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LITTLE BIG BUBBLES
On November 27th, a story appeared in the Financial Times telling readers that rich investors were having to resort to “underhanded” means and special favors in order to get into the best hedge funds. Somewhere in the dark mush of our own brain came a flicker of light ... and the ringing of a bell. We recalled how hard it was to get in on the dot.com IPOs of the late ‘90s. They were normally priced at a level where they were bound to go up, even though they were already selling for far more than they were worth. This meant that getting in on the early stages of the IPO was almost guaranteed money-in-the-bank. And it is why Barbara Streisand, to cite a famous example, would send tickets to her shows to IPO managers, hoping for more than a round of applause.
Of course, the dot.coms blew up in January 2000, and investment bankers stopped getting the free tickets. Now, they are going to hedge fund managers. But the average fund has not been doing well. So far in 2006 you could have done better by accident than by hedge fund. The typical fund is up only about 7%. The FTSE has risen 9% and the Dow is up 15%. This seems only to have made investors desperate to get into the tiny group of funds that are doing well. Well-established and top performing funds are often “closed”. They already have plenty of money. And smart managers know that they cannot accept more without degrading their returns.
Last week, another bit of news reached us. The derivatives market, in which hedge funds tend to speculate, has reached a face value of $480 trillion – 30 times the size of the U.S. economy, and 12 times the size of the entire world economy. Trading in derivatives has become not merely a huge boom or even a large bubble, but the mother of a whole tribe of bubbles, dripping little big bubbles throughout the entire financial sector.
And now our friend Simon Nixon reports that the hedge fund industry is transforming the “social geography of Britain. Fortunes have been created on a scale and in a timeframe that we have not witnessed for 100 years, if ever before. According to the Daily Telegraph, the average age of buyers of old rectories – those quaint country houses favored by the new-moneyed classes – in Britain has fallen by ten years to people in their early 30s.”
Societies go through major trends and minor ones, small fads and big ones, cute little peccadilloes and major public spectacles. Before the Renaissance, societies were besotted with religion – a passion that burned itself out in the crusades, the wars of religion, and the inquisition. Then, they took up politics – and became so wrapped up in “isms” that, by the 20th century, they were killing each other at the fastest pace in history. More than 100 million people died in the 20th century – victims of bolshevism, national socialism, communism, nationalism or some other excess of political enthusiasm. And now it is finance that has the world’s attention. China says it is a “communist” country. But it seems not to care. Nor does anyone else care what the Chinese call themselves. The only thing anyone seems to care about is that China is open for business. They could throw vestal virgins into Vesuvius or tear the beating hearts out of their enemies so long as their economy grew at 10% per year. The Chinese are the envy of the entire world. Politics has yielded to money.
The fashion for politics peaked out in the U.S. during the Kennedy Administration. That was before the war in Vietnam came a cropper, along with the wars on poverty and drugs. Now of course, we have a war on terror, but few people talk about it at all ... and no thinking-person mentions it without an ironic smirk. In fact, the war on terror is hardly a political war at all – but a campaign designed to protect the flanks of the great financial empire. If it were discovered that it diminished consumer spending or raised mortgage rates, for example, it would be stopped tomorrow. Now, it is money that counts. And mommas now want their babies to grow up to be hedge fund managers. They know where the money is.
In this late, degenerate imperial age, no one gets richer faster than hedge fund managers. Last year, Edward Lampert, of ESL Investments (a hedge fund business), set the pace with $1.02 billion in compensation. We look at the numbers not with jealousy, but simply puzzlement and amusement. Every penny had to come from somewhere. And every penny had to come from clients’ money. Investors in leading hedge funds must be among the richest, smartest people in the world. Still, with no gun to their heads, they turned over billions of dollars’ worth of earnings to slick hedge fund promoters.
What do you need to do to get that kind of work? Well, it helps to be good with complicated math. Then, you can join other hedge fund managers who trade derivative contracts that the clients cannot understand, such as the recently launched CPDO, the Constant Proportion Debt Obligation. The CPDO is remarkably similar to the CPPI, or Constant Proportion Portfolio Insurance, which made its debut 20 years earlier. The CPDO is meant to protect investors against the risk of investment-grade credit defaults. CPPI was meant to protect investors from a stock market crash, using a complex formula that clients also could not quite understand. Then in 1987, only about a year after the CPPI was introduced, the stock market crashed and investors finally figured out how they worked. Sifting through the debris, analysts determined that CPPI had not protected investors. Instead its fancy programmed trading features actually magnified the losses. We do not know how the CPDO will hold up under pressure, but we can barely wait to find out. Whenever the higher math and the greater greed come together, there are bound to be thrills.
The twitty quants at big investment firms invent the complex derivative contracts, give them a jolt of juice, and then the abominations spring to life. The next thing you know, the hedge fund whizzes are building big houses in Greenwich, Connecticut – and there are billions of dollars ... no, trillions ... in CPDO and other contracts, in the hands of buyers who do not quite understand the elaborate equations behind the contract ... and (here we are just guessing) who will be surprised when they find out.
If you are good with figures, you can at least partially protect your own investments. But it usually means taking a position on the opposite side of the great weight of investment capital. You can also find ways to make more money than your slower-moving peers, again, by doing things a bit differently. But nothing can protect a whole market. The whole market cannot protect itself from itself. The more people climb onto an investment platform – whether it is derivatives, dot.coms, dollars or dirigibles – the more it creaks and cracks, and the more damage it does when it finally gives way.
But buyers of CME (the Chicago Mercantile Exchange) do not seem to notice. Google, the newest, hottest technology stock of late 2006, trades at a forward P/E of 36. CME trades at an astounding 51. CME is where futures and derivatives trade. The stock came out three years ago at $39. Since then it has gone up 14 times, to more than $550. In New York, meanwhile, the NYSE gets half its daily volume from hedge fund trading. Its stock too, has been on a roll, now trading at 10 times sales, 119 times trailing earnings, and 46 times forward earnings.
If you want to profit from hedge funds, the best way is to become a hedge fund manager. Or, if wish to retain your dignity, you could consider investing in a hedge fund company. At least two hedge fund companies have sold shares to the public on the London market. But hedge funds are supposed to be able to produce superior returns for both investors and managers. If they could do so, why would they wish to trade their shares for cash? What will they do with the money? Invest it in someone else’s hedge fund? With returns falling, more hedge fund impresarios are likely to want to get out while the getting is good. More will probably be sold to strangers who do not know any better.
And then, someday – perhaps someday soon – a peak in the credit cycle will come. The mother of all bubbles will finally pop and then the “little big bubbles” in the financial industry will pop. The Dow will come down. The dollar too. Junk bonds will sink. Builders in Greenwich will notice that their phones are not ringing as often. NYX and CME will crash. And 5,000 hedge fund managers will be on the streets, looking for the next big thing. When will it happen? How? We do not know. But our guess is that when the history of this bubble cycle is finally written, derivatives will get a special “tipping point” place ... like the Hindenburg in the history of the Zeppelin business. Or the Little Big Horn in the life of George Armstrong Custer.Link here.
HOW I WOULD HAVE BLOWN A HOUSING BUBBLE ... IF I HAD DONE IT
Or: A former Fed Chairman’s confession.
People are always asking me about bubbles. Like do I believe in bubbles? And how do you blow them? Well, I am not sure I have all the answers on bubbles. I am just a former central banker who spending his twilight years playing bridge and looking at the correlation coefficients of economic variables. Typical retirement stuff. So when it comes to bubbles, I don’t know. A few years ago Beannie Babies got a little out of hand, but you know, the market is the market and who is to say what’s a fair price?
Back in the day, some people thought I had the power to make things happen, you know, like I was Bono or something. If you want to know the truth, I spent a lot of time sitting around a big table shuffling boring academic papers and wondering why the hell we could not get some decent coffee. But if I were to think about it, I guess I could come up with some ideas about how to make a bubble. Just off the top of my head, for example, I would lower short term interest rates, you know so people would buy more stuff.
That might get things cooking, but maybe not so bubbly. So next I would lower interest rates some more. And I would keep lowering them until people decided that apartment living was for suckers and that they should run out and buy a house ASAP. And, people already in a house would think that they deserved a bigger house, figuring that if their brother-in-law can buy a 3,000 square foot Colonial with a pool, why can’t they? And what better time to buy than when rates are low? So then you have people already in houses wanting houses, and you have apartment people wanting houses, and a lot of those houses are new houses, that gets the homebuilders building because suddenly there are not enough new houses to go around.
And then if I kept pushing interest rates lower and lower, pretty soon even people already in a house, even those who just bought a few months ago, would figure out that they could refinance their mortgage at these new lower rates and have some extra money at the end of the month. Then, before long, people would figure out that instead of getting a little money at the end of the month, they could get a whole lot of money all at once by doing a refi and taking money out.
Then if all went according to my plan – if I had a plan that is – with all those people wanting houses, the price of houses would start going up. But I would not call that inflation. That is too depressing and could put a damper on the high spirits that you need to push a bubble along. I would call it “wealth creation”. And pretty soon homeowners would figure out that they could borrow against that new wealth. They would build new kitchens, and add bathrooms, and maybe even add on a room to the garage to store that table saw they just bought on credit.
