|W.I.L. Home Page||Finance Digest Home|
|Sign Up||Offshore News Digest Home|
THE U.S. DOLLAR WAS LAST WEEK’S BIGGEST TURKEY
While Americans were busy digesting their Thanksgiving feasts, the rest of the world was barfing up dollars. As a result of our massive trade deficits, foreigners certainly have their bellies full of them. This week’s action in the Forex markets indicates that they may have finally eaten their fill. Unfortunately, the bad taste will likely linger as the dollar’s rout has only just begun.
As American consumers hit the stores on Black Friday, few will have noticed that the most significant mark-down occurred in the value of their currency. If anything can be said to have been blackened this Friday it is the U.S. dollar. While the media remains focused on the dollars Americans are irresponsibly spending, the real story lies in the loss in value of those dollars that foreigners are foolishly saving. The losses are particularly more pronounced among foreign central banks, most notably China, whose foreign exchange reserves, the vast majority being U.S dollars, recently eclipsed $1 trillion. When foreigners finally decide that they have had enough, their reluctance to accumulate additional dollars will mean that America’s perpetual shopping spree will finally come to a screeching halt.
Last week the U.S. dollar was carved up like a Thanksgiving turkey. Against the Swiss franc, euro, British pound, and Japanese yen, the dollar lost 3.0%, 2.2%, 2.0% and 1.8% of its value respectively. In fact, year to date the Dow is only up by about 3.5% when priced in euros, vs. its 14.5% advance when measured in depreciating U.S. dollars. From its high in 2000, the euro price of the Dow is down by over 27%. In terms of gold, the world’s only legitimate money, the Dow is off better than 50% from its 2000 peak, and actually down over 7% thus far this year. So much for Wall Street’s phony rally!
At the risk of over using the term, one conundrum is the relative strength in the bond market given the dollar’s recent weakness. From our creditors’ perspectives, the only thing worse than holding dollars is holding future claims to dollars, which is what bonds in fact represent. When foreigners begin factoring 10+% annual dollar declines into U.S. bond yields, bond prices will head south fast. It also never ceases to amaze me how U.S. investors can be so fixated on stock prices yet remain oblivious to what those prices actually denote. Stock prices of course represent quantities of dollars. Therefore, true stock market values actually depend on the purchasing power of the dollar. Concentrating on the former while ignoring the latter is one of the biggest mistakes most investors make.
Unfortunately the technical outlook for the dollar, and by extension that of the entire U.S. economy and the financial markets it supports, is rapidly deteriorating. The dollar Index, now trading near 83.5, has broken though some key support levels and the next test will likely be its all time record lows of just under 80. If that test fails, as it most likely will, look out below. Once the dollar moves into uncharted territory, the selling could intensify, with the dollar index trading below 70 in short order. My ultimate target for that index is 40, which would literally cut the dollar’s value in half. I think the entire move could occur in just two years. This assumes the Fed finally gets religion and Congress and the President heed its sermon. If not, and hyperinflation ensues, the dollar index could fall far lower, perhaps even breaking into the single digits before bottoming out.
Don’t make the mistake of thinking that this is somehow a problem for foreigners. It is Americans who will feel the losses the greatest, as it will result in substantial increases in both consumer prices and interest rates, and in declining assets prices, particularly for residential real estate. In the other words, what we own will be worth a lot less and what we need to buy will cost a lot more.Link here.
Dollar’s dive depends on Fed zigging as ECB zags.
Combine faltering U.S. growth with a robust European economy, diverging monetary-policy outlooks for the two regions, and maybe you have an explanation for the dollar’s precipitous decline in the past week. Maybe. The U.S. currency dropped to a 20-month low of $1.3218 against the euro this week, down from about $1.28 last week. The British pound now buys about $1.95, up from $1.72 at the start of the year. Even the Japanese currency has managed to strengthen, to about 116 per dollar from as weak as 120 yen a month ago.
While dollar bears are rejoicing, it is hard to isolate a trigger for the sell-off, which began while the U.S. was slipping into its annual tryptophan-induced Thanksgiving coma. It seems likely, though, that further dollar weakness depends on Mr. Market’s interest-rate forecasts coming good. A year ago, economists were predicting that 2006 would conclude with the benchmark U.S. interest rate at 4.75%. Instead, the Federal Reserve has cranked borrowing costs up to 5.25%. The most recent surveys suggest that the next move will be a zig back down to 5%. In Europe, the consensus calls for the European Central Bank to zag twice more. Economists see the ECB raising rates when it meets next week and again in the first quarter of 2007, pushing its benchmark lending rate to 3.75% from 3.25% currently.
This is the first time since the euro’s 1999 introduction that borrowing costs in Europe are heading higher at the same time as U.S. rates may be poised to decline. The currency market, though, has a mixed record when it comes to paying attention to such differentials. The last time U.S. and Europe diverged this way, with European money-market rates rising while U.S. deposit rates decreased, the dollar gained against the euro’s predecessor, the European currency unit.
The dollar’s trajectory last threatened to take it into freefall at the end of 2004, when it dropped to a record low of $1.3666 on Dec. 30. The front cover of the Economist magazine at the time featured a Chinese silkworm chowing down on a greenback. At that time, the Fed was still in tightening mode, the ECB looked more likely to cut rates than raise them, and the Bank of Japan was still battling the demons of deflation with a 0.15% benchmark rate. By February 2005, the dollar was back to about $1.28, and by June 2005 it was at $1.22.
Fed Chairman Ben Bernanke appears to be trying to damp expectations for lower U.S. rates. The dollar barely budged, though. Even revised figures showing the U.S. economy expanded at an annual pace of 2.2% in the third quarter failed to spur the U.S. currency. European officials are struggling to find a way of talking the dollar down from its ledge. They have been claiming for months that the euro area has acquired immunity from any U.S. economic slowdown because of the diminishing importance of trade flows between the two regions. That makes it difficult to start bleating now about the currency needs of European exporters. Treasury Secretary Henry Paulson is sticking to the official U.S. mantra, saying on Nov. 28 that “a strong dollar is clearly in our nation's best interest.” It is becoming increasingly hard to reconcile that claim with the U.S. currency’s decline of more than 30% against the euro in the past five years.
So what next for the dollar? Betting on higher ECB rates next year is likely to be a winner. Betting that the Fed will cut rates in the next few months, though, seems riskier. So if that is your reasoning, you might want to think twice before you sell another dollar.Link here.
THE FORBES 2007 INVESTMENT GUIDE IS OUT
Since the 2000 tech crash, large-cap growth stocks have lagged their counterparts by historic proportions. Time to buy.
Big earnings boosts. Big market valuation increases. Big price/earnings multiples. Big futures. That is what large growth stocks are all about. But these issues also are big on volatility. They have this Icarus-like trait of flying high, then plunging. Lately, however, they are showing signs of heading up once again. If so, now is a good time to get back in, while large growth shares are still relatively cheap.
Of the 62 different stock fund categories that Lipper researchers track, large-capitalization growth is ranked 60th over the past five years, returning a paltry average annual 2.3%. Compare this with almost any other fund area over the same period – small-cap value (near the top) at 15.3%, midcap value 14%, even small-cap growth 7.7%. More stunning still is that of the 35 different bond classes Lipper has, including munis, large-cap growth has lost out to all of them.
To John Jostrand, manager of William Blair Growth Fund, a smallish ($256 million assets) large-cap growth portfolio, this means the category has never been a better buy. “Everything in the market is cyclical, and big growth stocks again will have their day,” says Jostrand, with no small self-interest but a lot of common sense. Over the last 25 years return for large-cap growth funds is a solid annual 11%, within a percentage point or two of the five other broadest-ranging fund categories. So, Jostrand reasons, if you believe that returns regress to the mean, large growth must outperform hugely in the future to keep in line with historical averages. Jostrand runs a fairly concentrated portfolio of 48 stocks (average market cap is $11 billion), with a trailing P/E of 21. The S&P’s is 18.Link here.
Once the economy dips, high-yield debt will start defaulting. But you can buy bonds of consumer staple goods makers whose businesses should hold up well in a recession.
Want to buy a junk bond? That is a good way to spice up the anemic yields you are getting nowadays in a world of still low rates. Too bad there is this little problem with ... risk. Our usual advice is that these beasts are best held within the corral of a good mutual fund, where expert managers can oversee them. But what if you want to walk on the wild side and own some of these wicked securities outright? We consulted two junk-savvy money managers on how to do this. Their recommendation is to buy junk issued by makers of consumable goods. If the economy slips, odds are that the issuers’ businesses – food, tobacco, wine – will not.Link here.
Japan has not roared back ... yet. But that means good buys are available.
Prosperity’s return to Japan, after 15 years of economic woe, is coming in fits and starts. Growth has not been as robust this year as many had expected. The Nikkei 225 is up a mere 0.65% as of mid-November, amid worries about a slowdown in the U.S. export-dependent Japan’s biggest market.
But there are opportunities to be had in Japan. Among the least risky: The $13 billion iShares MSCI Japan Index Fund is the largest single-country exchange-traded fund in terms of assets. With a track record of 10 years, it is also one of the oldest single-country funds. Its 3-year performance of 13.6% a year mirrors Japan’s nascent recovery. This ETF aims to mimic the Japanese market by investing in large companies like Toyota, Honda and Canon. Expenses come to 0.59% of assets yearly, compared with the average of 0.52% for all global and international ETFs.
