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ISSUES 2007
One captivating, historic and – likely – fateful year is in the cards.
I simply have a difficult time getting on board with the view that the U.S. housing markets will be this year’s major Issue. Actually, I will be surprised if the U.S., Chinese or the global economy takes center stage. When it comes to Issues 2007, I fully expect developments in and around finance and the financial markets to overshadow economic issues, concerns and risks. I will even go out on the analytical limb and predict it will be one captivating, historic and, likely, fateful year – and very much All About Finance.
The concurrent credit boom and economic transformation are these days quite comfortably entrenched. Contemporary unchecked “Wall Street” finance can now so easily adapt to changes in the quantity and composition of demand for borrowings from both the real economy and the securities markets. And today’s energized credit apparatus has no problem adjusting to well-telegraphed marginal changes in short-term interest-rates. A quasi-pegged cost of funds suits the markets just fine.
The “resilient” U.S. services-based economy efficiently adapts to (finance-driven) changes in demand – effortlessly expanding the volume, type and price of “services” rendered, while imports freely satisfy whatever quantity of foreign-produced goods is desired. Traditional measures of inflation are now far removed – and capture little of the effects – from prevailing inflationary manifestations. Meanwhile, manufacturing and inventory cycles these days engender only a secondary impact on the overall economy. As we witnessed in 2006, even major downturns in housing and auto manufacturing leave much of the bubble economy unscathed and even stimulate key sectors such as financial services.
Do not, however, even think of allowing this feel-good backdrop to seduce you into the complacency that has enveloped the vast majority. The financial sphere’s miraculous adaptability and the economic sphere’s trumpeted resiliency owe everything to an unprecedented and continuous flow of new credit and liquidity. This predicament is both the secret of recent success and the magic elixir offering the possibility for the inordinate stretching of this venerable boom – one person’s so-called “bullish” 2007 and another’s disastrous extension of “blow-off” excesses. Today’s acute dependency on massive credit creation and superabundant liquidity is the system’s fatal flaw, playing guilefully into ingrained optimism and for the duration of the boom toying with calamity.
The bottom line is that the U.S. credit and economic bubbles have no alternative than to expand (“failure is not an option”). But with risk intermediation and speculation having already been pushed to risk-taking extremes, sustaining this boom will be no small feat. Indeed, it will require another Herculean pushing of the finance envelope. We did witness as much last year with developments in global credit derivatives, high-risk lending, financial leveraging, and M&A. One can at this point safely assume the U.S. financial sector is up to 2007’s challenge, which leaves me pondering the ramifications for only greater monetary disorder.
Wall Street employees and “bank” executives have every intention of earning even fatter bonuses in 2007. Corporations (led by the financials) were remunerated handsomely for buying back stock and will plan on only larger repurchases in 2007. Coming off a decent year, the leveraged speculating community will enjoy additional robust inflows, while incorporating only greater leverage in the corporate debt and “credit arbitrage” speculations that served them so well in 2006.
The continued rapid increase in total system credit and liquidity in the face of rapidly decelerating U.S. nominal GDP was the prevailing dynamic of 2006. Apparently focused on housing sector vulnerabilities, the Fed halted rate increases mid-year. An energized financial sphere – feasting in ultra-loose financial conditions – was waiting keenly to take full advantage. Bubble economy fragility set the stage for a record year in M&A, corporate and junk debt issuance, “leverage lending”," and global financial flows and imbalances. The credit derivatives marketplace went nuts, global liquidity excess went bonkers, and global equities went crazy. U.S. and global finance completely lost their moorings. The degree of credit, speculative, and asset inflations experienced over the past year (or the past 4, or 14) does not unfold without the impetus of some underlying credit system disorder.
For Issues 2007, we would point to some key marketplace assumptions – today’s defining tenets of contemporary finance – that are suspect and increasingly susceptible to miscalculation and eventual repudiation. Sustaining the U.S. credit bubble is dependent upon the markets’ adherence to a confluence of (interdependent) specious assumptions with respect to marketplace liquidity, the Fed and global central bankers’ capacities, derivatives, risk intermediation, and the fallacious notion that Wall Street “structured finance” (alchemy) can interminably transform risky credits into top-quality and highly liquid marketable instruments.
