterprise resource planning (ERP) system. If the new ERP system goes as planned [Ed: This is a speculation, not a given.], investors can ultimately expect better integration of acquisitions and improved profit margins.
Intervoice products are sold in more than 75 countries, and international sales were 45% of total sales last fiscal year 2006, vs. 41% in 2005 and 2004. In October, Intervoice announced it would be establishing sales and support staff in China with the help of its partnership with Alliance Digital. As China’s economy develops and a focus on better customer service becomes more important, Intervoice will be there to win more customers.
Despite some bumps in the road over the past year due to the integration of new acquisitions and transitions in its products, Intervoice is poised to make a comeback. When third and fourth quarter results are announced, it will be too late for the rest of the investment world to get in on this deal.
P.S. Some of Intervoice’s top executives are buying shares of their own stock. Two company directors and the chief operating officer have purchased shares. One spent more than $194,000 of his own money.Link here.
BUY INTO THESE COMPANIES BEFORE GOOGLE DOES
Months after a May-June market meltdown to 9,000, Bombay’s Sensex Index recently nailed a new lifetime high above 13,000, surging past the 12,671.11 high of May 11, 2006. Now that the rally has sustained itself, I am looking for heavy buy interest in small- and mid-cap names, especially those associated with e-commerce. Namely, Rediff (REDF: NASDAQ) and Sify (SIFY: NASDAQ). According to The Inquirer, India is expected to see a 160% jump in Internet users, which should drive more traffic and revenue to Internet sites. And second, I believe Rediff and Sify are buyout candidates for Yahoo! or Google based on recent discussions.
Could we see 14K in the Sensex by year’s end? Possibly, considering the strong corporate earnings, the strong overseas fund inflow, the positive news that India will spend $350 billion on infrastructure. The economy is running strong. Corporate earnings are good. And, considering the historical bull runs witnessed by the likes of American and Japanese markets, there is no reason why the Sensex run could not be sustained. Welcome to the Indian bull market.Link here.
INVESTING IN MEDICINE
Way back in the 20th century, a movie called Fantastic Voyage created quite a stir. It envisioned a future in which miniaturized vehicles would travel inside the human body. While we cannot miniaturize people in that way, thanks to nanotechnology the vehicles are at hand. Through teleoperation and telepresence, people may soon be able to virtually experience such a voyage. Meanwhile, it has tremendous therapeutic applications. Xinhuanet reports that Chinese scientists have developed a unique drug delivery system. It moves within the bloodstream and delivers drugs with pinpoint accuracy.
The Chinese Academy of Sciences in Shanghai invented the device. According to Dr. Shi Jianlin of the Academy, it will have the twin advantages of both greatly reducing side effects from drugs and also allowing them to operate with maximum efficiency so the minimum dosage can be used to affect a cure. A mere 200 nanometers in size, the empty vehicle is simply excreted when no longer useful. Thousands of such vehicles would be needed to deliver a single gram of medication. Preliminary tests have already been conducted with analgesic and cancer drugs.
There is another important implication here. Nanotechnology research has become an international race. Both Europe and the U.S. have committed billions of dollars. However, it would be foolish to discount other players who are also eager to participate. While some believe that China and India are racing us to the bottom by offering far cheaper labor, the reality is that they are also racing us to the top. For example, the Indian Institute of Technology is now the world’s most competitive university. Its computer science education ranks on a par with the finest schools in America.
China intends to create the equivalent of a dozen Harvards in the next few years, and given time there is no reason why they cannot accomplish this. China’s elite already has educations, laboratories and intellects comparable to the best elsewhere. While it remains a far smaller percentage of their total population, their absolute numbers are already in the millions and rising rapidly. I predict that we will see many more important nanotechnology advances from Chinese laboratories in the next several years.Link here.
IT’S VALUE TIME
Read The Little Book of Value Investing by Christopher H. Browne as one of the best guidebooks toward protecting and growing a retirement nest egg. This advice comes from a legend of value investing, and it is presented with enough clarity that anyone can follow it.
Lesson One: You have to be a long-term investor. The facts are compelling. Between 80% and 90% of the investment return in stocks occurs during only 2% to 7% of the time. The other 93% of the time returns have been a minuscule or negative. “It’s a marathon, not a sprint,” says Browne. This is hard for jumpy investors who are easily rattled by the daily noise of the markets. But the only sure way to capture the market’s best performance is to hang in throughout the good and the bad.