Method two, for the hands-on investor, is to buy Japanese blue chips available in the U.S. as ADRs. Honda and Toyota are obvious candidates. Two others, somewhat less well known, are Kyocera, which makes telecom gear and various electronic components, and Nidec, which manufactures things like spindle motors for computer hard drives. ADRs are tradable at low transaction costs and spare you currency headaches.
Method three, for the truly adventuresome, is to dive into the Japanese market in search of yen-denominated shares. Peter Boardman, managing director at money manager Tradewinds NWQ Global Investors, has a favorite sector: consumer finance. It is a contrarian bet for a nation that abhors personal debt. Boardman finds a good value opportunity in these lenders to consumers who are poor credit risks. The lenders sport strong balance sheets and should benefit from industry consolidation. Economic turbulence has created 20 million customers for subprime lenders. Big Japanese banks will not lend to them. “A clear area where there’s a lot of value and a lot of fear,” says Boardman. The larger consumer lenders have a low price-to-book of around 0.8.Link here.
Your broker may be making a pretty penny lending your stock to a short seller without your knowledge. Here is how to get a cut of the action.
Roger Metzler likes his investment in NovaStar Financial (NYSE: NFI). The stock pays a $5.60 dividend, for a yield of 18.5%. He does not mind that NovaStar, a Kansas City REIT, is the target of hard-charging short-sellers who for nearly two years have kept the shares among the most heavily shorted stocks on the NYSE. In fact, he is counting on this short-selling to continue. Metzler lends his NovaStar shares to traders through his brokerage account at Smith Barney. In exchange, Smith Barney pays him 13% a year. The arrangement adds $4 a share on top of his $5.60 dividend. “If I’m going to hold it, I might as well get as much money out of it as I can,” he says.
Metzler is an exception, not the rule. Wall Street securities houses rake in $10 billion a year in revenue from lending the shares of long-term holders to active traders. Brokerage firms are free to lend out any shares that customers put in margin accounts, the kind of account that allows the customer to borrow against his securities. Does your brokerage pass along to you any of the profits it gets from its stock loan department? Probably not. If you want to profit by lending shares of a sought-after stock like NovaStar, you may have to first move them (or threaten to) out of your margin account into a cash account where the broker cannot touch them without your permission.
It is easy for investors to find out if they own shares that are likely to command premiums. The stock exchanges publish daily lists on the most heavily shorted stocks, thus the hardest to borrow. Overstock.com, an online retailer that sells brand-name products at clearance prices, is such a favorite of short-sellers that lenders are charging 54% a year for the shares. A price war in online brokerage has all but eliminated commissions for active traders who keep big balances. Competition may come next to fee sharing by the stock loan department. At the moment brokers are reluctant to share fees unless the customer has a large block, a cutoff of $100,000 worth of shares being typical.
A word of warning before you buy a stock with the intention of lending it. Short-sellers do not go after ExxonMobil. They tend to go after companies with weak balance sheets or disappointing cash flows, and sometimes they are vindicated. Over the past year NovaStar’s price is up slightly but Overstock.com’s has halved.Link here.
Do the meager yields on Treasurys leave you cold? You can get an extra point of interest with mortgage-backed securities. But there are pitfalls.
That 10-year Treasury sitting in your brokerage is earning you a crummy 4.6% return. Can you do better with a high-quality, fixed-income investment? You can, and this article will tell you how. But it will also tell you that there is no free lunch. Enhanced yields come with risks and/or tax costs.Link here.
How to thwart inflation with Treasurys and, now, municipals.
Two killers for bond investors are inflation and taxes. If you want peace of mind you can buy protection against one or both of these nasty brutes. But the protection does not come cheap. You will not be left with much. But then you might not be left with much of a return if you do not buy protection. A 10-year Treasury yields 4.6%. But at tax time you have to give some right back to the government. A top-bracket holder is left with 3%. Knock off 2.5% for inflation (just a guess) and you are left with a real aftertax return of 0.5%.
For protection against the decline in the purchasing power of the dollar, buy a Treasury Inflation-Protected Security instead. The 10-year TIPS pays 2.3%. This coupon is tacked onto a consumer price adjustment (most of it delivered at maturity) to give you your total return. If inflation averages 2.5% from now to maturity, you will get a return, measured in conventional dollars, of 4.8%. Alas, the government that issues these things taxes you on the nominal, not the real, return. If you are in the 35% tax bracket, this TIPS will give you a 3.1% aftertax return. Subtract inflation of 2.5% and you wind up with a real aftertax 0.6%. For protection against taxes only, buy a municipal bond. A tax-exempt bond due in ten years and rated AAA will yield you 3.5%. Subtract our hypothetical inflation rate and you have a real aftertax 1%.
A newer alternative protects you against both inflation and taxes. It is an inflation-adjusted municipal bond usually referred to as a muni CPI. These bonds yield anywhere from 0.7 to 0.8 points over inflation. If inflation shoots up to 10% or if the federal tax rate shoots up from its present 35% top rate, you can shrug off the damage. Over the past year the CPI has climbed only 1.3%. If you think this is what is in store for the next decade, forget about either TIPs or muni CPIs.Link here.
Buying an inflation-protected annuity is the most rational retirement investment many people could make. Very few people behave rationally.
The biggest worry among retirees is that they might outlive their assets. One way around that is to buy a product called an immediate annuity. You pay an insurance company a lump sum, and it cuts you a fixed monthly check for life. Such annuities are a great way to turn money in your 401(k) into a lifetime income stream. The longer you live, the better the investment. And it is impossible for your retirement income to give out.
Trouble is, your check might not stand up well to the ravages of inflation. With a standard annuity, your lifetime income is fixed in nominal, not real, terms. With people living decades in retirement, even a mild inflation of 2% to 3% yearly is bound to seriously erode the buying power of your annuity payout. And heaven forfend a return of 1970s-style double-digit inflation. Sales types may try to persuade you that you should instead buy something called a variable annuity, which combines a mutual-fund-like investment coupled with an insurance policy. If the market does well, so will you. But what if the market does not do well? And besides, variables are laden with horrendous fees.
The good news is that you now can buy a fixed annuity with inflation protection built in. These are modeled after Social Security – which pays a lifetime benefit linked to a cost-of-living index – thus keeping their real value steady from year to year. But inflation-protected annuities are not easy to sell, because the initial payouts are less than those of an ordinary annuity. Too many potential buyers recoil in horror at the notion, says Paul Pasteris, who runs the retirement division at New York Life.Link here.
True or false: Your 401(k) plan is costing you more than $1,000 a year. If you cannot answer that question you are like a lot of Americans.
Roughly 40 million Americans, or two-thirds of the private-sector workforce participating in a retirement plan, have only a 401(k). In 1980 that was the case for 20% of workers. Some big companies get competitive bids for their 401(k) business, landing low-cost funds from Fidelity, Vanguard and other vendors. But subpar offerings are a common problem at small companies, where fees often gobble up 2% to 3% of assets each year. For a worker investing in a conservative blend of stocks and bonds, a 2.5% cost wipes out a significant fraction – perhaps half – of the real return that can be expected. “Costs in this industry are way out of line,” says Gregory Carpenter, chief executive of Employee Fiduciary, a firm that runs 401(k) plans at a fraction of the usual cost.Link here.
Which is best: paying a commission each time you buy or sell a stock, or a flat fee?
One of the most difficult things to do on this planet is to trade yourself rich. So we are not advocating that you try to do that. But perhaps by acting a bit more rationally you have most of your investable wealth segregated in low-cost buy-and-hold positions (like index funds), and yet you would like to trade very actively with the 10% or 20% remaining. What is the cheapest way to do that? Now we can comfortably give you some advice.Link here.
Commodities usually go up with inflation. But try stocks in resource businesses rather than futures contracts.
History suggests that investing in commodities is one of the best ways to beat inflation. Look back at the last great inflation, from 1977 to 1982 it tacked 68% onto the price of goods while the price of silver doubled and both oil and gold tripled. Yet to Frederick Sturm the ideal strategy to beat inflation is to buy not commodities but the companies that produce them. And while inflation does not appear to be a problem right now, he is prepared for when it might be again.
“We invest in companies that invest in the stuff, not in the stuff itself,” says Sturm, chief investment strategist of Toronto’s MacKenzie Financial and manager of the $4.2 billion Ivy Global Natural Resources Fund. “If you invest in raw commodities, you’re betting against human ingenuity.” Another argument in Sturm’s favor is that futures are tricky things for amateur traders, and you cannot buy and hold them for years the way you can a share of stock. Exxon shares have fared well in the commodity boom of recent years, having doubled since 2003. They pay a nice dividend. And they have not lurched downward with the price of oil, which has fallen from $78 in July to a recent $56.
Diversification is the key to commodity stock investing, Sturm says. While most resource-oriented funds concentrate on just energy or precious metals producers, Sturm long ago decided that his fund would invest as broadly as possible to capture all the angles. If you want to avoid the 5.75% load on his fund, you could replicate Sturm’s approach by buying equal parts of Vanguard Energy and Vanguard Precious Metals & Mining, then adding individual agriculture and forestry stocks that these funds do not cover. Sturm has as much as 60% of his assets in energy, including utilities. The rest is split more or less evenly among base metals, precious metals, forest products, industrial materials like concrete and agricultural commodities.
Sturm thinks gold, now $619 per troy ounce, is likely to trend sideways for a couple years before mounting a climb toward $1,000 an ounce. A vexing crosscurrent, says Sturm, is the influence of exchange rates, which move by their own logic and do not necessarily track inflation and market demand for commodities. Nearly all global commodities are quoted in dollars, so when commodity prices go up, the reason might simply be that the dollar is going down. But if you hedge adequately against inflation by owning resource companies, you do not have to worry too much about what happens to the yen or the euro.Link here.