So imagine, you have people running around trying to buy new houses, you have people adding on to their houses, you have people spending money they have taken out of their houses, you have some builders building houses, other builders building second houses, and other builders tearing down houses to build bigger houses, and pretty soon you cannot get from the driveway to the grocery store without dodging three plumbers, two cement trucks and a half dozen cable installers. You keep that up and you have got a shot at a bubble. Theoretically.
But when it comes to keeping a bubble alive, it is also important what you do not do. I mean, remember when I did not raise margin requirements when stocks were going nuts in the late ‘90s? That was classic do-nothing policy. I used ... I mean I would use ... the same strategy if I wanted to keep a bubble going. Assuming you could even identify a bubble. Anyway, the key here is to pretend that everything is normal no matter how crazy it gets. 10% down on a new home? Normal. No money down? Double normal. No income verification? No problem. Negative amortizing mortgages? Borrowers are more sophisticated than ever before!
Then, once you get the combination of rising home prices and easy financing, something magical happens. The speculators move in. They appear out of nowhere, like ants on the countertop after you knock over the sugar bowl. And the more housing prices go up, the more successful the speculators. This gives the speculators lots of confidence, especially in traditionally expensive markets, like on the coasts, where people figure that if they had just bought that beach house back in 1981, today they would be hanging out at charity balls with Bill Gates and eating hamburgers with Warren Buffett.
Pretty soon, some speculators are making so much money that they become cover stories on personal finance magazines, and thus role models to millions. Eventually, people get so used to housing prices going up so fast that they begin to think that is what housing prices are supposed to do, and if they had not been so busy working they would have become housing speculators years ago. But better late than never.
And at this point, I would say you have got a pretty good bubble going. I mean, if I were to guess.
Anyway, I sure would not want to be around when it was over.Link here.
What statistics on home sales are not saying.
Down in Naples, Florida, a fast-growing city on the Gulf of Mexico, there was an auction of houses about a month ago. An auction is not the usual way to sell a home, but it can make sense for people who do not want to leave their houses on the market for months at a time and also do not want to take the first offer to come along. So on a Saturday morning inside the Naples Beach Hotel and Golf Club, a few dozen houses went on the block in front of about 500 bidders. Based on the official housing statistics, you might have guessed that the sellers would have made out just fine, despite all the talk of a real estate slump. According to one widely followed real estate index the average house in Naples sold for 20% more this summer than it would have a year earlier.
But that was not what happened at the auction. In fact, if you were at the beach club that Saturday, you could have been excused for thinking that the real estate market was crashing. One 3-bedroom ranch house with a pool sold for $671,000. In 2005, the same house sold for $809,000. Another house, just steps from Naples Bay, sold for $880,000 at the auction., compared with $1.35 million a year earlier. On average, the houses that changed hands at the auction had fallen about 25% in value since 2005, according to Thomas Lawler, a real estate consultant who analyzed the auction’s results. Now, Naples is not a typical housing market. House prices nearly tripled in the first half of this decade, and speculators, who are more likely than residents to sell a house in a panic, flooded into the area in recent years. But with that said, Naples is not as unusual as you may think.
The truth is that the official numbers on house prices – the last refuge of soothing information about the real estate market on the coasts – are deeply misleading. Depending on which set you look at, prices have either continued to rise, albeit modestly, or have fallen slightly over the last year. But the statistics have a number of flaws, perhaps the biggest being that they are based only on homes that have actually sold. The numbers overlook all those homes that have been languishing on the market for months, getting only offers that their owners have not been willing to accept. In reality, homes across much of Florida, California and the Northeast are worth a lot less than they were a year ago. Tom Doyle, a Naples real estate agent, estimated that a typical house there, sold in the normal way, would go for about 20% less than it did the previous fall.
In the Boston area, prices have fallen about 10 to 15% since the middle of 2005, estimated Chobee Hoy, who owns a real estate brokerage firm in Brookline. Jerome J. Manning, who runs the Massachusetts-based auction company that conducted the Naples sale, told me he thought that values had dropped about 20% around Boston. (The government, meanwhile, says the average price rose 1% from last summer to this summer. But here is all you need to know about how well the government tracks the Boston market: the index excludes any mortgage larger than $417,000.)
The market in northern Virginia is similar: prices are down 10 to 15%, according to an analysis by Mr. Lawler. In Portland, Maine, the typical house has lost about 10% of its value in the last year and a half, said Bill Trask, the former head of the local Realtors’ board. In New York City, where co-op boards generally bar the door to absentee speculators and creative mortgages, prices seem to have slid a bit in the last few months, but only to roughly their 2005 levels. In the New York suburbs, though, values have fallen perhaps 10% or more since last year. Prices also appear to be down in Sacramento and San Diego.
For many homeowners, of course, the decline does not much matter. They did not really benefit from the run-up, and they will not suffer from the decline. And for any renters hoping to buy a home, the fall in prices is downright good news. Unfortunately, there are also a lot of families that took on huge mortgage debts based on the ephemeral peak values of their properties. The “equity withdrawals” have been so big that the average household in Boston now has slightly less equity in its home than it did in 2000, according to an analysis by Economy.com. Then there are the people who bought their homes in the last couple of years and made almost no down payment. Many of them may now be underwater, owing more on their mortgages than their houses are worth. Most worrisome, growing numbers of these families are falling behind on their mortgage payments, and they will not be able to bail themselves out by refinancing or selling.
For the broader economy, this may turn out to be just a hiccup. Big piles of debt can often look scarier than they really are. Then again, the housing slump of 2006 may also be the start of something larger. Over the last few decades, the world’s financial system has endured a crisis roughly once every three or four years: the stock market crash of 1987, the Asian and Mexican meltdowns in the 1990s, the dot-com implosion of 2000, and the aftermath of Sept. 11, 2001. We may now be living on both borrowed money and borrowed time.Link here.
Subprime loans going from boon to housing bane.
In the housing boom of the last six years, millions of blacks, Hispanics and members of other minority groups achieved the dream of homeownership. While a steadily growing economy helped, experts say a new breed of high-cost home loans deserved much of the credit. Now, however, those gains are being threatened by those very same mortgages, many of them resetting to even higher interest rates.
Delinquencies and foreclosures, though still low by historical standards, are rising fastest among these borrowers, a group that is commonly referred to as subprime because they have troubled credit records or otherwise have difficulty obtaining a mortgage. There were almost 6 million such loans outstanding at the end of June. The problems tend to be concentrated in areas facing other forms of economic stress as well. But while the rise in delinquencies is not expected to have much of a reverberating impact on the overall housing market and the national economy, experts say that the pain will be all too real for borrowers and many of the neighborhoods they live in.
So far, a healthy national job market has kept the distress limited to the Great Lakes region, where manufacturing industries have sharply cut employment, and the Gulf Coast, where rebuilding efforts after the hurricanes are proceeding slowly. But economists worry that if the economy slows significantly in 2007, the number of poor and financially struggling households facing the potential loss of their homes could escalate sharply, adding to the troubles of the subprime industry. Big concentrations of subprime loans exist along the Texas border with Mexico, in California and in Southern cities with large minority populations. Within metropolitan areas, urban and minority neighborhoods tend to have more of these loans then suburban and primarily white areas.Link here.
Late payments on high-risk loans jump.
Late payments on subprime loans have surged, The Wall Street Journal reported, and while economists do not expect major harm, a continued rise could hurt investors in mortgage-backed securities. Subprime mortgages are loans made to borrowers who are considered to be higher credit risks because of past payment problems, high debt relative to income, or other factors.Link here.
THE BIG WILDCARD: THE CORPORATE FINANCE BUBBLE
A Bloomberg News headline from last week read “Pimco’s Gross Says Corporate Bond Rally May Be Over.” From the article: “[Bill] Gross has said a jump in derivatives trading is distorting debt prices and recommends investors buy two-year Treasuries to profit from Federal Reserve interest rate cuts. The corporate bond market’s situation is similar to when the Fed’s target rate for overnight loans reached 1 percent in 2004 or when Japanese government 10-year yields reached a record low in 2003, he said.”
The unfolding bubble in global corporate finance (investment grade, junk and foreign bonds, Credit derivatives, business and M&A lending, syndicated “leveraged lending,” and “structured finance” broadly) has been the major financial development of 2006. Undoubtedly, the happenings of this expansive bubble will be a principal issue for 2007. A faltering corporate finance bubble would likely prompt multiple Fed rate cuts, while a typical maturing of this adolescent bubble could for some time hold the anxiously-anticipated easing cycle at bay. As an analyst of bubbles, I am today not all too inclined to proffer the imminent end to such a powerful speculative bubble (and financial mania) thus far demonstrating intense inflationary biases. I certainly do not expect Wall Street to freely throw in the towel.
When it comes to similarities, I am instead reminded of the marketplace dislocation back in the first-half of 2003. After beginning the year at about 4%, 10-year Treasury yields dropped precipitously to 3.12% by June. Benchmark MBS yields during this period sank 110 basis points to a record low 4.25%. The fledgling mortgage finance bubble was empowered and quickly enveloped the entire credit system. Declining yields stimulated waves of mortgage borrowing that created only greater marketplace liquidity and a self-reinforcing bond market (and mortgage finance/housing) moon-shot. Homes sales, having already increased significantly from the ‘90s, jumped an additional 10% during 2003 and another 10% in 2004. National home prices jumped almost 20% in 18 months (beginning in 2003), with California prices surging almost 40%.