Lesson Two: Over the past five years, value investors have outperformed growth funds by a 5% compound rate of return. That is a huge differential. Browne warns investors to stay away from the glamourous darlings of the moment, the sexy high-flying stocks that are being widely promoted. In that way, you can beat the pros. Only 5% to 10% of all professional money managers are value investors.
Lesson Three: There are plenty of value opportunities out there. The author found 751 stocks selling below book value, another 752 that appear to be cheap based on earnings and 96 companies that had fallen over 50% in price during the first few months of 2006. Another 209 companies had significant share buying activity by insiders and officers – often a buying signal to Browne. He quotes several studies that show that, “stocks with insider buying outperformed the stock market by at least a two-to-one margin.” This was true on a global basis as well.
Lesson Four: Browne is especially fond of the value opportunities to be found in European stocks. In 2003 he was able to buy shares of Volkswagen, the German auto producer at 50% of book value, and it has doubled in price even while U.S. manufacturers have suffered. Plowing through European accounting regulations is like “a treasure hunt”. The Tweedy Browne Global Value Fund has been performing better than its U.S. counterpart.
Decades of experience have made Browne a sage investor. He avoids companies with “a lot of debt relative to their net worth.” Companies with a great deal of free cash flow often are a good value. Buying stocks after a crisis or bad news has been profitable. Value investing, Browne feels, can make back the losses from a bear market in less than three years. If he is right, then wake up readers. It has taken six years for the Dow Jones industrial average to return to its 2000 peak. The Little Book of Value Investing is clear, to-the-point and makes a solid case for its subject. It may be a “little book”, but it is a big-time opportunity.book review here.
BARTON BIGGS SEES BUBBLE IN PRIVATE EQUITY
Barton Biggs says the record level of cash being raised by private equity firms is a financial bubble in the making. The former Morgan Stanley market strategist says institutional investors are setting themselves up for some major disappointments down the road, if they keep betting that buyout firms will continue to keep delivering better-than-average market returns.
Biggs says investing in private equity is the flavor of the month for institutional investors who are not content with the returns generated by the stock market. But he says private equity firms are so flush with cash, they do not know what to do with it. “In the history of the world there is no asset class that too much money cannot spoil,” said Biggs, who spoke at conference sponsored by DealFlow Media. “Investors in private equity have excessive expectations.” Biggs, now a managing partner with the hedge fund Traxis Partners, predicts that once the current buyout craze ends, private equity investors are looking at years of poor returns. He noted the hefty management fees the managers of private equity firms take in each year.
Private equity firms typically charge management fees of 1% to 2% and can skim off up to 20% of the profit a fund generates from its investments. Over the past several years, private equity firms have generated fat returns by buying up struggling companies, sprucing them up a bit and then quickly unloading them for a tidy profit. In light of those solid returns, the private equity world has been on fire, raising more than $160 billion from investors this year alone. Yet despite a number of megadeals such as the proposed buyouts of HCA, Harrah’s and Freescale, only a fraction of that newly raised money has been put to work.
Cynics like Biggs worry that with private equity firms sitting on so much money, they will be forced to spend it on ever bigger and bigger deals. Some of these debt-laden transactions may end up going bust, or the acquired businesses may prove too difficult and costly to slim down and turn around. However, Biggs says he is bullish on the market. With the equity markets performing strongly the past few months, he expects institutional investors to scramble back into stocks.Link here.
MORGAN STANLEY ARRIVING LATE AT THE HEDGE FUND PARTY
Nobody could accuse Morgan Stanley’s staffers of ignoring the boss. Late last year, Chief Executive Officer John Mack said he wanted to expand into hedge funds. Now they have delivered. The 2nd-largest U.S. investment bank by market value has just spent almost $1 billion buying stakes in three hedge-fund management firms. Even for an organization like Morgan Stanley, that is a sizable bet to make on the future shape of the financial-services industry.
Is it the right one? Probably not. Morgan Stanley is arriving late at this party. It is making a small, half-hearted move into the industry when it should be staging a serious assault or steering well clear of it.