The Reel World
The idea of owning part of a motion picture has fascinated outside investors since as early as 1915, when director D.W. Griffith convinced business leaders to finance his $100,000 ($2 million in current dollars) silent epic, The Birth of a Nation. Today’s film investors, certainly a well-heeled bunch, could easily find much smarter things to do with their capital. But Tinseltown’s allure is intoxicating.Link here.
A DANGEROUS ADDICTION
It has become customary in the U.S. to speak of “asset-driven” economic growth. “Asset-driven” is, of course, a euphemism for bubble-driven, because it requires particularly large rises in asset prices. Many modern economists consider asset-driven growth a valid alternative to the traditional growth pattern, nowadays called “income-driven” economic growth.
Mr. Greenspan gained high regard in the late 1990s for nourishing the rising stock values that provided such a massive “wealth effect” and, therefore, such a massive boost to consumer spending. Plainly, this inspired him to subsequently nourish the housing bubble. A new, indirect and apparently more efficient method of stimulating consumer spending through intermediation of an asset bubble was invented. Rising asset prices can boost “wealth” much more quickly than income growth, while also providing facilities with high leverage. But if these are advantages, they must be regarded in context. Real GDP and productivity growth as a rule are in line with what people actually experience in the incomes they earn and the prices they pay in the shops. But this time, there is an unprecedented gross discrepancy between the very good looks of these two aggregates and what they experience in actual life. It is an open secret there is extensive statistical spin.
We liken asset bubbles and associated credit bubbles with drugs. Just like human bodies can become dangerously addicted to drugs, economies can become dangerously addicted to these bubbles. Of course, drugs cause severe damage to body and soul, and so do asset and credit bubbles to the economy and its financial system. In the U.S. case, these damages are highly visible. Witness the collapse of saving, the monstrous trade deficit, the capital spending crisis, miserable employment and income growth and, on top of that, the debt explosion devastating balance sheets.
These are definitely the attributes of pathological, unstable and unsustainable economic growth. These are more than just symptoms, because they exert their own malign effects. The decisive problem is that credit bubbles do not evenly distribute their effects across the economy. They concentrate on one or two areas, which expand out of proportion to normal trend growth. In the U.S. case, the latest credit excess has centered on durable goods, housing and financial speculation. Put differently, asset and credit bubbles distort the economy’s demand and output structure in an unsustainable way.
Have the borrowing-and-spending excesses of the past years in the United States been of a size to make a severe adjustment crisis and deeper recession possible or probable? A crucial related question, of course, is the U.S. economy’s resilience and flexibility to resist the coming adjustment shocks. According to forecasts, the consensus economists expect the U.S. economy to see little more than a brief and minor economic slowdown from the housing blow. Basically, it is still in their eyes a “Goldilocks” economy, its outstanding emblem being low inflation and interest rates. For American economists, it is dogmatic that low inflation rates are the infallible indicator of economic health. The Great Depression and Japan’s prolonged economic malaise should have taught a lesson about the inadequacy of this aggregate as a measure of health and a guide for policy.
The key point about the U.S. economy, really, is that the forces that caused the 2001 recession never went away. They went from bad to worse. Business fixed investment has not really recovered from its slump in 2000-02. The counterpart and implicit cause of this capital spending crisis are the spending excesses on consumption and housing absorbing a growing share of GDP. In 2005, consumer spending and the housing bubble accounted for 90.1% of real GDP growth. Real disposable income of private households grew 1.2% vs. an increase in real consumer spending by 3.5%. It is no secret what made this incredible discrepancy between the two aggregates possible: equity extraction against inflating house prices. Over the four years 2001-05, outstanding mortgages of private households have jumped from $5,292.9 billion to $8,888.1 billion, or 68%. Apparently, the housing bubble was not only the icing on the cake. It was the cake.
While U.S. real economic data overwhelmingly keep surprising on the downside, comments by economists and the media keep surprising on the upside. This is grotesque. Compared with 2000, when the last downturn started, the U.S. economy’s growth fundamentals – savings, investment and the trade balance – have dramatically worsened. Debts, in particular of private households, have escalated as never before. And now comes the housing bust ... a bust that has barely started. The wealth effects will become anti-wealth effects. Rising home values have been supporting the U.S. economy’s recovery. Any significant fall in home values will abort it.Link here (scroll down to piece by Dr. Kurt Richebacher).
Hard Lessons: Harder Landings
We will begin 2007 with Democratic majorities in Congress. We feel confident that the arriving Democrats plan little and will execute on even less in the way of seismic economic adjustment. Our interest is in forecasting their response to the trouble that we are very confident is coming.
The housing market is early into a multi-year correction. The 2003 IMF study in the April 2003 World Economic Outlook is among the more well-articulated modern studies of the likely fallout from a burst housing bubble. The U.S. is just beginning to unwind the largest housing bubble in modern history. There will be upswings in the secular bear market for housing as well as local exceptions and wide regional and price bracket variation. This changes nothing. Hundreds of billions of dollars in household access to cash and debt from refinancing, equity extraction, home equity lines of credit and house flipping will dry up.
This will constitute a radical reduction in the wealth effect, access to credit, low cost credit and notions of improving conditions for the long suffering American middle class. The revolt of these folks in the November 2006 mid-term election is just the first in a series of cuts that their reaction to worsening conditions will carve into the national economy and polity. Middle class reaction to deteriorating economic conditions will be definitive across the next year and beyond.
The debt, income and savings situation of the American middle – if we take the three middle quintiles of the income distribution to be the middle class – is horrifying. Many of these people are in the difficult situation of potentially becoming former members of the middle class in terms of material quality of life. 2006 will be a year where America’s aggregate savings rate is negative. Real average weekly earnings of production and non-supervisory workers – over 75% of all us payrolls – have been stagnant since the mid 1970s. If we use 2005 dollars and the CPI-U (consumer price index for urban consumers), average weekly earnings decreased by about $1 per week over the 30 year interval 1975-2005. The folks dis-save and have taken on massive amounts of housing and consumer debt.
A look through the Federal Reserve’s Flow of Funds Accounts of the U.S. release of September 19, 2006 is a traumatic experience. It reveals the contours of America’s debt disaster in stark statistics that grow worse with each passing quarter. In 1999 total outstanding household debt was $6.4 trillion. As of the end of the second quarter of 2006 total outstanding household debt was $12.3 trillion. Way back in 1999 household mortgage debt stood at $4.4 trillion. At the close of QII 2006 it had more than doubled to $9.33 trillion. This is usually soft sold and talked down by comparison to skyrocketing housing values. Household assets held as real estate increased by $9 trillion from Q1 2000-Q2 2006. This might be called the mother of all modern bubbles. Yet household net worth struggled up by a mere $1.2 trillion. Net worth badly lags housing values because of waves of cash out. American households are totally dependent on inflating house prices and have already borrowed and spent the paper gains that every credible economic model suggests are now deflating. When these waves crash ashore it will be with massive destructive force.
Across the last year this process of refinancing has taken on a desperate air. Mean house prices are now falling. Interest rates are above recent lows and unlikely to test them absent a serious recession. However, Americans keep refinancing and re-mortgaging. Why? There really is only one answer: desperation. Freddie Mac informs all those who dare to look that 90% of its refinanced loans resulted in new balances at least 5% higher than the previous loan. This is the desperate top of a very troubled bubble.
It is clear that legions of folks are desperately continuing to pursue survival strategies that built them mountains of debt and no longer make any sense at all. There will be little way out. The traditional routes of savings reduction, debt increase and government counter-cyclical spending and tax cuts have already been over-utilized. There are no savings or the false savings some economists claim come from rising house prices. The sustainability of present debt stretches credulity. Who still would be willing to loan to earnings-strapped, deb–burdened Americans with deflating collateral and home equity?
Meanwhile, the federal government has gone on a tax cut and spending bender that almost recasts the American consumer in a thrifty light! The Fed report mentioned above offers a handy little table called “Consolidated Statement for Federal, State and Local Governments”. Between Q1 2001 and Q2 2006 all assets of all levels of government grew by 16% to $2.4 trillion. During the same period, liabilities grew by 40% to $7.9 trillion. Thus, the state has in fact already been firing on all cylinders – native and borrowed. There is real trouble coming as tax increases and spending cuts in some combination are required to slow the growth of Federal debt and foreign borrowing ahead of falling tax receipts and rising payments associated with underfunded liabilities. Thus, the government is more likely to prove hindrance than help in the near term future.
We urge all our readers to focus on moving ahead of and understanding the realities facing America’s middle class. The shape and speed of the coming troubles, and mass reaction to them, are likely to be the largest shapers of domestic macroeconomic performance. We believe there are also significant international implications. Housing is the next shoe to drop and the first sign of the upset was the mid-term elections.Link here.
The economy as turkey leftovers.
Think of the U.S. economy as one big roasted turkey that amply fed the family members gathered round the Thanksgiving table. Everybody took their favorite parts – white meat for Mom and Dad, dark meat for Grandpa Joe, drumsticks for the kids – and then the huge bird was served as leftovers. Here is a quick rundown of this year’s economic leftovers.