It is impossible to predict when markets might begin to seriously question some of contemporary finance’s more suspect premises. It is reasonable to assume that some unexpected geopolitical event, development or crisis could prove the catalyst for a radical market reassessment. Much more knowable, however, is that last year’s acute monetary disorder has set the stage for speculative dynamics to dominate global financial markets. After recent serial melt-ups, one would expect monetary disorder to more regularly give rise to some hair-raising market reversals and downdrafts. A top analytical focus for 2007 has to be discerning at what point speculator-driven market volatility begins to evolve into liquidity-reducing position unwinding. The challenge will be distinguishing the elevated noise of volatile and scheming trading dynamics from important liquidity-impacting market developments. At this point, I will give benefit of the doubt to ongoing liquidity excess and do not believe we have witnessed the demise of the anti-dollar bull market in energy, metals and commodities.
It is the nature of credit and economic bubble imbalances, disparities and asset price inflation to keep policymakers confused, unassured, hesitant, and, in the end, accommodative. I find it rather astounding that some are today calling for the Fed to soon initiate an easing cycle. This would be an enormous mistake, one I do not expect the Fed to be in any hurry to make. Unrelenting financial sphere excesses today pose by far the greatest systemic risk. To what extent the Fed and global central bankers recognize this reality may very well be The Key Issue for 2007. The Fed and the markets are in an especially tenuous position if the Bernanke Fed actually attempts to wrest some control of “money”, cedit and the entire financial system back from Wall Street and the speculator community. Ditto if foreign central bankers dare enter the fray.
Link here (scroll down to last heading in the left/content column).Incredulity redux!
Surveying the past year and reading the unanimity of positive economic and market opinion on the coming year in the typical year-end publication of such leaves this correspondent, yet again, incredilous. This is not to say that the prognostications of these learned and astute analysts will be incorrect. Our disbelief last year simply increased our humility in attempting analysis or outlook in these areas, as belief was the place to be. Belief may well be the winner again in the coming year. In the particular area we concentrate on, financial institution credit, 2006 saw recent record lows in losses, delinquencies and reserves. Any aberrations were usually dismissed in conference calsl with either the “one-off” explanation or the more elegant, “We remain comfortable with the normalization of credit costs.” In general, financial institutions also showed record profits, particularly among those not hobbled by commercial banking regulatory requirements, i.e., the investment banks.
The other subject worthy of comment was the extension of these trends globally. Naturally, records were set in virtually every type of financial activity as global liquidity washed in globe-circling tsunami fashion. Another defining moment of incredulity was the “over-subscription” of an already expanded IPO for the Industrial and Commercial Bank of China Ltd. The bank raised a little less than $22 billion but demand for subscriptions exceeded $500 billion! The bank had been recapitalized prior to the offering but I will posit that a Chinese bank is more of a “black box” than our investment banks and hedge funds. They are loaded with loans to the privatized industries that they were forced to make. Analysis of such portfolios would require membership in the regime inner circles, and still might not be possible. To think outside buyers have a clue is clueless.
Hedge funds managed to add close to $100 billion more to a total of some $1.44 trillion in a year where their allure was superceded by “private equity” funds, and they underperformed generally both the indices and the far less costly fund industry they compete with. The world of private equity is now sitting on some $750 billion. Expect the $50+ billion deal shortly. In the world of equities, geographers finally got some respect. If you could find a market, Wall Street would pour unlimited amounts into it. The only failures were the little bitty Arab markets that attracted and then exterminated their local investor populations. When Venezuela, Indonesia and the Philippines top the WSJ list as best performing markets, we have truly re-entered the world of “hold your nose” investing!
Monstrous credit increases created economic expansion sufficient to offset the slowing of the previous bubble when housing finally ceased inflating during 2006. Is the bursting of the bubble in the residential real estate sector over, has the bottom been reached, and can this sector re-contribute to economic growth in 2007 and onwards? Can the seemingly ever-expanding financial transaction bubble (much of it enshrouded in opaque non-public form) not only continue to expand in 2007, but expand sufficiently to bring about the expected rate of economic growth? Having been wrong in 2001 in thinking the bursting of the dotcom, etc. bubble would produce serious economic damage and having been wrong in thinking the bursting of the residential real estate bubble would cause 2006 to be a year of economic difficulty, the author is hesitant to answer in the negative. But there are several new factors entering the equation that at least impel us to say maybe.
This is a residential real estate bubble far more complicated and extended than previous real estate bubbles. I am willing to go out on a limb and say that we are perhaps only in the 1st quarter of the residential downturn. That quarter usually sees the first signs of slippage give way to a market “freeze” where foreclosures are not yet comparable with auction numbers, and sellers still have sugarplums rather than reality dancing in their heads. A wild prediction: The eventual residential downturn will approach the Texas 1980’s or the New York 1974/5’s. Maybe worse!