Compared with its main competitors, Morgan Stanley has missed out on the boom in hedge funds, though it has done well as a prime broker to them. But it is buying while the market is strong and the industry – according to Merrill Lynch – possibly approaching a top. Of course, no one can say exactly where the top of the market is except in hindsight. That said, it is clear Morgan Stanley is not buying at bargain prices. Morgan Stanley is playing catch-up, and that is often an expensive game. In any new industry, the big bucks are usually made by entrepreneurs and by big companies that get in on the ground floor. Anyone arriving late at the party gets fleeced. Indeed, Morgan Stanley is rehiring its former people, at a high price. Finally, the nature of the deals is cause for concern. In two of the deals, they are paying a lot of money for minority stakes. Minority stakes are usually a recipe for disaster.
Morgan Stanley has opted for some deals that are too little, too late. They may not lead to disaster, though it is hard to see what good they will do the bank.Link here.
HOW 2006 IS LIKE 1968
Here is one thing that is not an October surprise for these midterm elections: U.S. voters are still polarized, just as they were back in 2000 (Bush vs. Gore) and 2004 (Bush vs. Kerry). Split down the middle into Republicans and Democrats with very few swing voters left in the middle. But let us not blame this polarization on political slogans (“stay the course” vs. “cut and run”) or October surprises. Instead, let us take a look at the financial markets to see the kinds of rifts that have developed, mirroring the rifts in the body politic.
Generally speaking, the stock market goes up and the economy is strong when Americans are happy. Their positive social mood creates harmony even though political, social, and religious views vary widely. Today, though, even with auspicious financial news, people are upset about the war in Iraq, they are mad about illegal immigration, they cannot stand what is going on in Congress, and more than 60% do not like the way the president is handling his job.
One reflection of this negative mood might be the Dow itself. How can that be if it has been going up, which should reflect a positive mood, you ask? Although the nominal Dow (the one priced in terms of the U.S. dollar) has pushed to a new all-time high above 12,000, the Dow priced in terms of ounces of gold is actually down significantly from its top in the year 2000. The same is true if you view the Dow priced in terms of commodities. So an inflated dollar is carrying the Dow higher than it would be if it were measured in real, non-inflated terms. Polarized voters are examples of a split social mood, which can also account for the rift between what the stock market seems to be and what it really is.
Usually, when social mood is positive, the stock market is up, the economy looks good, and incumbents win. Today’s markets and presidential popularity polls mirror another time in our nation’s history when people were polarized over a war and huge changes in society. The year was 1968, when Lyndon B. Johnson’s vice president, Hubert Humphrey, ran for the presidency against the Republican nominee, Richard M. Nixon. It was the year that students protested on college campuses against the Vietnam War, that Robert Kennedy was assassinated after winning the California Democratic primary, and that police beat up anti-war protestors at the Democratic convention in Chicago.
The Elliott Wave Financial Forecast pointed out in the June 2006 issue that, “Today’s interplay of markets against a backdrop of diverging social phenomena – from plunging presidential approval ratings to attacks against the most successful corporations to an increasingly unpopular war – duplicates the collective social experience of 1968.” The markets had been rallying since 1966, but LBJ was hugely unpopular because of the Vietnam War. As the Dow rose about 35% – going from a low of 735 in 1966 to a high near 1,000 two years later in 1968 – Johnson’s popularity fell from about 50% to below 35% and then went back up to around 45%. In each case, although the Dow rallied in the late 1960s and in the mid 2000s, these presidents grew more unpopular as people focused instead on their protracted wars, troop deaths and profligate spending.
Analysts at Elliott Wave International say that the “big difference between Bush’s readings vs. the stock market and those of Johnson is that this time the discrepancy has been building for roughly twice as long” – two years vs. four years. They interpret this divergence between a high-flying Dow and low-tumbling popularity numbers as the precursor to a turn in the stock market. In fact, since the Bush build-up has been longer, they expect that the turn in the markets will be bigger than during 1968-69 when the Dow dropped about 20% from its high. This polarized atmosphere also suggests that the social unrest that the U.S. has been experiencing should grow larger, including more negative and confrontational behavior that we have not even thought of yet.Link here (scroll down to piece by Susan C. Walker).
BILL GATES WARNS OF RETURN TO INTERNET BUBBLE ERA
Bill Gates warned against the rush to new Web-based software services, likening the frenzy to the days of the 1990s Internet bubble. Asked to name the next YouTube, the free video exchange Web site that is being acquired by Google for $1.65 billion, Gates said that he was cautious. “There are a hundred YouTube sites out there,” Gates said during an interview with a group of journalists. “You never know. It’s very complicated in terms of what are the business models for these sites.”