Economy Pot Pie à la Fed – The Fed’s head chefs have concocted a pot pie that they claim is steaming hot from inflation pressures. In other words, the Fed is always fighting the last war, which is, was and ever will be, inflation. Fed policymakers talk about inflation even as Wal-Mart, the nation’s largest retailer, cuts generic drug prices and grocery items; as U.S. homesellers drastically reduce prices on their houses to get someone to buy them; and when it takes $1 billion to make it onto Forbes list of the 400 richest Americans. (Millionaires are now a dime a dozen.) That is beginning to sound a lot like deflation. And we all know that Fed Chairman Ben Bernanke has studied the Great Depression and will do whatever it takes to avert one now. But there is no guarantee that the Fed can.
Dealmaker’s Turkey Tetrazzini – Take $52 billion in mergers and acquisitions that were announced on Tuesday, add it to the other billions in deals announced in 2006, and you have got yourself Dealmaker’s Turkey Tetrazzini. This year will go down as the #1 year for deals, with $3.4 trillion being exchanged so far to buy and sell companies. But just because these deals have been made does not necessarily mean they will benefit the shareholders. For example, Blackstone Group will buy Equity Office Properties, the largest U.S. office REIT, and take it private. As one of my finance-savvy friends who works with REITs wrote me, “Personally, I think the only people that are going to make money off this are the Blackstone firm (its partners, employees and the institutional investors that are its Limited Partners) & EOP executives.”
Housing Hash – Take the chopped-up remains of a turkey, add potatoes and a few other ingredients and you have made a hash. The same as the Fed has made a hash of the housing market by pumping it up with too much credit and then letting it fall down by raising interest rates. Not to mention the mortgage lenders who created bizarre mortgage schemes to lure people who could not afford a down payment or a normal monthly payment. So now we have got foreclosures on the rise and permanent “For Sale” signs.
Cold Turkey Consolidation Salad – Delta Air Lines, a mainstay of the airline industry and the metro Atlanta economy, may find itself going cold turkey and leading the way in consolidations following Thanksgiving. U.S. Airways has made its second bid to merge much more unfriendly than its first, which was ignored by Delta’s management last spring. With Delta still in bankruptcy, though, it will be tempting for many of its debtors to decide that a buyout bid is the best way to recoup their money.
Deficit Turkey Sandwich – We have got is a deficit-spending sandwich dripping cranberry-red stains all over the U.S. budget. To my mind, the biggest turkeys are politicians who spend more than the tax monies the nation takes in, leaving the mess for our children and grandchildren to clean up. If you want to go to war, find a way to pay for it. If you pass a law to build a fence on the border between Mexico and the U.S., then find a way to fund it. If we could only build a section of fence around the Capitol each time Congress passes laws it does not fund, we might be able to keep them contained.Link here.
FED OVERSTEERING LEAVES INVESTORS IN A QUANDRY
Central bankers rarely admit mistakes unless they are discussing events long lost in the fog of history. That is what makes the November 2 remarks by Richard Fisher, president of the Federal Reserve Bank of Dallas, so remarkable. Fisher candidly said that an inflation gauge relied on by the Fed (the index for core personal consumption expenditures) was malfunctioning four years ago. Back in those days the annual increase in the core PCE was drifting below 1%, signaling an approaching deflation. This moved then Fed governor Ben S. Bernanke (now chairman) to deliver a dense and noteworthy speech, “Deflation: Making Sure ‘It’ Doesn’t Happen Here,” on November 21, 2002. The most memorable line was a semiserious reference to the possibility that the Fed, in a real pinch, could increase the money supply by dropping bills from helicopters.
The Fed did not, in any event, employ aircraft in its open-market operations. But it did manage to work the Fed funds rate down to 1%, providing considerable fuel to the inflation in commodity and home prices over the past four years. Fisher concluded that this looseness in the money supply was a mistake and that it was caused by faulty statistics. The Fed’s favorite measure was underreporting inflation.
If nothing else, Fisher’s diagnosis of the recent past is yet another good reason to dust off the works of economists from the Austrian School, particularly Friedrich Hayek’s. Hayek stressed that changes in general price indexes do not contain much useful information. He demonstrated that it was the divergent movements of different market prices during the business cycle that counted. Even a casual review of prices for different commodities, goods and services, as well as assets and the value of the dollar, would have enabled the Fed to avoid its mistake. This, of course, does not provide much comfort for those who are now trying to unload real estate after being enveloped in the Fed’s liquidity-driven housing bubble.
To get a handle on where we are and where the Fed may be going, let us examine the entire Greenspan era. Were there other mistakes or perverse policy patterns between August 1987 and January 2006? A Fed zigzag pattern is clear. An overreaction to a so-called crisis, resulting in the excessive injection of liquidity (a sales boom), is followed by a slow draining of liquidity and a mild recession (sales slump). The problem this time around is that the economy is only starting to search for a bottom. But you would not know it by looking at the way risks are priced. Risk is cheap. Specifically, the cost of purchasing credit protection against the nonpayment of corporate debt (with a credit default swap) has recently reached an all-time low. The best way for investors to protect themselves from the Fed’s oversteering is to build a core position in Treasury Inflation-Protected Securities. TIPS generate a real yield of 2.3% at the 10-year maturity and 2.2% at 20 years.Link here.
THE END IS NEVER THE SAME
Drawing comfort from a benign inflation outlook, financial markets are convinced that central banks pose little risk of a classic interest-rate-led endgame. However, just because cycles of the past have been terminated by interest rate pressures, that need not be the case in the current cycle. Three possibilities – none of them driven by interest rates – have the potential to trigger a cyclical endgame: (1) A post-housing-bubble shakeout in the U.S. could derail the American consumer and a still U.S.-centric global economy. (2) The renewed decline in the dollar is a reminder of the possibility that massive global imbalances could lead to a disruptive rebalancing of the world economy. (3) A pro-labor shift in economic policies could occur – reflecting a backlash over growing inequalities of income distribution; a post-election U.S. is especially vulnerable, but there are similar risks in Europe, China, and India.
Awash in liquidity, financial market participants have no compunction about putting more and more money to work in what they perceive to be benign circumstances. I have my doubts. We are all creatures of habit. That is true of economists, investors, policy makers, and politicians – all of whom look to signs from the past as guides to the future. That leaves us captives of history, whether we like it or not. I have great respect for history and spend a lot of my time reading it. But I have long been struck by the flaws of autoregressive thinking – extrapolating on the basis of recent trends and looking for guidance from historical patterns to predict the future. Time and again, we learn that no two cyclical endgames are alike. Yet time and again, we draw the wrong inferences from patterns of earlier periods. This is one of those times.
On one level, the world is in the midst of a very benign cyclical climate. At work is a remarkably constructive inflation climate. Absent the normal tendency of a cyclical upsurge in inflation, there appears to be no need for central banks to take the proverbial punchbowl away. A lot has been made about the recent updrift in core inflation. But let’s face it, by standards of the past 35 years, these are excellent outcomes. In that context, the “normalization” response of central banks is a far more tolerable course of action than the wrenching monetary tightenings that have wreaked such havoc on cycles of the past. Absent the primary peril of past cycles, goes the argument, there seems to be little to fear in the current cycle.
Yet this time is different. Sure, that is the classic “ah ha!” – code words for ever-cynical investors to ignore anything that follows. But it is important to understand the corollary of this reaction – namely that nothing ever changes. That is where I have a serious problem. Consider globalization, the most important mega-force of our lifetime. This is the first time that the powerful disinflationary forces of globalization have had a major impact on the endgame of a modern-day business cycle. Consider IT-enabled technological change and ever-mounting global imbalances, which both shape and threaten the endgame for the first time. Consider the gap between record returns on capital and the sharply depressed rewards of labor in the developed world. It has been a long time since the potential social and political consequences of such tensions were in play. I could go on and on – underscoring the unprecedented growth in synthetic securities (derivatives), the doubling of the global labor supply traceable to the emergence of China et al, rapidly aging populations in the developed world, unfunded retirement and medical-care liabilities, and surging M&A and LBO activity. The point is that it makes no sense whatsoever to ignore the truly unique features of the current climate.
The cyclical endgame is invariably a by-product of the excesses that build up during an expansion. This cycle is no different in that regard. Three such excesses are at the top my list are a profusion of asset bubbles, ever-mounting global imbalances, and the growing potential for pro-labor shifts in economic policies. Cyclical history conditions us to look for the proverbial trigger that might take an excess to the breaking point. The current cycle, with its absence of serious inflationary pressures, seems almost trigger-free in the context of cyclical excesses of the past.
But despite a lack of interest rate pressures, there can be no mistaking the abrupt sea-change in America’s housing market. This is quite consistent with conclusions of Yale Professor Robert Shiller, who has devoted as much effort as anyone to studying the excesses of speculative activity. Shiller has long argued that asset bubbles do not need to be pricked by a pin (i.e., rising interest rates) – that they invariably implode under their own weight. That is pretty much the way the equity bubble burst in 2000, and 6 1/2 years later, such a thesis applies equally well to the demise of America’s property bubble. I am in the camp that believes these post-bubble adjustments are a big deal for the asset-dependent American consumer, as well as for a U.S.-centric global economy. I may be wrong there, but it is important to stress that it did not take an interest rate trigger to bring this issue to a head.