And while there is today little room for further corporate spread compression, the key issue is actually the sustainability of the current environment of (self-reinforcing) unlimited corporate finance. Faltering housing bubbles, some slowing in mortgage debt growth, and economic moderation were major factors inciting this year’s bout of heightened financial sector expansion and leveraged securities speculation. The backdrop was obviously highly constructive for the reemergence of a corporate lending bubble, a multifaceted boom with powerful feedback impulses fueling stock market and asset inflation at home and abroad.
As I have explained previously, it is my view that enormous global U.S. Current Account deficit “recycling” operations (back into Treasuries and agency securities) provided powerful impetus forcing the leveraged speculating community into the corporate arena (certainly including credit default swaps, CDOs, CPDOs, etc.) in search of profits. The resulting boom in cheap finance pushed the fledging M&A boom into today’s historic bubble, not to mention financing unprecedented stock buybacks. Importantly, the prevailing leveraged securities speculation bubble and the burgeoning corporate finance bubble ended up sustaining the vulnerable U.S. credit bubble, in the process perpetuating massive Current Account deficits and escalating global imbalances overall. The question for today: How might the current bond market melt-up and dollar meltdown impact these bubbles?
First of all, I have a difficult time buying into “the economy is about to fall off a cliff” viewpoint. After all, the U.S. bubble economy is chiefly dictated by finance and “services”. Financial conditions remain ultra-loose and, as far as I can tell, the services arena maintains an expansionary bias. Global liquidity conditions are unparalleled. As such, I am more inclined to believe that we are witnessing yet another case of derivative and interest-rate hedging-induced market dislocation. In the past, such circumstances incited a boost in lending and market-based finance. More importantly, however, previous bond market melt-ups pushed those bubbles and sectors demonstrating the most robust inflationary biases to problematic extremes. All eyes on the global corporate finance bubble and M&A, in particular.
I am still waiting for a faltering dollar to negatively impact U.S. and global liquidity. Outside of Europe, the recent precipitous dollar decline has been greeted by yawns in most global equities markets. I doubt this would be the case if economic weakness was the primary factor behind the dollar and bond market moves. And if the economy was in the process of faltering, we would at the minimum expect widening credit spreads at home and abroad. On the other hand, the stubborn global equities boom and narrow risk premiums are reasonable in the circumstance of a U.S. interest-rate market dislocation.
Yet market analysis is these days extraordinarily challenging and fraught with unusual risk. Are we in the early stages of the long-simmering dollar crisis, with the marketplace simply hopelessly complacent? Or is it more a case of the dollar bulls and currency derivative players now taking their turn for a market pummeling, with the currencies to reverse once sufficient pain has been inflicted? With global markets now dominated by leveraged speculation and derivatives trading, abrupt and dramatic market lurches have become the norm. The Law of the Jungle rules, and the marketplace goes out of its way to severely punish those that find themselves on the wrong side of a trade.
What is not at all clear is to what extent this escalating monetary disorder is acting as a wrecking ball, chipping away at the leveraged players’ returns and risk tolerance, along with market confidence generally. It would be a major bearish development if interest-rate and dollar market dislocations evolved to the point of inciting heightened risk aversion throughout global corporate finance. There just are not as yet indications of this unfolding. Conversely, I can envisage the scenario where the sophisticated market players, freed from the fear of actual Fed and global central bank tightening, see recent market gyrations – and specifically dollar weakness and lower global yields – as constructive for ongoing liquidity and speculative excess. Time to gear up for the speculative blow-off. There are indications ...
And at risk this evening of sounding hopelessly out of touch, I am not ready to jettison the heightened inflation scenario. If this proves yet another case of the ballooning Financial Sphere dictating the Economic Sphere, the current market dislocation and yield collapse could be setting the stage for a 2007 inflation surprise. On a global basis, the faltering dollar will pressure foreign central bankers to tolerate loose financial conditions, while leaving domestic credit system free to expand at will. A weaker dollar will make it only more difficult for the Chinese to manage their unwieldy credit and economic booms. Here at home, we surely have not seen the last of energy and import price inflation. The booming export sector will be further stimulated.
But I will have to label the corporate finance bubble as “The Big Wildcard”. Considering the liquidity and speculative backdrop, I would be willing to bet that sinking market yields foster some extraordinary (inflationary) consequences. And it is my view that heightened compensation pressures are today a major inflationary bias, nurtured through years of credit and liquidity excess. Barring financial crisis or some development that restrains credit expansion or incites deleveraging, the combination of ballooning corporate liquidity and the worsening skilled labor shortage would appear poised to manifest in continued income inflation. All bets are off, however, when the marketplace turns against the corporate (“credit arbitrage”) trade. For now, I am going to force myself to see it before I believe it. Wall Street and the global leveraged speculating community have become incredibly powerful. I do not expect they will be willing to let go of this pot of gold without a hell of a fight.Link here (scroll down to last subheading on content/left column).
LEFT HOLDING THE BOND
The purchase of big public companies by private-equity firms, like this summer’s acquisition of hospital giant HCA, come prepackaged with a standard win-win spin. HCA shareholders made about 20% on their stock. Private-equity firms that spent more than $21 billion for HCA, including Boston’s Bain Capital, came away with a trophy company for their portfolios. The business itself, many people argue, will operate better out of the public spotlight.
Everybody happy? Not quite.
Investors who own HCA’s corporate bonds got clobbered on news of the deal. Those bonds quickly shed 15% of their value. “That was a painful one,” says Michael Roberge of MFS Investment Management in Boston. HCA bondholders are not alone. Investors who own bonds of big public companies with businesses that generate lots of cash, generally considered low credit risks, have discovered a new minefield in the surging market for leveraged buyouts. Public companies acquired in leveraged buyouts pay off stockholders but usually do not redeem existing bonds. The company, and its new owners, assume the old debt and continue making the interest payments. Private-equity firms finance deals by borrowing most of the money, loading the businesses with new debt. That makes the company less creditworthy and their old bonds worth less. Sometimes, much less.
Until recently, this was a real but rare risk. Now money is pouring into private equity funds at an unprecedented pace, so leveraged buyouts are much larger and more frequent. Companies with fat and dependable cash flows, most likely to own sterling credit ratings, are the prime targets. “It’s become a long list of companies,” says mutual fund manager Margie Patel of Pioneer Investments. “What’s good news for the equity holder is bad news for the bondholder.”
Investors have responded in two ways to the new and unpredictable risk of some corporate bonds. Most directly, they are demanding new covenants protecting their interests. Companies issuing riskier junk bonds often must promise to buy back their debt at face value if the business is sold. Now, highly rated companies are doing the same. Investors also are hedging against leveraged buyout risks by purchasing credit default swaps, a kind of tradable insurance policy. The swaps pay off only if a company defaults on its debt, but they become more valuable and their market price goes up when risk increases. The profit on the swap can offset the decline in the bond. Some fixed-income investors are going a step further and targeting companies or industries that could be susceptible to leveraged buyouts and buying swaps without owning the actual bond. If risk increases, they pocket the insurance profit.Link here.
THE RISE OF THE DOLLAR VIGILANTES
In the 1980s and 90s the financial world was policed by the “bond vigilantes” that would threaten when the U.S. government fiscal policies got out of line or the Federal Reserve monetary policy was viewed as easy. The implied threat would be that if investors became concerned about inflation they would react by selling Treasury bonds.
Over the last decade this has fallen by the wayside as foreign governments became the larger buyers of U.S. government debt. They would buy regardless of what happened as they had to recycle and invest their trade surpluses in U.S. dollars. As these foreign reserve holdings have approached $1 trillion for some countries, concern has arisen about the need to diversify away from the dollar. China’s Central Bank Governor Zhou Xiaochuan among others has spoken of China’s intention to diversify its dollar holdings. This sentiment has been echoed by central bankers around the world. Counties around the world are now less inclined to hold dollars. This has eliminated a natural support for the dollar that has existed over the last 4-5 years. This chart details the explosion of foreign exchange reserves that has developed in many countries around the world – numbers that will be materially higher across the board for 2006.
This is leading to the rise of the “dollar vigilantes”. In addition to countries with large dollar holdings, hedge funds with almost $2 trillion would be included in this group. Hedge funds are naturally mercenary in their investment choices and are a potential destabilizing force on the dollar. In 1992, George Soros, a major hedge fund manager, forced a devaluation of the British pound by shorting close to $1 billion of British pounds. At the time it was widely assumed that the pound was too large to be attacked. Hedge funds overall are now a 100 times bigger. This could force the U.S. to reign in deficit spending in the future. This will also make it more difficult for the Fed to reliquify if the economy slows down in 2007 as we expect. Starting in 2001 the Federal Reserve took Fed Funds down to a low of 1% due to concern about an economic slowdown and deflation. It will be very difficult to cut rates again to 1%, as the dollar could fall precipitously. This could be result in the Fed lagging the markets on interest rate moves more so than they have in the past as they keep one eye on the economy and the other on the dollar. This is similar to what happened when investors watched the long bond as a gage on the economy and the Fed.