Some of them, including sites that offer Web-based word processing and search engines, are being promoted by their creators and analysts as possible competitors to makers of retail packaged software like Microsoft. “We’re back kind of in Internet-bubble era in terms of people thinking: ‘O.K., traffic. We want traffic. We want traffic,’” Gates said. “There are still some areas where it is unclear what’s going to come out of that.”
On another issue, Gates said that U.S. competitors were attempting to manipulate foreign regulators to weaken the newest version of the Windows computer operating system. Microsoft a month ago redesigned elements of the software to address the concerns of European regulators. “I think all of our competitors have had fun flying around the world – they are almost all U.S. competitors – trying to get regulators in any market to castrate the product. But it didn’t happen,” Gates said.
During a brief public speech, Gates predicted that the pace of technological change over the next decade would be dramatically faster than anything ever seen before, as the digital revolution leads to fundamental changes in everyday life.Link here.
AVOID THE CRAP STOCKS
“Stocks just keeping making money – a lot of money. They are on a roll.” So a priest said to me last night at a dinner before mass in West Baltimore. He told me he was thinking about investing now that everything seemed to be humming right along. The only key to success, Father told me proudly, is diversification. “As long as you are diversified, you should be O.K.”
I cringed when he uttered those words. Warren Buffett, John Templeton and every other billionaire investor who still lives would be appalled! But Fr. (we will call him Joe), is like 99% of all investors in America. They do not get excited about stocks until the market is making new all-time highs. Pour souls.
In his weekly commentary, Dr. John Hussman noted that, “... the market climate in stocks remained characterized by unfavorable valuations and moderately favorable market action.” He went on to explain that since the start of this recent bull-run, stocks have already gained a full 85.1% since their 2002 lows. If the stock market were to close up shop today, this current rally would be the third most profitable run since 1947. But the stock market is not going to close shop any time soon. And more than likely, the average investor will not be 85% richer in a year from now. Not even close. What the average investor fails to ever understand is what happens after a large rally. Stocks fall – usually a lot.
Hussman examined every major market rally from 1947 to today. First, he measured how much stocks advanced to at the top of every bull-run. Second, he calculated their returns after a full market cycle – in other words, once the bottom fell out. And third, he noted the P/E of the S&P 500 at its low and high throughout each cycle.
To take a recent example, look to the rally from 1990 to 1998. At the beginning of this bull-run stocks traded for 11.3 times earnings. While they were not as cheap as at other times - at the beginning of the great post-war bull market in 1949 stocks traded for just 5.8 times earnings – they were still attractive on a historical basis. And slowly but surely, investors started to jump in. By its peak, stocks were up 374% and trading for 28 times earnings. It is at this point that the fools jumped in and the bear came a calling. By the end of the market cycle, the total gains were 244.8%, not 374%. A lot of people lost a lot of money despite the overall bullish trend.
Now fast forward to today. Since October 4, 2002 stocks have shot up 85%. Unlike all previous rallies before this one, stocks were not cheap at the beginning of the bull cycle. The average stock traded for 15.3 times earnings in late 2002. The last time stocks were this expensive at the beginning of a cycle was in 1987. We all know what happened then ... Folks, a fall is coming this time around. I guarantee that. All the signs are there.
Corporate earnings growth is at an all time high – an unsustainable high at that. Valuations, while not super expensive, are certainly not cheap either. The average company on the S&P 500 currently trades for 20.9 times earnings. And the average small-cap stock in the Russell 2000 (excluding those that do not have earnings!) trades for 19.7 times earnings. Finally, the stocks that average investors are buying these days are garbage. Here is how I know.
I created two screens several months ago. The first screen is what I call my “good stocks” screen - stocks cheap on a P/E, price to book, and price to cash flow basis, with positive sales and earnings growth, and which generated free cash. The 17 “good” stocks that fit the bill are only up an average of 6.1% over the last year. Then I created a “crap” stock screen – small-caps on the NYSE that have minute sales growth but no earnings to speak of, do not generate free cash, and trade at over 2 times book value. The 19 stocks that fit the bill are up an average of 51% over the last year. When stocks like this are leading the way, it is only a matter of time before the Grizzly Stock Market Bear hunts you down.