Nor does a disruptive rebalancing of an unbalanced world require an interest rate spike to mark it to market. I will concede that I have certainly been wrong in warning of the imminent consequences of America’s coming current account adjustment. But with the dollar now under pressure again amid renewed talk of central bank diversification out of dollar-denominated assets, it is important not to lose sight of the fundamental saving disparities that might allow this adjustment to take on a life of its own. Most investors and currency experts see the trigger of recent developments in foreign exchange markets as a “euro overshoot”. That is quite possible, but here as well, let the record show that currency markets are on the move in a relatively benign interest rate climate. The dead weight of America’s massive current account deficit may finally be coming into play at just the point when most believe it is not a problem. The long history of currency markets – especially the time-honored tendency for a tightly bunched consensus to get it wrong – hints at just such a possibility.
In the absence of interest-rate pressures, most believe that financial markets enjoy a Teflon-like immunity from any and all potential sources of adversity. A number of potentially powerful macro forces are now in play, any one of which has the potential to derail a seemingly benign macro climate. A combination of them would be all the more destabilizing. The risk is that investors are trapped in the past – aiming their defenses in the wrong direction.
Such a possibility reminds me of the legendary Battle of Singapore in 1942. Convinced that the next war would be like the ones of the past, British military strategists positioned their fixed artillery for a classic invasion by sea. The Japanese, of course, invaded by land from the North – leading to what historians have called one of the largest and quickest capitulations in British military history and Winston Churchill’s worst disaster. Here is where history may have something to say about increasingly complacent financial markets. No two endgames are alike.Link here.
RESULTS OF THE HOUSING DECLINE
Many have been asking for an update on the Florida housing scene from Mike Morgan at Morgan Florida. Although we chat several times a week, it has been hard to come up with a new angle, given the steady deterioration in things. Hopefully, the following post accomplishes the mission. It is an attempt to look at things from the perspective of the homebuilder rather than the homebuyer, with a brief preliminary discussion on stock prices. From Mike Morgan:
I have been receiving quite a few calls regarding the surge in homebuilders’ stock prices. Well, first off, I am not a financial adviser. My research and consulting services are purely information for the end users to incorporate into their financial analysis.
I think that what is going on nationwide in housing will affect the country to levels we have not seen since the Depression. Some of you may be equating me with Chicken Little. After all, Cramer is bullish on the homebuilders and so is Bill Gates. Well, it is not Bill Gates making the call. It is his financial advisers that run the foundation that are making the call. Second, even if it were Bill Gates, he is been wrong more than right for the last few years. Bill Gates is not Warren Buffett. As for Cramer, I have no comments except to say that his show speaks for itself. I think you can read between the lines. Finally, the market seems to have bought into the “Goldilocks” soft landing theory. Well, housing has never seen a soft landing ever, and I fail to see how this time can possibly be different, given the affordability problems and the disparity between housing prices and rents – not just in Florida, but pretty much nationwide. With that comment, let us now turn our attention to the situation facing the homebuilders.
Following are the three business strategies builders are using to survive the downturn in home building:
1.) Reduce Inventory. Housing inventory is at the highest level we have ever seen since the beginning of time, and growing daily. The Catch-22 here is simple. Margins after all of the sales incentive nonsense are approaching zero for most builders, and the madness has not stopped. But if builders do not dump standing inventory now, they will have heavier losses if they continue to carry these homes and watch prices further deteriorate as the competition drives prices down further. Catch-22.
2.) Monetize Land. If the builders move forward with the developments, they are further increasing inventory. If they do not, they face problems with carrying costs of entitled land or shutting down a development that has already started. If they have already started the development, they most likely have a time frame with the local government to complete the build out. Some local governments require builders to post a bond insuring the completion of developments. And how many homes do you think a builder can sell in a ghost town of a few spec homes? Second Catch-22.
3.) Scale Back. One would think this is the smartest option. When demand drops off, it is usually a good time to cut back on supply. But if the builders scale back, that means lower numbers for Wall Street. We would see lower starts and lower sales and lower revenues and lower profit. Oh, almost forgot the “bonus factor”. We would also see lower bonuses to the top dogs who greedily reaped in tens of millions of dollars each during a market fueled by irrationally greedy speculators that essentially had nothing to do with their business acumen or experience. If the builders scale back, Wall Street will not see the numbers it wants to see. If the builders do not scale back, bottom-line losses will be the only numbers Wall Street will see. Catch-22 again.
In addition to the three Catch-22 issues, Wall Street seems enamored with the low book values of the builders. I have got news for you. The book value numbers for this group are as misleading as a deaf and blind Seeing Eye dog. We have seen a few builders take write-downs on some land, but if you crunch the numbers, it is crystal clear that these write-downs are not enough. For land purchased prior to 2000, the book value will most likely hold. For land purchased in 2005 or later, these guys are in trouble, and much of that land is probably worth 25-50% less than what they paid. Land purchased between 2000-2004 is a gray area. The bottom line when it comes to land is that builders bought land just like the flippers bought their preconstruction homes. Price was a secondary issue. The primary concern was getting entitled land.
The crash of the housing industry is only now getting started, as it will spread virally to all of the boats it floated during the rising tide. Housing has touched every single segment of our economy, and it will darken all of those segments as the industry collapses to the worst levels we have seen since the Depression. The NAR and other groups producing numbers have been great cheerleaders, but when you are pumping out misleading numbers, I do not care how beautiful or loud the cheerleaders are, the situation is a no-win Catch-22 for the homebuilders no matter how one looks at it.
I find it interesting to see yet another Catch-22. Please compare and contrast “NAR Thinking Big for ‘07’” with “2006 Subprime Loans Doing Badly”. “Thinking Big” outlines additional (and unwarranted) handouts the NAR wants from the Democrats, including subsidized flood and hurricane insurance, eliminating the FHA’s 3% down-payment requirement, raising the cap on loan terms to 40 years, and getting the “FHA and Fannie Mae and Freddie Mac back on track and working in every state.”
The policies Lereah espouses are the very same policies that made housing unaffordable in the first place: an ownership society promoting housing, subsidized insurance, decreased lending standards, and unmitigated growth in GSEs. I see four policies attempting to make “housing more affordable” all doing the exact opposite. Now Lereah’s solution to the problem is the same solution that led to the bubble in the first place.
While pondering that idea, please consider “2006 Subprime Loans Doing Badly”: “Subprime loans – or loans made to borrowers with less than perfect credit – from 2006 aren’t just performing badly. The loans, in particular those used to back mortgage bonds, could prove to be one of the worst performing groups yet, according to UBS. ... The rate of subprime loan delinquencies of 60 days or more – meaning borrowers are that far behind in their payments – has climbed to about 8%, up from about 4.5% a year ago.”
Lereah is, quite simply, a huge part of the problem, and zero part of the solution. Anyone who wants a house already has one or cannot afford one. Looser lending standards will have a negative impact on both writeoffs and affordability. In the long term, what is sorely needed is an enormous housing bust to deal with affordability issues as well as to put a final end to the credit bubble we are in. But that will eliminate some of Lereah’s perceived power and, arguably, all of his credibility, so he cannot go along with it. Instead, he promotes the policies that got us into trouble in the first place.Link here.
The Housing Market: A Sliver and a Slice
Some topics will make the financial media reflexively put on their rose-colored glasses whenever possible. Take the housing market, for example. Here is a sample of headlines from early this week: “Existing Home Sales Rise, Prices Fall” ... “Slashed Prices Spur October Home Sales” ... “Home Sales Top Expectations”. They portray a mixed picture at worst, as if the sales rise was somehow keeping up with the price fall – although some headlines did not even mention the decline in prices.
As always, the full story is in the details. First, the rise in sales was month-to-month, meaning October had more than September. But October sales were lower than every other month of the past year except September. It does not change the trend, or the 11.5% year-year drop in sales. Second, the prices fall part of the headlines is where the real story was. The drop in home prices over the past year is literally the largest such decline since the record keeping began in 1968 – not that I noticed any headline to that effect.
Obviously nobody wants to beat up on the housing market. Most families own one, and I do not want anyone kicking my house around. But let’s be serious. We all know that as recently as Summer of 2005, the national media made it sound like the real estate market was a like a lottery than everyone could win. They overemphasized the truth then, and they are underemphasizing it today.Link here.
WHERE IS ALL THAT HOT AIR MONEY FUELLING THE BUBBLES COMING FROM?
Most people and even most economists believe it is the Fed that controls the money supply, and that it is Fed know-how that is maintaining our CPI within historically “reasonable” limits. A minority of us, however, think our present economy is in a falsely optimistic booming phase of a bubble-and-burst cycle started more than 10 years ago by excessive credit and money creation, and that the excess dollars are camouflaging themselves in assets and speculation rather than in the CPI.
There is plenty of evidence to support this idea, starting with the dot com and stock market bubbles that burst in 2001, the global real estate bubble that has started to turn in the U.S. and is still strong globally, and now the still growing U.S. bubbles in corporate profits, bond issuance, M&A activity, finance industry bonuses, and hedge fund and credit derivative frenzies.
Statisticians will try to disprove the bubble conjecture pointing to stats from the Fed and relative government entities, because the figures do not all corroborate the nature of the bubbles we think we are observing. There are two hypothetical market dynamics that might explain this: (1) Money and credit creation mechanisms could exist outside Fed control, and (2) the excess purchasing media may be sidestepping the statistics. Hereafter are three scenarios that illustrate how this might be happening.Link here.
WHEN TURKEYS FLY
I predicted that the Republicans would lose 3 seats in the Senate and 6 in the House, and that the stock market would move up in anticipation of this outcome. I have to eat some crow on the political soothsaying (actual losses: 6 and 29), but I am not backing down on my bullish forecast. The S&P 500 has climbed 6.2% since that column came out and is on its way to a double-digit gain next year. Reason? 2007 is the third year of the presidential term, and third years tend to be bullish.