We believe that these changes will manifest themselves in a number of ways. This will force the Fed to be much more vigilant on inflation. This can be seen in the remarks made recently by a number of Federal Reserve Governors concerning inflation and the need to stay vigilant. We believe the dollar is the main reason they are making this case. We expect interest rates to stay higher than anticipated as the economy weakens to support the dollar. This will translate into less help for the housing market than is expected and more concern for financially leveraged companies as the economy slows. This should lead to a longer term economic slowdown and a slower recovery. Over time the recovery could benefit more from a declining dollar and less from interest rates than past recoveries. Given the present situation with the dollar vigilantes, it is important to recognize we have less room to maneuver in fiscal and monetary policy than we have had in the past.Link here.
What is a dollar?
Investors, businessmen, bankers, and consumers all have to communicate. The consumer has to state his preferences. Investors have to give their judgments and guesses. Businessmen have to listen carefully and respond. The world of finance speaks in the language of dollars. An ounce of gold is worth so many dollars. A new car sells for so many dollars. A house in Houston, or a sack of grain in Bombay, or even an hour of a Chinese worker’s time – it is all expressed in terms of dollars. Global markets speak in dollars.
But the trouble with the language is that nobody knows what a “dollar” means anymore. The term has lost its fixed meaning. Instead, it has developed different inflections wherever it is spoken. It has changed ... evolved. One day, a dollar means “a solid thing, a sure store of value ... equal to approximately 1/300th of an ounce of gold.” A few days later, you look in the dictionary and you might find an entirely different meaning: “America’s weak currency, beware ... currently worth about 1/600th of an ounce of gold, but falling rapidly.” Might we not some other day – if we live long enough – pick up a copy of the Random House Dictionary of Financial Terms, published in 2030, and read the following entry: “U.S. Dollar ... currency used by America, from 1780 to 2025, when hyperinflation rendered it valueless. It was replaced by the gold-backed American Yuan.”
What is ahead for the dollar? Cannot all prices be figured as a product of supply and demand? The feds stopped reporting the growth in M3, the principal measure of the U.S. money supply, earlier this year. But Adrian Van Eck, who keeps track of these things, estimates that the world’s supply of dollars has increased by $3 trillion over the last three years. That is an astounding figure. But dollars have become such an abstraction – such whiffs of smoke – we do not know what it means. For every ounce of gold added to the world supply over the last three years, the U.S. has added $120,000. But we have to include the increases in the rest of the world’s money supplies. We will not even try. Instead, we will guess that, altogether, the foreigners added about the same amount of new currency – which gives us a total of about $240,000 for every ounce of gold added to the world supply.
What does this mean? We do not know, exactly. But our guess is that the incremental dollar could be worth less than people think ... and the incremental ounce of gold a bit more.Link here.
THE FED HAS LOST CONTROL OVER INTEREST RATES
Last week the world called the tune, and the U.S. dollar danced. The dollar’s tumble and Fed Chairman Ben Bernanke’s attempts to placate overseas investors are the clearest signs to date that the foreign investors who finance the huge U.S. trade deficit have gained significant control over the U.S. economy. A few more weeks like that, and it will be clear to everyone outside of Washington that the Fed has lost control over U.S. interest rates. Here is what happened:
On November 28, as the dollar edged toward free-fall against the euro, hitting a 20-month low against that currency and plunging below key support prices in the currency markets, Bernanke got up on the old soapbox to say that inflation was still “uncomfortably high”, growth in the economy was solid and the Fed’s next decision would be whether to raise interest rates again. That came as a big surprise to financial markets that were anticipating a cut in interest rates, perhaps as early as the first half of 2007. Just that morning, the markets had, in fact, received confirmation of their view when durable-goods orders, an important gauge of the health of the economy, fell by 8.3% – the biggest drop since July 2000 and well above the 5% decline Wall Street had expected.
Bernanke’s words did not stop the carnage. Without some proof that the economy was as strong as the Fed said it was, the markets simply tossed off the Fed chairman’s comments as a transparent attempt to talk up the dollar. It did not help that new Treasury Secretary Henry Paulson was out – predictably – trying to talk up the dollar at the same time. The dollar did not stabilize until the next day, when revised figures on Q3 GDP showed the economy growing by 2.2%, rather than the 1.6% rate in earlier data. That provided enough credibility to Bernanke’s remarks to push the dollar up 0.3% for the day.
The dollar faces three big problems, none likely to go away quickly: the whopping U.S. trade deficit, the slowing of the U.S. economy in 2007, and a declining yield gap as the European and Japanese central banks raise their interest rates while U.S. rates hold steady. This week’s stumping for a stronger dollar by the Federal Reserve and the Treasury marks a shift of priority for U.S. monetary authorities. Yes, fighting inflation remains important to the Fed, and, yes, the Fed would prefer not to tank the economy. But Bernanke and company know that the tough choice must be made: Managing the dollar is more important at this point than managing inflation or growth.Link here.
MAYBE THIS IS THE YEAR TO BET AGAINST THE AMERICAN CONSUMER
The American consumer is the world’s worst short sale. Somehow, despite imposing statistical improbabilities, the American consumer always seems to devise new ways of spending money he may or may not have on things he may or may not need. Betting against the consumer, therefore, has been a terrible idea for more than 60 years. But just maybe, it will pay to bet against the consumer THIS year. Just maybe, it will pay to bet against the retailing stocks that comprise the Retail HOLDRs Trust ETF (NYSE:RTH). The top five names in this ETF are Wal-Mart, Home Depot, Target, Lowe’s and Walgreen’s.
Not since the Great Depression has the American consumer paused to take a break from his tireless borrowing and spending. Neither the Korean War, nor the Cold War, nor the Vietnam War, nor the Oil Embargo, nor the Carter stagflation, nor the mid-80s oil bust, nor the post-2000 stock market bust, nor the unfolding housing bust has succeeded in curtailing his consumption. To the contrary, each new episode of adversity seems to foster ever-more creative ways of financing consumption. If this epic consumption has a limit, the American consumer has not yet found it. But we wonder if that day might soon arrive. “Nearly every current financial trend is telling us to slow down our spending,” explains Addison Wiggin, author of Empire of Debt, “but we are clearly bent on living beyond our means.”
We do not know where this money comes from, exactly, or how long it will continue to arrive. We only know that Americans spend a lot more money than their paychecks provide. Today, “savings” have become a museum piece. At some point, therefore, Americans should begin to spend less.
Given the trends before us, we would expect U.S. assets to decline in popularity. We would expect U.S. stocks to fall and U.S. bonds to fall and the U.S. currency to fall. And we would also expect Americans to begin trimming their consumption. If home prices are falling, and if savings are disappearing and if debts are already unmanageable, how will we continue to spend what we do not have? Just maybe, finally, we consumers will run out of ways to spend more than we earn. In fact, maybe we have already begun to exhaust our mechanisms for borrowing and spending. Wal-Mart’s first-ever drop in same-store sales this month suggests that low-income consumers, at least, as cutting back.
The price action of most retailing stocks tells a similar tale. Over the last two years, the Retail HOLDRs trust has merely bounced along, without ever gaining ground, while the S&P 500 has gained nearly 20%. Does the lackluster action of retail stocks anticipate lackluster consumption from consumers? We do not know, but we would not rule it out. Selling short the U.S consumer has been a bad idea for about six decades. But selling short retailing stock may not be as bad of an idea.Link here (scroll down to piece by Eric J. Fry).
Americans will shop ‘til the dollar drops.
It never ceases to amaze how televised media reports on the U.S. economy are almost exclusively about shopping. Such reports almost always feature images of sales clerks frantically stocking shelves and long lines of consumers swiping their credit cards. In contrast, reports about the economy of Japan or China typically include footage of smoke stacks billowing, production lines moving, robots assembling, and people actually making things. Does it ever occur to anyone producing these segments just how ridiculous this is?
Despite the implications that Americans and Asians are simply relying on different types of fuel to fire their respective economic engines, production and consumption are by no means interchangeable. Production is the means, consumption is the end. A society can no more consume its way to prosperity than an individual can. However, just as an individual can consume himself into bankruptcy, so too can a nation.
Americans are not producing wealth, but merely consuming the wealth produced by others. When Americans go shopping this Christmas season (primarily spending borrowed money on imported goods), classic economic theory holds that the principal benefit goes not to the U.S. but to those who supply the goods. In exchange for their production, they receive interest and dividend paying assets (dollars, bonds, stocks, etc), which should provide future wealth. Americans in return accumulate depreciating consumer goods and piles of external liabilities that must be serviced and repaid. So Americans squander the wealth of their parents while their vendors amass it for their children.
However, the classic economic theory may not actually be in play as the liabilities our “trading” partners are now accumulating will likely be repaid in currency with severely diminished purchasing power. Trade normally involves the exchange of real stuff for real stuff. As illustrated by our yawning trade deficits, we now have a system where real stuff is simply exchanged for currency, which in effect represent IOU’s for future stuff. And as the Chinese and Japanese clearly understand, any attempt to use their vast amount of dollar reserves would cause their theoretical value to collapse. Therefore they continue to accumulate more rather than to admit the extent of their prior folly.