As Hussman writes, “With stocks still near their recent highs, I think it’s useful to remember the tendency of bull markets to surrender large portions of their gains over the full market cycle. Without that understanding, investors are vulnerable to the temptation to ‘chase’ returns in what is already a richly valued, aged bull market advance, where recession risks continue to gradually increase.” Now is not the time to be chasing crap stocks. And now is not time to blindly invest just because stocks are on a roll – even if you are a priest. They do not always “keep making money.” Just wait, you will see.Link here.
WRONG TIME FOR GRIDLOCK
Conventional wisdom in ever-cynical financial markets has it that gridlock is good. The implicit assumption is that a dynamic U.S. economy is in such great shape, the best thing that Washington can do is nothing. In my view, that would be tragic. Gridlock is the last thing America needs. Granted, there are times when government can, indeed, get in the way. But there are also circumstances which demand leadership and decisive policy actions. This is one of those times.
The policy challenges facing the U.S. economy are daunting, to say to the least. At the top of my list is America’s chronic saving problem. In 2005, the net national saving rate – the combined saving of individuals, businesses, and the government sector adjusted for depreciation – plunged to a record low of +0.1% of national income. As best we can tell, this is also a record low for any leading global economic power in the modern history of the world. Lacking in domestic saving, the U.S. must import surplus saving in order to grow. In 2005-06, our estimates suggest that America absorbed about 70% of the surplus saving elsewhere in the world. And, of course, in order to attract the foreign capital, the U.S. has had to run massive current account and trade deficits. With the current account deficit at an $874 billion annual rate in the second quarter of 2006, or 6.6% of GDP, such external financing requirements boil down to about $3.5 billion of capital inflows each business day of the year.
Washington can no longer afford to take lightly a saving shortfall of this unprecedented magnitude. For starters, it exposes the U.S. to currency and real interest rate risk in the event of a sudden loss of confidence by foreign lenders in dollar-denominated assets. It also raises serious questions about the wherewithal for America to fund retirement for its aging generation of some 77 million baby-boomers. In a gridlocked climate, Washington must rely increasingly on the “kindness of strangers” to keep funding a saving-short U.S. economy without demanding currency or real interest rate concessions. It must also count on manna from heaven to fill the retirement funding gap. Washington must face the imperatives of a saving agenda head-on.
Number two on my list is plugging that portion of the saving hole attributable to the Federal government’s structural budget deficit. CBO’s latest estimates place the “standardized” structural budget at -2.2% of GDP in 2007 – identical to the -2.2% average over the preceding four years, 2003-06. In a gridlocked climate, that means a slowing in the pace of economic activity would put pressure on growth-sensitive revenues – leading to yet another round of cyclical deterioration in the federal budget deficit and renewed pressure on national saving and external financing. The imperatives of deficit reduction should be an important down-payment on America’s saving agenda.
Trade policy is the third item on my personal action list. Protectionist pressures are as serious a problem as I have seen in my years in this business, especially in the context of what is historically a low unemployment rate. These pressures are unlikely to vanish into thin air now that this election has come and gone. With fully 25% of America’s massive trade deficit traceable to the bilateral imbalance with China, Washington is convinced it has an ironclad case to hold the Chinese accountable for all that ails the American worker. If Washington were to shut down trade with China completely, a saving-short U.S. would have to source its deficit elsewhere – most likely with a higher-cost producer that would impose the functional equivalent of a tax hike on American consumers. And then, of course, Washington may be forced to face a very different attitude from its Chinese lenders. In a gridlocked climate, trade policy runs a real risk of moving further down the very slippery and dangerous slope of protectionism. In facing up to America’s saving imperatives and globalization’s new realities, such a mistake stands a much better chance of being avoided.
America’s competitiveness agenda is another priority that should not be held hostage to gridlock. Globalization is the most powerful macro force that we face in the world today. In a gridlocked climate, Washington in effect says no to globalization and threatens sanctions on offshoring. In an activist climate, the long overdue heavy lifting on educational reform, basic research incentives, and reskilling begins in earnest.