Can churning financial markets, in spite of producing nothing other than deals, fees, profits and employment/compensation, then serve as a new bubble sufficient to replace the wealth destroyed by the dying residential housing bubble? As serious observers of quite a number of credit cycles over a half century, we see the “at the margin” signals that we have seen before. Perhaps not in the exact same places or format, but with the same meaningfulness. Serious degradation of 2006 Collateralized Mortgage Obligation fodder so soon in the payment process says, vociferously, that there has been a really ugly turn in residential. The pile-up in the ability of mortgage originators to get rid of the “equity tranches” to the greater fools is another straw in the wind. The increasing “one-off” credit hits that individual lenders are announcing is out there.
Q3 saw the first generalized bits and pieces of deteriorating credit – admittedly here and there and not everywhere, but that is the way credit cycles start. In 50 years we have not yet see one reverse itself without something like the Greenspan rate cuts of 2001 – and that was not a real reversal but rather just a significant moderation from what might have been. The big question this time is whether Bernanke cuts can provide the same effect. Again, we say maybe. The risk here is then when a true bear curmudgeon is willing to say maybe in this situation, there are no true bears left out there – a situation the bulls never want to reach!
Link here.B STANDS FOR BUBBLE – AND FOR BANKRUPTCY
The Wall Street Journal reported that no less than 71% of companies with Standard and Poor’s credit ratings had junk-quality ratings – BB and below – in 2006, up from 32% in 1980. An astounding 42% of companies with credit ratings were rated single B, the lowest possible credit rating that is not vulnerable to immediate default. Only 7% of rated companies were single B in 1980. So does B stand for bankruptcy – or just for harmless, profitable bubble?
The modern corporate finance fetish for debt originated with the Modigliani-Miller Theorem (MM) of 1958, which said that the value of a firm was unaffected by its capital structure, so that it did not matter how much of its capital was debt, how much equity. MM and its corollary the Efficient Market Hypothesis both made assumptions that are not remotely true in the real world, but they quickly became popular with non-practitioner academics, because they appeared explanatory and subtly downgraded conventional financial skills. Academics promoted the theories vigorously among their students, so like many well marketed academic nostrums, they eventually became fashionable among practitioners as well as theorists.
Prior to 1958 and for some years afterward, U.S. financial managers, in those days with experience of the Great Depression, limited their debt to the amount on which interest and principal amortization could be paid even in the bottom of a severe recession, when operating revenues were at the nadir. This led to very low leverage ratios, with debt generally no more than 20-25% of total capital.
Since debt payments were tax-deductible and dividends were not, it followed from MM that a rational company would maximize the amount of debt on its balance sheet, subject only to the constraint that actual bankruptcy imposes additional costs on all parties. The advent of inflation in the late 1960s made debt financing seem even more attractive. Then the sloppy Jimmy Carter-era Bankruptcy Code of 1978 introduced the Chapter 11 provision, whereby in a debt default management could control a corporate reorganization themselves and remain in office, with only the unfortunate shareholders losing out. From that point, turbo-leverage was off to the races.
As the junk bond market exploded in the 1980s, it was expected to lead to an enormous number of defaults, which would in turn lead to a retreat from the market and a rebalancing of credit appetite by investors. In 1990-91 and again in 2000-01 there were a lot of defaults (the latter concentrated primarily in telecoms) but not the level that had been anticipated. The secular bull bond market of 1981-2004, in which long term interest rates dropped by over 8%, while inflation continued significant and the U.S. economy remained generally strong, made the leverage in the borrowing companies diminish as cash flow improved and interest rates declined. And, except for a modest squeeze in the early 1990s there has not since 1980-82 been a period of tight liquidity. Instead the Federal Reserve has since 1993 been increasing M3 money supply by close to 10% per annum. In such an environment, unless the borrowing company’s operations have truly deteriorated (which happens only occasionally if there is no recession) it can always indulge in take-out refinancing, borrowing more money to cover its cash flow deficits.
This is the ugly secret about B rated bonds: If monetary conditions remain easy, then increased investor appetite allows potential defaulters to refinance instead of defaulting, which in turn keeps default rates low and increases investor appetite. This has particularly been the case in the last few years. Provided the junk bond market does not crash, refinancing of all but the worst rubbish is still readily available. Thus the normal corrective mechanism of rising default rates ceases to work, and the market spirals towards bond-market nirvana. Essentially the safety valve on the engine of speculative financing has been jammed shut.