There are many in economic circles who maintain that China and Japan are compelled by mutually assured destruction to perpetuate the current system. While there will be destruction for sure, but it will hardly be mutual. While the American economy will surely suffer, foreign economies, perhaps with a few initial hiccups, will actually prosper. Americans will soon learn that they can keep shopping only as long as foreigners continue to support the dollar. When that stops, these sanguine economists are in for a rude awakening. Imagine an America where we could only consume those goods we produced domestically, and where individuals, corporations and governments could only borrow from domestic pools of savings. Then imagine the rest of the world flooded with all those extra consumer goods and savings that were formerly showered on Americans. It will be one huge problem for us when we have to make do without them.
The sad reality is that it is foreign producers that will eventually have the last laugh. Sure we will screw them by repudiating our debts through inflation, but in the end they will enjoy all of the abundance of their productive capacity and we will suffer the wide-spread shortages that result from our lack of it. Their standards of living will soar just as ours plunge.Link here.
STOCK BUYBACKS OFF THE CHART
Through the first nine months of this year, big U.S. corporations spent a record $325 billion snapping up some of their outstanding shares – up 33% from the same time last year, and more than double the $130 billion spent on buybacks during the first nine months of 2004. To put those figures in perspective, consider that total operating earnings for S&P 500 companies through the end of the third quarter was $590 billion. In other words, the biggest companies spent more than half their earnings power retiring their shares.
The wave of buybacks is a testament to how much cash companies have on their balance sheets, and to the ease with they can borrow money now with rates low. Companies are doing buybacks as away to juice earnings, by reducing the number of shares outstanding, and boost stock prices. “The numbers are just phenomenal,” says Howard Silverblatt, an S&P senior index analyst. “I’ve been doing buybacks for 19 years, and we’ve never had anything like this. And it is literally getting larger because companies are being encouraged by institutions and hedge funds to do buybacks.”
The list of companies buying back stock includes some familiar and widely held names, including Microsoft, Pfizer, Coca-Cola, American Express, Cisco, and Motorola. Silverblatt says oil giant Exxon Mobil has been one of the most prolific share repurchasers, buying up $8 billion in stock in the third quarter alone. Over the past 12 months, Exxon has spent about $26 billion buying its stock. Companies in the energy sector are the most frenetic repurchasers of stock, accounting for 15% of all buybacks. Next in line comes the financial services sector, with 12%. In most instances, companies are financing share repurchases with either cash or short-term debt. But in some instances, companies also are using bank loans to gobble up shares.
Shares of companies buying back stock typically rise in the short term, which is one reason hedge funds often agitate for a buyback after sinking their teeth into a company with an underperforming stock and lots of cash and little debt on its balance sheet. But buybacks can be trouble for bond investors. Ratings agencies often take a dim view of debt-financed buybacks, believing the money could be better spent on capital expenditures or acquisitions.
Stock buybacks also can be too much of a good thing if they are being done by a company mainly as a way to boost earnings-per-share numbers. S&P estimates that 23% of the companies have reduced their share counts through buybacks by 4% or more. The elimination of those shares has led to a corresponding 4% increase in earnings per share. But Silverblatt says some investors may be overestimating the impact a buyback can have on company’s profitability. Over time, he says, stock that is put into a company’s treasury often has a way of finding its way back into the market, either through a subsequent stock offering, the exercise of stock options or a merger. “We do not believe investors fully appreciate the impact that share-count reduction is having on earnings per share,” Silverblatt says. “They can come back out again. These shares sit under the full control of management.”Link here.
SARBANES-OXLEY HASSLES PRODS BANK OF AMERICA CFO TO QUIT
In a stunning announcement, B of A CFO Alvaro G. de Molina said he will resign after just 18 months on the job. Bank of America, the nation’s second largest bank, did not explain why de Molina, 49, abruptly decided to leave. “Al has done a great job in the many roles he has played for our company, most recently as CFO over the past year,” said Kenneth D. Lewis, CEO, in a statement.
De Molina, who has been with Bank of America for 17 years, said in a statement, “While I have enjoyed many aspects of being CFO, I also am very interested in other business opportunities, and I have decided that now is the right time for me to make a move.” In an interview with Bloomberg, de Molina cited the regulatory constraints of the Sarbanes-Oxley Act, as one of the reasons for his departure. Sarbox regulations, he said, made his job, “a little less fun.” Indeed, de Molina noted that he likes taking risks, “and you don’t want a CFO who’s a risk taker” in this regulatory environment, he told Bloomberg.Link here.
Sarbox getting costlier for small firms.
Costs related to the Sarbanes-Oxley Act seem to be increasing for small businesses, according to a Merrill Lynch report. 35% of small-business CFOs and CEOs predict Sarbox expenses to rise over the next year. The executives are hoping a new Congress will bring them some Sarbox relief next year when the two legislators who created the 2002 law will no longer be in office.
Last week’s release of the Committee on Capital Markets Regulation’s report from 22 professionals garnered plenty of headlines, and likely the attention of legislators when it blamed Sarbox for the debatable threat of increased American capital going overseas. Having no authority, but the support of Treasury secretary Henry Paulson, the committee claims that the cost burden of Sarbox’s Section 404, which requires management’s assurance of internal controls, can have a “significant” impact on a small business’s decision on whether to enter the U.S. market. Meanwhile, in its most recent quarterly survey of smaller firms, Merrill Lynch noted that regulators are indeed paying attention to small-business executives’ angst.
The Merrill Lynch report acknowledges that Sarbox’s promotion of transparency in financial reporting benefits investors and the markets, but questions whether that goal can be achieved in a more cost-effective manner. Likewise, the study’s authors point to what some small-business owners have considered an unbalanced seesaw of burden. When energy giant Enron filed for bankruptcy five years ago, the economy and markets felt the effects – and still are – but can the same be said if a small public company falters? “The question raised is whether accounting rules are properly set for all firms and should regulators worry about firms ‘too big to fail?’” the report asks. "When such behemoths fall, all parties lose."Link here.
THESE PENNY STOCKS SHOULD GROW LIKE WILDFIRE
For me, the fun part of investing is the detective work. Discovering a company’s hidden potential before anyone else can be extremely rewarding. It does not take many smart penny stock plays to make a lot of money, either. If you bought shares of Wal-Mart in the early 1970s, you would have paid only about 5 cents a share. Adding up the regular dividends, stock splits and rampant growth over the years, this one investment would easily make up for two or three decades of strikeouts. To be successful in the penny stock market in order to you do have to swing for the fences and let your big winners make up for any bumps you may encounter along the road. But the difficult part is how you find these home runs.
In the world of smaller stocks, it sometimes takes a lot more than simple valuation to measure a company’s potential. A lot of these small companies are not even turning a profit ... yet. The trick is to pick out the ones that will, while avoiding the ones that could just be poison to your portfolio. Luckily, there are some very tangible factors you can use to evaluate how well some of these super-small stocks can perform. Here are the criteria I use to help me find quick-growing penny stocks everyone wants to get their hands on so badly:
I will write more next week about how I have used these guidelines to find some great fast-growing penny stocks.Link here.
Online retail’s backdoor play.
Online retailers have become more and more successful as the World Wide Web has matured over the last 10 years. And now, Internet shopping even has its own “Black Friday”. The National Retail Federation was smart enough to point out a special day on the calendar year when the entire country is logged on and buying stuff from Amazon, eBay and other popular sites. It is called “Cyber Monday” – the Monday after Thanksgiving, when everyone is back at work in front of his or her computer ... buying presents. However, Cyber Monday is not actually the biggest online shopping day of the year. Despite its inaccuracy, the media has taken note and has compiled some interesting statistics. According to the data, online sales this Cyber Monday hit $608 million – up 26% vs. 2005. U.S. online retail sales are expected to more than double over the next few years, reaching $316 billion by 2010, according to Forrester Research. Online sales are expected to account for 12% of total retail sales in 2010, vs. less than 7% in 2004.
But major problems persist in the online retail industry. Customers are abandoning their shopping carts online at a rate of 50% or higher. Plenty of people are shopping online, but a lot of websites are having trouble when it comes to closing the deal. Some online businesses are looking to change these gloomy statistics by targeting their shoppers with more personalized experiences. In a 2005 survey, 96% of executives from 176 North American companies said they planned on increasing online interactions, and 78% percent of these same executives anticipated the increase in volume to be significant.
This brings us to our small-cap play on this sector. LivePerson (LPSN: NASDAQ) helps some of the biggest online retailers in the world make more money, by providing software that helps online retailers better assist and communicate with customers. For example, outdoorsman “John” is looking for a specific kind of backpack. He calls all the nearby stores that might carry his item, but ends up on hold for countless minutes. And after all his troubles, the salespeople tell him they cannot find what he is looking for. Then, John decides to search on the Web for his backpack of choice. He stumbles upon a site called Backcountry.com and notices they have a live chat feature. John clicks on the icon and gets to chat with a real-life expert. In about 30 seconds, the expert gives John a link to the backpack he wants and he makes his purchase.