These issues, of course, just scratch the surface of the many challenges that face the U.S. economy in the years ahead. Others have written far more eloquently than I on matters of healthcare reform, retirement funding, regulatory reform in a post-Sarbanes-Oxley world, income inequality, and environmental issues – just to name a few. And, of course, this is just the economic agenda – there is obviously plenty to chew on in the foreign policy arena these days. But the point is a simple and very powerful one: Can the U.S. afford to crawl into the shell of gridlock and do nothing on matters of great national and global importance over the next two years? If you believe the answer to this question is “yes”, I suspect that you risk making some very heroic assumptions about the way a saving-short U.S. economy is likely to squeak by in the years ahead. Insofar as financial markets are concerned, gridlock is not good news for a saving-short U.S. economy. In particular, it underscores the potentially ominous current-account funding implications for both the dollar and real U.S. interest rates at precisely the time when most investors have concluded that there are no consequences from America’s gaping external imbalance.Link here.
In the year of our Lord, 2005, on the Pacific coast of the North American continent, a two-bedroom trailer was offered for $1.4 million. This was hardly a first ... or even a most. Other mobile homes have been sold for $1.3 million and $1.8 million. Still another was on the market for $2.7 million. Why would people pay so much for mobile homes? The $1.4 million trailer, we were told, was in a gated community and on a “triple-wide lot”. “Location, location, location,” a quick-witted reader might think to himself. The views were said to be spectacular. But the buyer of the million-dollar trailer would not be buying location. He only rented it.
Unlike most single-family dwellings, trailer owners do not own the land upon which their houses rest. Instead, they are permitted to park their mobile homes on someone else’s land – for a fee ... and for a while. In addition to a mortgage, the typical million-dollar trailer buyer has to pay “space rent” – which, for the $1.4 million mobile home was $2,700 a month. Not a fortune, but still a drain on your money. And mortgages are hard to get on trailers, because the trailer can be pulled off the land. In Malibu, in 2005, the average house sold for $4.4 million. A trailer is more modest than an average home, but put it on a lot overlooking the Pacific and it is worth a fortune ... at least it was in the great bull market that lasted from 1996 to 2006.
Meanwhile, in Florida, buyers were taking up condos that had not even been built yet. In Miami, “flipping” condos came to be a profitable speculation in the early 21st century. Speculators would buy a group of 5 or 10 condos – even before a single shovelful of dirt had been displaced. The idea was to sell the contracts to other speculators while the place was being built. The second buyer would then sell to yet another buyer when it was completed. Neither the first, nor the second, nor the third buyer had any intention of living in the condo. The trouble was that the object of their speculation looked rather lonely and forlorn when it was finally put up. Driving by at night, it was noticeable that few of the condos had lights on. Most were empty, waiting for their ultimate buyer ... the poor sap who would actually live in the place and, presumably, pay for it.
While buyers were leaping from one absurdity to the next, the lending industry fitted them out with special shoes – with wings! In the autumn of 2006, the regulators began to wonder. A group of regulatory agencies looked up at the sky and had a fright. They suddenly realized they had allowed too many marginal buyers to take off. The air was full of them. Many were beginning to crash. Even Ben Bernanke warned that a little more “awareness” of lending practices was needed. About the same time, the Comptroller of the Currency, John C. Dugan, spoke about the innovations of the mortgage industry: “Lenders who originate these types of loans should follow sound underwriting practices that consider the borrower’s repayment capacity.”
Traditionally the lender judged both his man and his market. If both were deemed solid, he would take a chance, lending the man a mortgage and hoping that the market was strong enough to allow him to recover his money if the man failed. But the new lenders did not care about the man at all. In fact, they rarely knew him and hardly met him. It was the market that they cared about. And when they judged the market, they found it foolproof. Longtime sufferers of my column know that no market is proof against the ingenuity of fools. Lenders seemed determined to prove this was so – by making outrageous loans to both fools and knaves. Among the number and variety of non-traditional mortgages that have flourished in the last six years, adjustable rates, of course, became common. But so did mortgages with zero down payments and alluringly low starter rates – including interest-only mortgages, flexible payments, and “stated income” applications, in which the borrower is left to use his own imagination in describing his financial circumstances.