In not a single one of the 16 third years beginning in 1943 did stocks fall. While the market rose only 5% or so in 2 of these years (1947 and 1987), all other third years saw double-digit gains. Interestingly, foreign markets did well in these years, too. Beginning in 1943 third years of U.S. presidential terms all showed gains for the Morgan Stanley World Index, gains that averaged 20.5%. Since this rally is getting a little old (it started in March 2003), 2007 may be the year that scrapes the bottom of the quality barrel. Turkeys will fly. This will be a change from recent years, when the trend favored quality value – prestigious companies trading at affordable multiples.
If the market is up big, as I expect, market leadership will shift away from these recognizable names. Many of the best-performing stocks will be those that folks have not bid up yet because they cannot fathom one single reason to do so. The bottom of the barrel! Bad becomes beautiful. But I am not going to recommend genuine turkeys on some theory that you can make money from a greater fool in the late stages of a bull market. No, here are five companies that, however boring, are anything but turkeys.Link here.
MARKET WARNING FROM THOSE IN THE KNOW
If George Muzea is right, Monday’s decline is just the start. Muzea, who runs Muzea Insider Consulting Services, has been negative on the market for just two weeks – the first time he has been bearish since July 24, when he turned positive. Muzea makes market calls based on the activity of corporate insiders. He is considered the grandfather of the insider-tracking industry, generally keeping a low profile to all but his high-paying hedge fund clients.
We speak every now and then. When we spoke last week he gave me an earful. According to Muzea, this is likely the beginning of a sharp and steep decline not unlike the one that hit the market last spring – and maybe worse. The only thing he does not know is whether, as is often the case, he is a month or two early. The wild card on timing, he says, is the impact 401k money will have inflows in January, which could give the market one last gasp into early spring. He will know, he says, if insiders stop selling early in the year.
Muzea notes, however, that insiders have been finding less value in the market over the past eight years. “Every time you have a low,” he says, “you have fewer and fewer stocks with positive patterns.” Before you go calling this a scare tactic on a down day, keep that Muzea has a record, and he is basing his forecast on a history of following the market as it relates to the actions of insiders. “If you want to lose money over a long period of time,” he says, “buy when insiders are selling and the public is bullish.”
Adding to the intrigue this time, he says, is the increasingly powerful role of electronically traded funds. “The players and numbers of ETFs are expanding exponentially, and they’re putting that money into EFTs” that track indices like the Nasdaq 100 or the S&P 500. The most disconcerting part of the story, he says, is that these investors what have flocked into the ETFs do not need an uptick to sell them short. “If the market is vulnerable right now,” he asks, “what would happen if a geopolitical event or something else happens? How fast would it take for the Dow to go down 500 or 700 points, with everybody going short to protect themselves? When they start selling these, who is going to buy them?”Link here.
It seems like the 1980s all over again, as the volume of takeover deals explodes. Two decades ago Michael Milken and his innovative junk bonds shook up corporate America. The signature deal then was the Kohlberg Kravis Roberts’ takeover of food-cigarette behemoth RJR Nabisco. The 1988 RJR transaction, at $31 billion including debt, was then the largest leveraged buyout in history. Today it would be just another deal. There once was such a thing as a company too large to LBO. At this point the sky is the limit. For the current group of private equity titans, which includes KKR, what were previously considered large war chests – $2 billion to $10 billion – now look scrawny.
Private equity firms are now acting in concert. The biggest of these so-called club deals – health care giant HCA – has beaten the RJR record. By working together former competitors can put more equity (and, correspondingly, more debt) into a single deal. Junk offerings are still very much a part of the picture, but lately the LBO bunch is turning to hedge funds to borrow capital. Hedge funds are willing to lend more money with fewer restrictions and debt covenants than banks or high-yield bond underwriters.
How will all these deals work out for private equity funds and their investors? It is too early to tell. Bigger may not be better. Moreover, if bidding wars erupt between private equity consortiums, deal prices could rise and returns could fall. Still, a clear beneficiary of the new deal mania should be the shareholders of midcap to large public companies, with enormous size no longer outside the realm of private equity targets. Several of my portfolio holdings could find themselves on dealmakers’ watch lists.Link here.
THE WRITING ON THE WAL-MART
Since the start of 2006, Wal-Mart has officially gone from class-act to class-action lawsuit, answering every charge imaginable from corporate fraud, book cooking, discrimination against minorities and women, environmental carelessness, violation of labor laws, and on, and on – culminating in the low-budget turned breakout success documentary The High Cost of Low Prices.
In addition to the anti-Wal-mart smear campaign, WMT stock stands more than 40% below its 2000 all-time high. And Wal-Mart officially put the black back in Black Friday (the day after Thanksgiving and first official shopping day of the Holiday season) when data revealed a 0.1% drop in November same-store sales. That was only the second time in 27 years that Wal-Mart has reported a fall in sales, and marks the weakest performance by the company since April 1996. That is the WHAT.
More important is WHY Wal-Mart sales are not improving. Word on Wall Street was, high-energy prices and low sentiment were behind the retailer’s woes this past summer. Voila: From its July 14 peak, oil has plunged over 24% to a 10-month low while gas at the pump is at its lowest level for all of 2006. At the same time, consumer confidence has soared to a 15-month high. Add a dirt-cheap offer of $4 prescription drugs AND the decline in sales remains mysterious.
That is, until you read what the January 2006 Elliott Wave Financial Forecast said about the “building drumbeat” of hostilities and hold ups just beginning to hurt Wal-Mart. In EWFF’s own words, “The source of the emerging opposition” is a reversal in mass social mood from extreme optimism to extreme pessimism. “A negative social psychology is grabbing hold” whereby those success-story companies that developed on the way up fall under fire on the way down. “Wal-Mart is facing the most formidable opposition to a retailer since the 1930s, when a campaign was waged against Great Atlantic and Pacific Tea (A&P), which subsequently lost its dominance of the retail market.”
Wal-Mart will reclaim its former bull market glory not via low-priced Prozac, but via an upturn in mass social mood, as reflected in the Elliott Wave pattern unfolding in stocks.Elliott Wave International November 27 lead article.
INVESTING IN INDIA
Why you must remember November 27, 2006 forever.
Mark that day down on your calendar. It is a day investors will look back to in 10 or 15 years and wish they would have realized its importance. Unfortunately, most will not until it is too late. Let me explain ...
For the first time since the British pulled out of India in 1947, the world’s largest democratic nation opened its virgin $300 billion retail sector up to a foreign mega-retailer: Wal-Mart. Wal-Mart announced it formed an alliance with Bharti Enterprises Ltd. (a leading Indian telecommunications company) to open hundreds of stores in India over the next several years. According to an article on investor.com, “Under the deal, Wal-Mart and Bharti Enterprises will set up a joint venture to manage procurement, inventories and logistics, while stores will be set up under a franchise agreement.”
This is a massive story – although it did not make the headline of any mainstream news source that I saw. (It was buried under about 10 stories that came out that day). This sole event will lead to billions and billions in profits for investors – especially small-cap. Until yesterday, 97% of India’s retail sector was made up of Indian mom and pop storeowners. For the last 49 years, the Wal-Marts, Targets and Sam’s Clubs of the world were not granted access to India’s blossoming consumer class. The country’s leftist leaders wanted to protect the millions of small-time shopkeepers that dominate the retail sector. And this has been the major item on the Communist ticket for years.
To be a true super power you cannot close yourself off competition, whether foreign or domestic. By doing so you sacrifice your own people’s long-term prosperity for short-term mediocrity. By allowing major retail outfits like Wal-Mart into India you encourage billions of dollars to be spent on access roads, parking lots, water purification, infrastructure development, banking development, insurance writing and real-estate development. And on top of that, you encourage billions in foreign direct investment – money India can use to improve its living standard.
The last time a major Asian country opened its retail sector to foreign direct investment was China. In 1992, it opened its then $75 billion cash cow to foreign investment for the first time ever. And what followed in China was a wildly lucrative series of events:
Looking forward, there are going to be a lot of investment ideas that pop up in India. Many of them will be small-cap in nature. But it is going to take time to find the really good ones. For now, please know this ... India’s retail market is not headline news at this time. No one is talking about it. No one is thinking about how to make money when it opens up. But it will open up. It is just starting to now. And investors who follow this story early on could make a mint. As investor.com reported, “India’s retail industry is estimated at about $300 billion, and is forecast to grow to $427 billion in 2010 and $637 billion in 2015, according to consultancy Technopak Advisors.”Link here.
PEAK OIL? MAYBE, AND MAYBE NOT
Lately it seems like everyone is concerned about the prospect of running out of oil. My colleagues talk about it a lot at our monthly editorial meetings. Peak Oil is the concept that we will soon reach – if we have not already reached – a level of production that is the highest the world will ever see. Thereafter, production levels will fall – despite discoveries of new fields and technological advances – at the same time as demand is rapidly increasing, thanks to the industrialization of India and China. It is a recipe for soaring prices and economic disaster.
Before I dispute this argument, let me say that I am no fan of oil as a source of energy. It is a great source of feedstock for plastics, but it is a ridiculously expensive and filthy way to power our modern lifestyle. It also helps to centralize political control in few hands. Had we made a commitment to a real space program 20 years ago rather than to NASA’s political boondoggle, we could today be providing all of Earth’s present and foreseeable energy requirements with clean power beamed from space. (For an eye-opening view of what is possible, read The High Frontier by Dr. Gerard O’Neill.)