The proof is in the pudding: The conversion rate for Backcountry.com shoppers who chatted with sales associates grew to 10 times greater than self-service shoppers. And the Backcountry “gearheads” who chatted with customers helped increase the average order value by 54%. In addition, the company conducted post-chat exit surveys. More than 80% of customers said they were satisfied with their experience. Customers who chatted with Backcountry’s sales associates said they would be more inclined to purchase from the site again.
LivePerson achieved profitability in September 2003 and has not looked back since. The business is on track to bring in about $32 million in revenue this year, vs. a little over $22 million last year. And as retailers continue to look for ways to find new customers and invest in better marketing tools, companies like LivePerson will grow and prosper.Link here.
NEW ORLEANS INVESTMENT CONFERENCE 2006 HIGHLIGHTS, LOWLIGHTS AND INSIGHTS
Well, another life goal checked off the list. I can finally say I have been to Bourbon Street, and I downed a Hurricane at Pat O’Brien’s. (It tasted like Kool-Aid with a dirty sock mixed in, but I drank the whole thing. There were witnesses.) More seriously, New Orleans is a great town, and the New Orleans Investment Conference is a great conference – one of the best I have ever attended. If you have room in 2007, put the New Orleans conference on your list.
And now some highlights, lowlights and insights from New Orleans 2006.Link here (scroll down to piece by Justice Litle).
WHY BOTHER WITH A STOCK MARKET, IF PRIVATE CONTROL IS SO EFFICIENT?
The Financial Times suggested last week that private equity might increasingly dominate the world’s capital markets, because it enabled a tighter rein to be kept on company management, and thus ensured better governance in the interests of shareholders. That is why private equity values for companies are higher than public market values, according to the FT. If this is becoming the case, why would anybody bother investing in a public stock market at all?
The FT’s thesis is at first glance plausible even in Britain, where corporate governance was reformed by the Cadbury Report in 1992. It makes even more sense in the U.S., where shareholders get to vote neither on what management gets paid nor (except purely as ratification) on the deal between management and the auditors. Even 15 years ago, the rash of poison pills adopted by companies, which brought to an end the contested takeover boom of the 1980s, demonstrated public company shareholders’ relative impotence in the face of serious threats to their financial wellbeing.
The problem with the FT’s view of the road ahead is that it begs the question of what stock markets are for. If the most efficient form of corporate ownership is through private equity funds, then public ownership becomes merely a transition stage between different private fund owners. And if public companies are worth less than private ones and private owners can sell to each other, why bother with the stock market middle man? However, you then lose the stock market functions of price discovery and liquidity. In effect, you have gone back to the situation of 16th Century merchants owning stakes in each others’ ventures and trading them over the Rialto. While I yield to no man in my enthusiasm for returning to tried and tested financial methods, I cannot believe that undoing the last 400 years of financial history is likely to prove a gain in economic efficiency.
Another problem with the theory that private equity improves shareholder governance is that in reality it simply moves the governance problem one step further back in the food chain. Whereas the management of the portfolio company has the joy of 28 year old MBAs crawling all over the company’s operations and making fatuous demands, the fund itself has very little responsibility to its own primarily institutional shareholders. Private equity fund managers are paid largely by a percentage of the profit from the fund, and are often able to use dubious means to revalue companies half way through the investment period. (Because who wants to wait 10 years for one’s yacht?) They are motivated to engage in all kinds of valuation and accounting tricks to extract additional returns from their shareholders, and there is very little shareholders can do about it. Institutional investors should not deceive themselves for one minute that by investing in private equity funds they are in some magical way getting better governance than by investing directly in corporate America. In reality they are investing only in fund managers with an outrageous sense of entitlement over whom they have very little control.
As those with long memories will know, “alternative investments” become especially fashionable in periods like the present when money’s available from everywhere but the conventional stock market’s performance is mediocre. This appears about to change. If it does change, the bloodbath in private equity will be especially severe, because it has expanded so rapidly in this cycle. Should the stock market lurch downwards, private equity’s takeout window, the IPOs market, would snap shut. At that point, investors in private equity would discover by default what the stock market is for. They would have no way of recovering cash from their private equity investments, and would be locked into them until prosperity returned. This has not happened in the U.S. since the Great Depression. It happened in Britain in 1974-75. In that case, the private equity investors ALL went bankrupt, along with most of the second tier banks which had lent to them. It took until the end of the 1980s for British investors to begin placing bets on private equity once again.
Once the crash has happened, a chastened pension fund and insurance company industry will realize that it cannot rely on private equity investment to ensure better corporate governance. At that point, if institutional investors act intelligently, investor associations will spring up. These will have the purpose of monitoring public company management, ensuring it does not pay itself too much, that it reports with properly conservative accounting to shareholders, and that it manages the company’s assets with shareholders’ interests paramount, as they should be. A pension fund investors’ association will have all the power it needs to ensure management’s compliance.
The surprising failure of U.S. institutional investors to form such associations with real power is probably the fault of the counterproductive focus by U.S. investors and their advisors on short term performance. Organizing an investor association to discipline management is a positive sum game. By such an association management remuneration can be squeezed down and management malfeasance stamped out, to the benefit of all shareholders. Higher returns for beneficiaries, not better performance against other managers, should be institutional managers’ chief objective. Investment manager selection procedures need to be restructured accordingly, to choose not the best relative performers in the short term, but the most rigorous enforcers of shareholders’ rights against management.
Capitalism is a truly wonderful economic system, but it depends on shareholders controlling the allocation of resources, and on hired management acting in their interests. As the FT points out, it is indeed high time this necessary discipline was strongly reasserted. Private equity funds, however, are not a useful mechanism for doing so.Link here.
BUFFETT IS A GENIUS AGAIN
On October 23, Warren Buffett’s Berkshire Hathaway (BRK.A) hit a price of $100,000 a share. As far as I can discover, that is the highest price ever for shares of a publicly traded company. The A shares are up about 5,555 times since May 1965, when Buffett took control of what was then a modest textile company. With that milestone behind the shares, of course, the question now is, will Berkshire Hathaway A become the first $200,000 stock? Yes. Not a doubt. Remember that you heard it here first: Berkshire Hathaway A will be the first $200,000-per-share stock. That does not mean the stock is a good investment now, however.
As I noted in my March 28, 2006, column, “OK, Bash Buffett – but Buy His Stock”, writers such as Pulitzer Prize winner James Stewart and Jon Markman wondered if Buffett had lost his touch. To understand why Buffett looked like he had lost it in March and now looks like a genius again – and why I am selling my shares of Berkshire Hathaway today – you have got to look at how Berkshire Hathaway makes its money ...Link here.
BILL GATES AND GOOGLE’S ERIC SCHMIDT LEAD INSIDER STOCK SALES TO HIGHEST SINCE 1987
Stock sales by America’s suggest they do not share the confidence of investors who sent the S&P 500 to a 6-year high. Executives including Microsoft’s Bill Gates, Google’s Eric Schmidt and Kohl’s William Kellogg in aggregate sold $63.18 of shares for every $1 they bought in November, an analysis by Bloomberg showed. That is the highest since at least January 1987. “They are pretty savvy market guys,” said Wayne Wilbanks, who oversees about $1.2 billion as chief investment officer at Wilbanks, Smith & Thomas Asset Management LLC. “They see things are slowing down, and they’re like, ‘Man, I’m taking some money off the table.’”
Advances by Microsoft, Google and Kohl’s have helped push the S&P 500 up 13% this year. The index, which closed early this week at a level not seen since November 2000, may retreat 9% within the next six months, according to Wilbanks. U.S. securities laws require company executives and directors to disclose stock purchases or sales within two business days. Investors such as Wilbanks follow insiders’ trading, on file at the S.E.C., for clues about the prospects for companies.
Insiders sold $8.4 billion in shares last month, according to data compiled from SEC filings. Buying was only $133 million, for a sell-buy ratio of over 63. That ratio surpassed a previous high of 62.8 reached in July 2005. The S&P 500 declined 2.2% from August through October 2005. Some investors express unconcern with the selling. “Insiders tend to buy when the prices are low and sell when they go up, so it’s fairly typical” to have selling during a rally, said Joseph Stocke, who oversees $700 million as chief investment officer at StoneRidge Investment Partners. “The issue that you want to be more concerned about is if they are selling while it is going down.”Links here and here.
A REASONABLE SPECULATION
Anytime the price of anything drops two-thirds in a matter of months, it is worth checking out the story. Financial train wrecks like these can make interesting reading – as long as your dollars were not riding on the train. For investors, though, it is the sign of possible new investment ideas on sale. And so we take a look at the price of natural gas. As the “Natural Gas – Where to Next?” chart shows, it has taken a beating.
The chart title poses a question, which I will take a guess at answering. First, you should know that natural gas prices are highly seasonal and dependent on the weather. We had a balmy winter last year. That meant a lot of leftovers in natural gas storage in the spring. It is like buying a lot of beer and wine for a dinner party, only to have the usual heavy drinkers not show up. On top of that, hurricane season was practically a nonevent. Someone forgot to tell the hurricanes it was time to do their thing. These effects seem temporary. A cold snap could burn through that excess supply in a hurry.