In 2000, only 5% of mortgages were of the so-called “sub-prime” variety – that is, mortgages to marginal borrowers. Five years later, one in four were to sub-prime borrowers. Also in 2000, only 25% of these sub-prime mortgages were of the “stated income” variety. Only 1% consisted of “piggyback loans” – junior mortgages designed to eliminate the need for a real down payment. And none were I.O., or interest only. By September 2006, 44% of sub-prime loans had “limited documentation”, 31% were piggyback loans, and 22% were interest only. This was the very moment at which regulators were asking the lending industry to be more careful – that is, after they had already let the weasels in the chicken yard.
Do you remember, dear reader, how we laughed? The stated purpose of both the federal government’s housing policy and that of the lenders themselves was to “help Americans buy their own homes” or words to that effect. Easy credit was meant to increase homeownership. They had “democratized” the credit market, they claimed. Yes, now not only rich speculators could lose their shirts. The common man could lose his too! The obvious effect of all these innovations was to turn Americans into a race of housing speculators, not of homeowners. These innovative mortgage products were more like options to buy a house rather than an actual purchase of one. As the I.O.’s, limited doc, flexible payment ARMs reached farther and farther into the general population of homeowners, fewer and fewer people really owned their homes at all. More and more of them became gamblers, betting that property values would rise fast enough so they could refinance again.
But we felt a little uneasy when we laughed, because the joke was on the people whom could least afford it – the gullible borrowers of the sub-prime market. But how we roared at the gullibility of the sub-prime lenders! One of the great innovations of the lending industry during this period was that it broke the link between the person who made the loan and the person who would suffer the loss if the loan went bad. That was what made the housing bubble possible. While the marginal lumpen took out I.O. low-doc ARMs, the hedge fund, pension fund and insurance fund geniuses bought MBSs – mortgage-backed securities. The securities were backed by the mortgages, which were in turn backed by the imaginary incomes of the borrowers and inflated house prices.
The credit agencies rightly judged the quality of the mortgages as less than perfect – BBB – and then with the miraculous powers of modern finance these same mortgages were put into MBSs and turned into AAA credits! This transformation of bad credits into good ones, in front of the very eyes of Ph.D. mathematicians and hedge fund quants, must be rated along with Christ’s performance at the marriage of Cana, where the Nazarene turned ordinary tap water into wine. Scientists often suggest that the Gospels lie. But as to the veracity of modern finance, they are mute.
When asked to explain, the institutional salesmen resorted to logic little different that of the ordinary homeowner. The component parts may be a little oily, they said, but put together the sliced and diced, processed mortgage packages were less risky than individual mortgages. It was as if you were less likely to get sick from eating a can of Spam than from eating any particular cut of meat. How that could be, was never explained. The sophisticated buyers did not merely buy the packaged mortgage debt. They ate it up. Cheap suits, expensive suits – they all fell for the same line of guff.
Just how bad some of this glop was became apparent only recently. As reported in Forbes, “The real estate market has never offered such opportunity for graft. Since the housing market started to soar in 2001, mortgage fraud has become the fastest-growing white-collar crime, according to the FBI. Last year crooks skimmed at least $1 billion from the $3 trillion U.S. mortgage market. ... Now that the market is slowing, fraud is only rising. As business dries up ... loan and title documents aren’t scrutinized as carefully as they might be ... Then there’s the mad rush to sell ... It’s like a tasting menu for con artists and grifters, so tempting that in some cities drug dealers have turned to mortgage fraud, plaguing lower-income neighborhoods with crooked mortgages rather than crystal meth.”
The Forbes article told the story of a pair of thieves who pretended to be who they were not, borrowed money to buy houses at inflated prices – forging documents, stealing identities, defrauding sellers and lenders alike – and made off with millions of dollars. Elsewhere it was reported that lenders made millions in mortgage loans to inmates in the Colorado prison system. The inmates were able to buy 17 houses for inflated prices and take away $2.1 million in excess loan proceeds. Hundreds of houses were sold in what was called “price puffs” – at prices above real market value. The price puffs began modestly, with buyers taking out $5,000 to $10,000 at the time of settlement, but then grew until they were walking away with 30% of the purchase price, or amounts over $100,000. By the autumn of 2006 these houses were going into foreclosure at the rate of one out of every 13. Then, the feds got on the case and people started going to jail again.
But that is how these stories tend to end – in regret, in court, in workout, in chapters 7 and 11. Every public spectacle ends in correction of some sort ... often in a house of correction. And if the force of the correction is equal and opposite to the deception that preceded it, this one ought to be a doozie.Link here.
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