If oil is essentially decayed biomass deposited over eons then there is truly a limited supply. In that case, the only logical question is when (and not if) we will reach the peak. On the other hand, have you heard of the Russian abiotic (a.k.a. abiogenic or non-biological) theory of oil? When I learned of the Russian abiotic theory, it just made a lot more sense intuitively ... which is not to say it is right. The “common sense” arguments advanced to support it seem persuasive to me. Col. Fletcher Prouty is an articulate advocate for the abiotic theory. The theory includes detailed chemical analysis of processes involving heat and pressure that it is argued could and do continuously convert pre-organic materials deep within the earth’s crust to crude oil. It would also explain the curious yet often-documented phenomenon of “dry” wells that become replenished after being left alone for decades.
Under this theory, there could never be an end to the supply of crude oil. (Left unanswered is the question of whether human demand for oil could outstrip our ability to extract it. If so – and this certainly seems plausible – the abiotic theory would merely delay the day when we must eventually switch from oil to alternative sources of energy.) For further details and references, see the Wikipedia entry, “Abiogenic petroleum origin”. A particularly noteworthy excerpt: “Russian geologist Nikolai Kudryavtsev was also a prominent and forceful advocate of the abiogenic theory. He argued that no petroleum resembling the chemical composition of natural crudes has ever been made from plant material in the laboratory under conditions resembling those in nature.”
Also, I find interesting that Russia has – in recent years – made the transition from being a net importer of oil to a net exporter. They have had several major finds, achieved by drilling deeply in areas that do not have the right characteristics according to conventional theory. I think this subject deserves a lot more debate than it has been receiving in the Western press. Meanwhile, I would not be rushing out to buy stocks in petroleum companies, unless they are doing something technologically revolutionary.Link here.
LONDON BANKS FACE INVESTIGATION OF TRADING COUNTERPARTIES’ COLLATERAL ADEQUACY
London’s largest investment banks are to face a wide-ranging probe into their measurement and management of collateral amid concerns that some may not be properly prepared for a sudden market downturn. The Financial Services Authority, the City watchdog, has launched an investigation into the banks’ systems for measuring and managing the collateral they demand from the hedge funds, banks and other trading counterparties.
The move is the latest stage of the regulator’s attempt to identify areas that may pose a problem for the financial system during a crisis. Other regulators around the world are likely to pay close attention to the outcome of the investigation, which may involve co-operation with the U.S Federal Reserve. FSA officials stressed that the probe was not triggered by any specific problems, but reflects the growing importance of collateral in banks’ management of their risks. “Time after time we as supervisors hear the words, ‘Don’t worry, it’s collateralized,’” Thomas Huertas at the FSA said in a speech last month. “Well, regulators do worry.”
Banks generally demand collateral from clients as security for loans or margin trading on securities. It is widely used by banks’ prime brokerage divisions, which handle relationships with hedge funds, but is also used in the bond market as well as the fast-growing equity and credit derivatives markets. But growing competition for hedge fund clients has prompted some investment banks to relax the criteria demanded by their prime brokerage divisions, which lend money to hedge funds to support their trading strategies. Earlier this year Timothy Geithner, president of the Federal Reserve Bank of New York, highlighted the importance of collateral in banks’ management of counterparty credit risk, particularly with hedge funds. The collapse of Amaranth, which suffered heavy losses after betting on North American gas prices, has also highlighted the scope for sudden violent swings in assets held by hedge funds.
Mr. Huertas said the FSA would look at how banks value collateral and whether they can get it back quickly in a crisis. The regulator would also examine in what circumstances the collateral accepted by banks might be linked to the value of the bank’s underlying exposure. Mr. Huertas pointed out that collateral is often pledged across borders, can continue to be traded after it is pledged, and that banks which have received collateral from one institution increasingly pass it on to another institution. “Will all this work, and will it work in a stressed environment? That is the key question,” he said.Link here.
Most of the incomprehensibly large notional value of derivatives are traded “over the counter,” meaning one guy calls another and writes a contract saying “let’s swap fixed liabilities for floating liabilities.” Then, the one that wants to shoulder interest rate risk (basically speculation on the future direction of rates) agrees to make the payments on the floating-rate instrument in return for getting the other guy to make the payments on the fixed-rate instrument.
Normally, one party is hedging and the other is speculating. The problem is, there is no good disclosure in the public domain on who the speculators are and how exposed they are to risk. My conclusion after studying them pretty intently? This market will experience growing pains. But this was my conclusion in 2002-2003. Now, considering the exponential growth of the derivative market (and its subtle connections with housing market speculation), I think we may see LTCM on a nationwide scale, with the U.S. dollar playing the role of LTCM’s capital base. In other words: waking up one morning to the announcement that a bank heavily exposed to derivatives is insolvent and working with the Fed and Treasury on an orderly liquidation and bankruptcy.
The most likely catalyst for this announcement? Interest rate spikes due to massive movements out of the dollar (Chinese/Japanese/Saudis/hedge funds). Those who contracted to pay skyrocketing floating rates are immediately insolvent and unable to pay the myriad other obligations they have. This sets off more bank failures, and all of a sudden Ben Bernanke has too few fingers to plug into an increasingly leaky dike.Link here.
A SPECULATIVE “BUY” FOR THE CLOSE OF 2006
Wireless communications networks have given birth to the cell phone industry, and Blue Tooth has severed the cords from our headsets to the phones. The only cord that is left has become a major source of irritation – the power cord. Until someone comes up with a commercially successful method of wirelessly distributing electricity, we are going to be charging our mobile devices with something connected to a cord. It really should not be that way.
Back in 1899, Nikola Tesla demonstrated that you could wirelessly transmit millions of volts without electrical lines. In fact, he sent 100 million volts through the air, lighting up 200 light bulbs and a motor. If this piece of history is hard to imagine, it is dramatically presented in the recent film The Prestige, in which Tesla is a character. Mystery has always surrounded the wireless transmission of electricity. J.P. Morgan backed Tesla’s invention, spent millions building transmission facilities ... only to walk away from the investment, and the facilities destroyed. More recently, a small upstart company in 2002 began marketing their ideas for wireless chipsets that could receive electricity to charge cell phones without the use of a power cord. After a lot of press attention, the story went quiet and the company’s website now redirects you to an Internet backbone provider.
So, for the time being, we are stuck with power cords for every portable device we want to charge. But at least one company has come up with a better charger. The company: Mobility Electronics (MOBE: NASDAQ). Their device is the iGo power adapter. The iGo line of chargers bills itself as an all-in-one way of charging all of your portable devices. So, if you are on a trip and your lugging a laptop, a cell phone, a PDA and an iPod, you only need this one charger to charge them all. The device is getting rave reviews.
Mobility Electronics is not a one-trick pony – they were a part of Energizer’s new push for inexpensive battery-operated chargers for cell phones and hand-held video games. It seemed like a great deal for both companies – Mobility Electronics builds a device that is distributed at Wal-Marts and drug stores everywhere, and Energizer gets a product that has a voracious appetite for its own batteries. Mobility also forged a deal with Dell to produce a/c adapters for their laptops.
Seems like a dream company, doesn’t it? Well, er, now it kind of is a dream ... On October 6, Mobile preannounced its upcoming results for the third quarter. Management said that they expected 3Q sales to be about $2.5 million below what Wall Street was looking for. And management also said that the Dell relationship is coming to an end, and their Energizer relationship is not expected to bare any fruit going forward in the form of sales. Mobility’s shares retreated back to their mid-2003 levels.
So Mobility is losing some major revenue sources and strategic alliances, but is this really a bad company? MOBE has a market value of $107 million, and 19.2% of that value is cash it has on the balance sheet. It also has zero debt. And right now, the company has only about $1.1 million in employee stock options. For its 7-year public history, Mobility has averaged 20.4% average sales growth each year. Gross margins, despite a drastic dip in 2001, have largely stayed in the high-20% to mid-30% range. However, high annual selling, general, and administrative expenses have made this company unprofitable right from the start. Only in FY 2005 did the company ever turn an annual profit, but the trailing 12 months after 3Q06 look like a disaster once again.
While this is not an ideal investment, I do think it makes for a pretty good speculative buy. First, there have been some insider buys lately, in fact, by an extremely loyal buyer who has been picking up shares for several months – Adage Capital, which now holds over 7 million MOBE shares, or just about 22% of the shares outstanding. They have accumulated blocks at prices much higher than levels today. Second, Mobility makes several great power charger products that are in demand, where the bulk of the reviews we have read from reputable sources have been very favorable. Third, the balance sheet is just about pristine. And it has a proven ability to grow sales at a fairly strong rate. It is small enough to be a takeover candidate by just about everyone. Fourth, it may be losing Dell and the Energizer relationship may not have delivered on its potential, but its products are being sold in some of Cingular Wireless stores in the southwest U.S., with the possibility that the pilot program could be greatly expanded. Punch up BestBuy.com and the iGo products are there. Same with Amazon.com. The company’s distribution channels are clearly strong. And fifth, MOBE is trading at onley 1.9x book value and 1.1x sales.
Remember, this is a speculation on Mobility gaining traction with Cingular or a possible buyout. The only thing offering us a little bit of downward protection is Adage Capital buying up lots of shares. In fact, their second-largest buy was done at levels similar to today. Mobility could be a profitable end-of-year surprise for your 2006.Link here.