Moreover, there are structural reasons for natural gas to stay at pretty high levels ($5+) compared with what it was in the late 1990s (under $3), at least for the next few years. “Structural reasons” is Wall Street-ese for “things that look pretty obvious long term.” For instance, natural gas powers 95% of the electricity capacity built in the U.S. from 1998-2005. Awash in cheap gas for most of the 1980s and 1990s, we did a lot of switching from coal to gas. Gas cheaper and much easier on the environment. Further grist for the mill: Each fall, the North American Electricity Reliability Council (NERC) puts out its forecast on the reliability of the America’s power grid. This year’s report showed demand growing 3 times as fast as capacity additions. There is little slack in the system, and gas figures prominently in America’s power supply. Currently, gas meets 23% of the nation’s energy needs. So the short of it is that demand for natural gas looks pretty steady.
What about supply? As the Red Queen – in Lewis Carroll’s Through the Looking Glass – says, “It takes all the running you can do, to keep in the same place.” Once natural gas is gone, new supply must replace it. Most of the natural gas we use – 97% – comes from North America. While there is plenty of natural gas, companies must drill deeper and work harder to get at it. And we have picked over North America pretty well. Perhaps someday LNG will be the answer, but that appears years and years away.
All of these reasons, combined with the steep slide in gas prices, lead to me to think warm bullish thoughts about natural gas. Still, my crystal ball is as fogged over as ever on predicting future prices. But I do like the odds of higher gas prices in the near future.Link here (scroll down to piece by Chris Mayer).
WHY OIL BULLS SHOULD BE GOLD BUGS
Oil has climbed nearly $4 since mid November, up 6.5%. It is this type of momentum that can push oil prices out of its 2-month trading range, and back into its long-term uptrend. That is good news for oil bulls, and also for gold bugs. For the past 60 years, one ounce of gold has bought 15.2 barrels of oil. So, if one ounce of gold should by 15.2 barrels of oil at $63 a barrel, then gold should sell at $957.60, according to this historic ratio. Gold would need to rise 50.6% to bring the gold-to-oil ratio back in line.
Interestingly, every single time in the past 60 years that the ratio dips lower than 11 (one ounce of gold buys less than 11 barrels of oil), there has been a massive correction in either the price of gold (rising) or the price of oil (dropping). That means we are on the verge of a huge correction. But even at $55 a barrel oil, gold would still need to rise 31.5% to bring the ratio back in line.Link here.
NO REFUGE IN THE HERD
My 4-year-old daughter heard the Rolling Stones song “You Can’t Always Get What You Want,” to which she added, “This song is a truth I already know.” Yes, we all learn pretty fast that we can’t always get what we want. And most of the time, bargains are hard to find. Like now. In times like this, I like to look back.
Investors, as with practitioners of other trades, are guided by precedent. And so I spend a good bit of time poring over old books and looking over nuggets of market history, like a geologist picking up bits of rock. In those layers of sediment lie answers. In this history, you will find ballast for those times when the rest of the market seems to go nuts. The historical record reminds us that common sense ultimately prevails. Herds, as a rule, make for poor investors.
Take the stock market of the 1960s, a maddening maelstrom of a market. All in all, it was not so different from the raging tech bubble of the late 1990s. National Student Marketing was the poster child of the era. Here was a company designed to capture the “youth market”. The company bought everything and anything that might aid it in this quest. It owned youth-oriented travel agencies and insurance companies, college ring makers, college mug manufacturers and more. At its great height, it was selling for 150 times earnings. Yet look who owned National Student Marketing. Bankers Trust and Morgan Guaranty, as well as General Electric’s pension fund. Also the endowments at Harvard, Cornell and the University of Chicago. These are the people to whom the uninitiated turn for trusted advice. These are the people who are supposed to protect and grow their clients’ wealth. In 1970, National Student Marketing went from $36 to $1. There were many others just like it.
Adam Smith (the pseudonym of George Goodman, best-selling author of The Money Game) hatched an unusual idea for an investment conference in 1970. Instead of the usual fare in which speakers talk about their successes and favorite ideas, Smith thought it might be good to have something of a public confessional. People would talk about their mistakes and misdeeds. Smith thought this would be good for the confessors and extremely instructive for the audience, especially after the go-go market of the 1960s met its inevitable bad end.
David Babson, our protagonist, was one of those invited to speak at Smith’s conference. Babson, then turning 60, ran the 6th-biggest investment counseling business in the country at the time. Babson started his firm in 1940. He was bullish then. Babson recommended buying growth stocks, a move that made him a radical in those days when the memories of the Great Depression were still fresh. He bought all the right stocks, it seems – 3M, Honeywell, Merck, Pfizer, Corning Glass, and more. By the 1960s, though, Babson was no longer bullish. The feisty New Englander was blunt and outspoken in chastising his peers for behaving like tape-watching speculators. He was a trenchant critic of the market at the time, which was a swirling stew of gimmicky malfeasance and excessive speculation. He called the stock market a “national craps game”. As in the 1940s, he found himself out of step again in the 1960s.
When Babson took the stage at the conference, Smith asked him if the blame should go to the professionals for the ‘60s bubble. Babson said yes, unequivocally, in so many words. “What should be done about this?” Smith asked. And that is when Babson, peering over his glasses, gazing down at the audience, delivered his knockout blow: “Some of you should leave this business.” Smith reports nervous laughter among the attendees. Then Babson practically named names and launched into an accusatory tongue-lashing, lambasting the folly and incompetence of his peers. Smith finally stopped him, but the conference had, as Smith reports, “taken a sour turn.” The audience sat in stunned silence.
Babson could say what he did because he did not own any of the nonsense stocks. He also solidified his status as an investment folk hero for his courage and independence. Not to mention the gratitude of his clients, who escaped the 1960s with their money still intact.
The current surging market surely will provide sins for future confessionals. What investment adviser could possibly justify putting his clients’ money into something as unsound as Research In Motion? The maker of the BlackBerry device posts slowing growth rates, faces numerous competitors and trades for more than 10 times sales and 60 times trailing earnings. Research in Motion is of a type that is fairly common in the thin air of speculation these days. Look at Google, at 16 times sales and 62 times trailing earnings, or the NYSE, at 10 times sales and 119 times trailing earnings. Yet these stocks find votaries among the pros. Look at who owns them. All the big houses – Fidelity, Barclays, Wellington, banks and trusts of various types. What are their investors paying them for?
So far, these stocks keep going up. One day the caffeine will wear off, and with it the temporary illusion that these stocks are worth these prices. It seems only a matter of time. Markets, though, are notoriously hard to read. People see what they want to see. Bulls will find reasons why these stocks will go higher. Bears will find reasons for them to go lower. The seldom-admitted truth is that most of the time, the market exists in some indeterminate state, like the muddled cherry of a whisky sour.
I think the main lesson from Babson is that you cannot trust consensus. You cannot rely on the “establishment”. You cannot find refuge in the herd. And you must resist the urge to join the crowd. “Passion of the moment,” as writer J. P. Donleavy observed, “a disaster over the years.” Babson’s firm, by the way, still lives on. Recently, it published a letter describing five essential truths the firm follows, laid out by its founder years ago. They are:
Not a bad set of self-explanatory truths. They are not sexy, but the best investment advice seldom is. Investors would do well to remember them – and remember Babson – when considering whether or not they should plunge in on the hot stocks of the day.Link here (scroll down to piece by Chris Mayer).
Sunsets on Wall Street.
Forget PEs ratios. Forget “dividend-discount models”. Forget productivity gains and “Goldilocks” economies. The stock market does not care about these things. The stock market goes up when it feels like it. And it falls when it feels like it. Over long-term timeframes, of course, things like earnings and interest rates exercise a great deal of influence over stock market valuations. But over the short-term, PEOPLE influence valuations ... not DATA. The collective attitude of investors determines share price levels.
To anticipate short-term market action, therefore, it sometimes pays to monitor the collective attitudes of investors. When they are feeling extremely pessimistic, stock market rallies often begin. And when they are feeling supremely confident and complacent, share prices tend to fall. At least, that is the bedrock assumption that inspires “contrarian investing”.
At the moment, investors are feeling extremely confident. Maybe too confident. The extreme low readings of the VIX Index corroborate this “bearish evidence”. The VIX Index measures the implied volatilities of various options on the S&P 500 Index. Because the VIX is based on real-time option prices, it reflects investors’ consensus view of future expected stock market volatility. “During periods of financial stress, which are often accompanied by steep market declines,” the CBOE Website explains, “option prices – and VIX – tend to rise. The greater the fear, the higher the VIX level. As investor fear subsides, option prices tend to decline, which in turn causes VIX to decline.” The fact that the VIX is languishing on 13-year lows (see chart), therefore, suggests that investors have become overly confident and complacent.
Put/call ratios tell a similar tale. “The 21-day volume-based put/call ratio for the broad market has dropped to just about where it was at the market top of early last May,” observed Jay Shartsis, a seasoned professional options trader and astute stock market observer, recently. Jay also notes that the Dow has soared 1000 points above its 200-day moving average. “That is an all-time record,” he says. “Joe Granville, who pointed this out, calls it a ‘major warning and a sell signal unto itself.’ This is hard to ignore.”Link here (scroll down to piece by Eric J. Fry).
In many ways, navigating the markets is like landing a plane on a foggy day. Intuition tells us one thing, but the markets react in the polar opposite direction. Over time, many come to believe that the market is just too complex, and that the safest thing to do is to follow the traditional advice espoused by most individuals. But is this the way that professional traders make decisions, or do they exhibit patterns similar to the thought processes of a professional pilot?
In the last few month’s numerous contrarian indicators have been pushed to historic extremes. And though some may be tempted to follow their intuition and “go with the flow,” we would do better to review the lessons we spoke about in “Hard Wired to Fail” earlier this year. For those of you who are concerned about the numerous confusing signals you are receiving, I would strongly encourage you to read “Traits of an Excellent Manager”, a section from our industry research paper on short selling titled, “Riders on the Storm”. As numerous economic and social news items are hitting the daily headlines, it is important that we do not allow ourselves to believe that flying through clouds of uncertainty is the same for pilots as it is for passengers.
But, before we get started, we should note that the financial planning profession was not designed to train advisors in the tools of trading. As such, most individuals giving advice are not “pilots” and they are not familiar with a “pilot’s” instrumentation. For this reason, most investors and advisors work off of intuition and stories, and end up chasing recent returns and looking for the appropriate mix of various stock indices. This works well in an environment where all markets move up together on an ever-rising sea of liquidity. But what would happen, God forbid, if credit started contracting?
Back in late August, it appeared that the markets were going to get hit hard. Seasonally, September and October are bad times for stock investors. And, with the housing sales sliding south, auto sales getting clobbered (in June and July), and all the major U.S. indices at historic highs, it looked like an excellent time to go opposite the herd. If we look at housing stock prices, reflected in the Philadelphia Housing Index, it looks like the storm has cleared.
If you had seen this chart in August, would you have said, “Wow, with such a sharp decline, it must be time to buy!” In fact, in my 21 years of practice, I have never had a client call me up after a decline of this magnitude and tell me they were ready to buy. But, since then, the price levels that continue to come in from the markets seem somehow disconnected from the headlines. At the same time, investors have come to believe that if they follow certain conventional rules, no pilots are needed. Worse still is the fact that, as shown in a recent paper titled “How Active is Your Fund Manager?”, many “pilots” are not even observing their instruments anymore. But good pilots are constantly looking out over the horizon to try to anticipate trouble before it arrives.
Paul Kasriel, Chief Economist of Northern Trust, in his November 8th article, “Near a Housing Bottom?”, confronts us with the fact that the amount of money withdrawn from home equity borrowing has contracted from an annualized pace of $732 billion, at the end of Q3 2005, to $327 billion, at the end of the Q2 2006 (chart) – a contraction of $400 billion in home equity loans in 3 quarters. Equally alarming is the amount of home equity borrowing that has taken place since 2000, when compared with the previous 45 years.
This next chart was produced in a November 1 CNN article called, “Can the Economy Survive a Housing Bust?”. The article opens as follows: “Tucked away in the briefcase of Liz Ann Sonders, chief investment strategist at Charles Schwab & Co, is a chart so scary she’s hesitant to show it to investors. It plots the National Association of Home Builders’ Housing Market index – a monthly measure of builder confidence – against the [S&P 500], with a one-year lag.” I can understand her reluctance to show this chart to investors. Not exactly a buy-and-hold confidence builder.
From the end of 2001 through Q3 2005, Americans increased their borrowing through home mortgage products from an annualized pace of $529 billion to $1,323 billion. Since Americans’ wages did not go up proportionately, this growth rate was not sustainable. Sure enough, as Paul Kasriel illustrated, the amount of money borrowed through home mortgages collapsed in just three quarters. The annualized pace of borrowing has declined from $1,323 billion to $858 billion. This contraction of credit throughout the lending industry is not all that far from the entire amount U.S. households borrowed long ago ... in 2001.
So with articles, charts, and data like this being presented to investors and managers at all levels of our financial markets, what do you guess the reaction of investors to housing stocks would have been? Would they buy and hold housing stocks or sell, or sell short, housing stocks? See for yourself.
So with data and analysis like these being presented to investors and managers at all levels of our financial markets, what do you guess the reaction of investors to housing stocks would have been? Would they buy and hold housing stocks or sell, or sell short, housing stocks? See for yourself. So let’s play a game of “You Make the Call”. It is the middle of October and you have seen the housing market index bounce back from 191 in mid August to 220 by the middle of October. Would you have said, “With all of the negative information and headlines about housing, I am selling my housing stock”? ... or, “I bet housing stocks will continue to climb.” What information would you use to decide when to sell? Would you ever sell this “bastion of safety?” If you held since the summer of 2005, would you feel the same way about housing stocks as those who purchased in August of 2006?Link here.
NOT SO BENIGN CONSPIRACIES
Hard to believe it is already December. What a year it has been ... and 2007 will have even more in store. The broad market appears to be firing on all cylinders. About the only thing getting sent to the woodshed is the U.S. dollar. The action in the greenback looks exceptionally ugly. Yet if you step back and look at a monthly chart of the U.S. dollar index, we have not even broken the December 2004 lows.
There is more to come ... much more. As Jesse Livermore, the greatest speculator of all time, once said, “The speculator’s greatest and truest ally is underlying conditions.” That about sums it up when it comes to the dollar – and gold. We have laid out the macro case from multiple angles over the past year or two, most recently in our summation of the debt liquidation trade. Our own Addison Wiggin, has also gotten a few words in on the subject. His book, The Demise of the Dollar, is seeing a surge of renewed interest along with the greenback’s free fall.
Bloomberg columnist Chet Currier thinks equities are getting a boost from the lack of appealing alternatives – a tongue-in-cheek “benign conspiracy” of sorts – as laid out in his piece entitled “Costly Bonds, Real Estate Make Stocks Look Good”. Currier notes the “sloshing sea of cash” that is desperate to earn a return, forcing investors to bid up everything in sight. Meanwhile, private equity players are busy privatizing everything in sight. Raymond James strategist Jeff Saut reports, “Almost 2% of the NYSE’s entire market capitalization has been taken private ... since the beginning of this year.”
Ben Bernanke, the warm and fuzzy Fed chair, continues to blame the “global savings glut” for this foamy tide that has lifted all boats. One of Gentle Ben’s key directives, I suspect, is looking out for his friends. Consider this intriguing observation from portfolio manager Chris Dialynas of PIMCO: “The Clinton and Bush administrations, as well as the Greenspan Fed, have relied upon many internal and external advisers. Without doubt, most of these advisers are of Ivy League vintage. It is particularly noteworthy to understand that the endowments of most of those universities – endowments that substantially accrue to the benefit of the respective professors – are primarily invested in very high-risk assets and high-risk strategies (as are numerous other investors in their quest for high returns in a low interest rate world). It is, consequently, of little surprise that policy advice has tended to aggressive stimulus. ... As long as these institutions maintain high-risk portfolios, the policy advice from the ivory towers will be highly stimulative based upon new, bizarre economic ideas. The global imbalances will grow. ... Professor Bernanke is a member of this fraternity ... There is an extraordinary challenge for a very high-quality person. My concern is his presumed pro-reflationary bias.”
An extraordinary challenge, indeed. Look at it from Gentle Ben’s point of view, and backdoor reflation is the way to go. Your friends are happy. Wall Street is happy. The president is happy. Trading partners looking a bit peaked, but are happy nonetheless. No one gets left out except those cussed Austrian types. High-quality person that he is, Bernanke has chosen to be a stand-up guy and keep the taps flowing for his friends.
As I type these words, and as you read them, “cash” is being turned into “trash” at a steady pace. The smart money is buying with abandon because it knows the paper bits floating around today will be worth less than the paper bits floating around tomorrow. How long can this go on? No one really knows. It is sort of like a game of musical chairs. As long as a veneer of psychological stability is maintained, i.e., as long as cash does not become trash too quickly, we could continue to see an upward trend in nominal values, even as real values stall out, or even decline.
Sooner or later, gold is going to break its 1980 highs in nominal terms. (This could easily happen in 2007.) After that, it will break its 1980 highs in inflation-adjusted terms – which will prove a much more noteworthy feat. It has always been sort of assumed that the conditions in which gold does this would be very ugly. Equity markets will have crashed, all Hades will have broken loose, and so on. That could certainly still be the case. But it could also be that the Dow marches steadily higher along with gold, calm as a flat and glassy sea. If the fiction of prosperity is maintained, investors might be content to keep riding the merry-go-round, smiling like mildly sedated children. In this scenario, everyone stays happy except the poor man in the street, who does not have enough paper asset holdings to cancel out the steady rise in day-to-day living expenses. A slow debasement of the currency, to the benefit of paper asset holders, is thus a rather ingenious way to rob hundreds of millions of unaware citizens. Not all at once, of course, but in dribs and drabs ... a little bit at a time.
Currier’s “benign conspiracy” is perhaps not so benign after all.
But in spite of all the chicanery and deceit, there is much to be joyful for and much to be grateful for. If you see all this madness as a game – a game you are forced to play, but a game nonetheless – it becomes easier to take things less seriously. Best of all, with a little skill and determination, it is a game you can win.Link here (scroll down to piece by Justice Litle).
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