BUY YOUR STAKE IN GLOBALIZATION FOR 90 CENTS ON THE DOLLAR
Most people have heard of the Suez Canal and the Panama Canal. But to many, the Strait of Malacca is virtually unknown. It is a slender strip of water that separates the island of Sumatra from the Malay Peninsula. It also connects the Indian and Pacific Oceans, and therefore Europe and Asia. At its widest spot, however, the Straight of Malacca stretches only 1.5 miles. A simple tanker crash can prevent other ships from sailing through.
This Singapore-controlled shipping lane serves as arguably the most important link in the vital chain of global trade. It is long, narrow, and essential for moving the major staples of trade – things like coal, oil, cars, and clothes. In other words, it is essential for moving basic commodities and finished goods – from producer to consumer. The Strait of Malacca connects American consumers with Asian producers. More than 60,000 vessels carry over half of the world’s petroleum and a quarter of all maritime trade through this narrow divide each year. Tanker traffic on these particular waters is three times greater than the Suez Canal, and more than five times greater than the Panama Canal.
Bypassing this waterway would force a ship to travel an extra 994 miles to reach most destinations. In the words of the Department of Energy, “If the Strait were closed, nearly half of the world’s fleet would be required to sail further, generating a substantial increase in the requirement for vessel capacity.” Shipping still serves as the world’s economic circulatory system. This business connects the world in ways technology never will. Roughly 90% of the world’s exports are still transported by ship. Shipping is, and will remain, irreplaceable on the world stage.
What does this all mean? Well, there is a Greek shipping company that deserves a serious look. Shipping can be broken down into three distinct categories: Tankers, containers, and dry bulk. Tankers are best known for moving the world’s oil supplies. They also carry chemicals and liquefied natural gas. Containers are used for finished products. Most everything we import from China falls under this category. And dry bulk vessels deliver the raw materials used in industrial production. Most everything China imports falls under this category. We are focusing on dry bulk. Dry bulk shippers deliver basic raw commodities such as iron ore, coal and grains. Iron ore and coal alone dominate over 50% of dry bulk demand. The dry bulk markets are driven by the economic growth in emerging markets, specifically China and India. As long as these economies continue to grow, the demand for ships to transport these goods will continue to grow as well.
The company I recommend you check out is called Excel Maritime Carriers (NYSE: EXM). Right now, you can buy the stock for 90% of book value and less than 4x cash flow. With a cash flow yield of 26.3% on a company that produces operating margins well above 60%, it is hard to believe the shares are so cheap. The first and most inhibiting reason that stocks become so cheap is too much debt. Excel’s management has taken a 70% debt to equity ratio to ramp up its fleet, but the company’s balance sheet contains 13% more cash than total current liabilities. Furthermore, total assets less intangibles are twice as great as total liabilities.
So what gives? I believe investors avoid this sector for a couple of reasons. First, shipping is a very cyclical industry. You have to get in at or near the bottom. Regardless of the fact that China imports roughly one-third of the world’s iron ore production, if there are too many ships sailing the seas, freight rates plummet and profitability suffers. At the end of 2004, shipping rates were at an all-time high. Consequently, this has led to a slew of shipbuilding activity. But it is important to note that the dry bulk fleet is aging very rapidly. There has been no major reduction in the number of seaworthy vessels over the past few years. Shipping companies have been stretching a ship’s useful life to take advantage of very favorable market conditions. 11% of the existing fleet is 25 years or greater. Next year, that percentage jumps to 14%. They cannot keep pushing these older boats forever. The greatest threat to supply looks to stem from the possibility of new shipyard capacity coming online. Even if this were to occur, I do not think the impact on the dry bulk sector will be all that great. Producing dry bulk ships is a low margin business. Shipyards would rather build tankers.
The second factor affecting investor confidence appears to be lack of historical record of dry bulk shippers. Granted, shipping has been around since the dawn of trade, but shipping stocks are something of a nouveau asset class. Now I am hesitant to say this stock provides an adequate margin of safety for long-term investors (I want to stress long-term, especially in such a cyclical industry). But I will give you this.
The risk here lies in the assumption that the company can maintain steady revenues for years to come. Well, if you believe globalization is not a fad. If you are convinced BRIC (Brazil, Russia, India, and China) countries will continue to grow, there will be ships on the open seas to service their needs. You can be sure there will be hiccups from time to time ... some driven by excess capacity ... some will be driven by nothing more than market exuberance. But as long as the fundamentals supporting your investment are still there, I believe pullbacks to be excellent opportunities to add to your position.Link here.
THE LONG VIEW
We at Casey Research like to take the long-term view. As part of our ongoing research to understand current investment options and stay abreast of long-term economic trends, we look at how the economy fared under the previous stressful times of the Great Depression. Are there any important similarities? There are a number of important sub-models of this investigation, but only one of them is featured here. Identifying a number of the significant economic drivers of then and now, we will expand on others in an upcoming International Speculator issue.
It is critical to get the real data for this kind of analysis because even after seven decades, there are very differing interpretations of the causes of the depression. Many who worry about the parallels and see economic difficulty ahead are looking for similarities, like the expansion of debt and the unusual rise in stocks. This piece examines one of the most important imbalances of our time, an item that is decidedly different from the 1920s: the trade Deficit.
Last week’s report from our Treasury on foreign investment in the U.S. brings me to focus on the trade balance, related foreign investment, our loss of manufacturing, and the long-term implications. I have been monitoring the big imbalances of our economic system to determine if we are heading toward a big economic convulsion that would change our investments and our lives. I have been evaluating long-term historical measures of prosperity and economic movement, comparing the last big depression to now to see if we face similar situations. Some of the similarities look dangerous, like the large overall indebtedness of then and now. Some of the differences do not show so serious a situation today, such as the relatively stronger financial institutions that would surely get government bail-out if liquidity became a problem. But there is one difference that is much worse now: the trade deficit.
The question is what that means for our financial system. Decades ago, the U.S. was smaller and dollars were worth more, so we need a baseline to make the periods comparable. The method I use is to calculate the ratio of trade deficit (or surplus) to GDP. The positive position we enjoyed in the lead-up to the 1929 crash has eroded now to a negative position.
The trade position of the U.S. was very strong before and during the great depression. The dollar was devalued against gold one time by Roosevelt, but was generally strong. In fact, we experienced deflation, meaning the purchasing power of the dollar increased, as prices of homes and other items crashed. The foreign situation of accumulated international debt is exactly the opposite of what it was in the 1920s. This important difference shows why the dollar then turned out to be strong, even in the face of disastrous economic contraction that brought 25% unemployment. Now, the accumulated trade deficit hangs over the dollar so that this time looking forward, the opposite conclusion is more likely: the dollar will succumb to decreasing purchasing power.
Many commentators suggest that if we are headed toward recession or, even worse, to depression, that will be deflationary just like it was in the 1930s. I believe we are headed toward serious financial times, but I do not see the deflation of that time returning. Foreigners lending us $2.5 billion per day cannot continue forever. When it fails, we will not see deflation but big inflation. Foreigners all wanting to get out of dollar positions will drive the dollar down and prices up as they bid for assets other than dollars.
We can look at today’s numbers from the Treasury on foreign investment to see the size of foreign support by their reinvestment of their trade surplus in our Treasuries, agencies, stocks and bonds. I monitor the reinvestment as an indicator of pressure on the dollar. The data from today, averaged over the last 3 months, does not show a problem. Foreigners are still investing in U.S. financial assets, despite pronouncements from the Chinese and other central banks that they want to divest some of their U.S. holdings. In aggregate they are continuing to invest. The reinvestment by foreigners is equal to the trade deficit, so imbalances have escalated together.
The underlying data show this source of reinvestment may be more precarious than the surface shows. China still added to their U.S. dollar denominated holdings, even if at a slower rate this month. The other two biggest purchasers are London and Grand Cayman Islands. They are different because they are money centers, and are passing through investments from other countries from such sources as hedge funds and countries that prefer anonymity, like oil countries. The surprise is the amazing size of the investment from London. London’s investment of $47 billion is huge compared to the worldwide net foreign purchase of $88 billion. This trade deficit and investment juggling act has succeeded, and on the surface has held together. When you look at the components, the underpinnings do not look so stable.
The other side of the trade deficit is that foreign cheap labor has replaced manufacturing in the U.S., hollowing out our lower and middle class incomes. The expanding trade deficit matches the decreasing U.S. manufacturing jobs. This is exactly as expected, but it is not good for the long-term economic strength of the U.S. The destruction of productive capacity will decrease our long-term wealth creation. Investment, which is the basis for future growth, has moved to Asia. That means less wealth for the U.S. because we are not producing as much. The economy will weaken because we are not paying our workers to make the things we import, so they will have less to spend. Foreigners have put off the problem in the short term by lending us the money to buy their exports and maintain our lifestyle. But this can only continue until foreigners fear that they may lose by holding too many dollar investments that start to decrease in purchasing value.
So in conclusion, the trade deficit is very serious, especially in the long term. It is part of the hollowing out of American production and wealth creation. As a consequence of borrowing to buy those foreign goods, we have sold off some of our future profits as we have to pay interest on Treasuries and dividends on stock holdings, with the result that the dollar will weaken. Foreigners have continued with the deadly embrace of extending more credit to us, so we appear wealthier than we are. But should they try to extricate themselves from their dollar holdings, the consequence will be a devaluing dollar. Even if we head toward a massive economic slowdown 1929-style, a serious deflation is unlikely because of the negative position of our trade deficit. A weakening dollar will be supportive to gold and precious metals in the long term.Link here.
|Previous||Finance Digest Home||Next|
|Back to top|