This is even more the case internationally. The only thing that ever causes countries to default is a refusal by the bond markets to finance their deficits. Since in an easy money period, with generally declining spreads, the bond market is open to all borrowers, no defaults ever occur. That is why there has not been a sovereign default since Argentina went in December 2001. The lack of “crises” has nothing whatever to do with good management, but is simply a function of excess liquidity. If Enron had been a country, “Enronia, Queen of the Pampas” lenders and investors would be showering money on it today, and Jeff Skilling, rather than facing a 24 year jail sentence, would be seen, blonde on each arm, happily campaigning for triumphant re-election.
The market for emerging market bonds is as distorted as any market in history. Both spreads and interest rates are low, so that the J.P. Morgan EMBI+ emerging market bond index yields well under 2% above Treasuries. Oddly enough, emerging market stocks are not particularly overvalued. The Morgan Stanley Capital International Emerging Markets Index has a P/E ratio of about 14. A portfolio of emerging market stocks that matches the MSCI Index gets you largely Asia, with particular concentrations in the rapidly growing economies of South Korea and Taiwan. Conversely an EMBI+ portfolio of emerging markets bonds dumps more than half your assets in the dodgy kleptocracies of Latin America, with another 1/6th subjected to the tender mercies of Vladimir Putin’s Russia. If ever a market was subject to extraordinary popular delusions and the madness of hedge fund crowds, it is this one.
One day, the Fed will notice that inflation has not disappeared, and will raise the Federal Funds rate, probably by a wimpy ¼%. At that point, panic will ensue in the junk bond markets, domestic and international. With higher interest rates and tighter money, junk borrowers will find all their comforting arithmetic thrown out of whack, as their cash drains increase in size, and the bond markets begin to close for them. At this point, a wave of defaults worse than we have ever seen will sweep over these markets. It will probably be worse than the 1930s in terms of percentage defaulting, even if any economic downturn is initially mild. It is also likely that when times get tough the countries of Latin America (plus probably Russia) will follow Argentina’s happy example and default en masse, daring international investors to do anything about it and looking forward to the inevitable domestic real estate boom. The days when gunboats bombarded the defaulting country’s Presidential palace are regrettably long gone.
Domestically, there is no question that a massive default experience, while unpleasant, would be cathartic. After it, the remaining solvent corporations would throw their modern financial theory textbooks in the bin, return to the sound borrowing practices of the 1950s and 1960s, and take much better care of their relationships with the debt and equity investors who provide them with the money to operate.
Internationally, it is a different story. Mass defaults by emerging market borrowers could damage the international financial system irretrievably, making trade credit and foreign investment very hard to come by, even for those countries that had not defaulted. The virtuous countries, open to international trade and not overleveraged, would be at least as badly damaged as the defaulters. Among the defaulters there would be actual beneficiaries – the large exporters of primary products, like Argentina and Russia, with only modest manufactured goods sectors. I am not sure how you work an international economic system which rewards the most dishonest and spendthrift while penalizing those who play by the rules. Probably you cannot, and so following a mass emerging market debt default international trade will go into a period of autarky similar to the 1930s.
Link here.DEBUNKING THE PRIVATE EQUITY MYTH
A series of laughable assertions is becoming vogue in business circles these days, regarding what a gosh-darn pain in the rear it is to run a publicly traded company. Hot-shot CEOs would rather work for a company controlled by a private-equity firm than by public shareholders, as The New York Times just asserted in a front-page story. Entrepreneurs would rather sell out than go through the tedious process of an IPO. Companies that do plan to go public intend to do it outside the U.S.
There is a word for this kind of thinking, but it is not the kind of word that I can use in print. So let us just say it is ridiculous. CEOs who leave the world of public firms for the supposedly cushy realm of private-equity-controlled corporations know damn well that one day – soon, if all goes according to plan – their company will attempt again to go public. That is simply how the game is played. Similarly, high-quality companies can and do go public – Google, Salesforce.com, and so on. Finally, companies with any self-respect do not run to lightly regulated exchanges like London’s AIM. According to the little understood rules there, eventually U.S. companies that list in London will come under the scrutiny of the U.S. SEC anyway. So running away from U.S. regulators is pointless.
What makes this going-private debate silly is that everyone knows the companies in question will be public again one day. Moreover, the private-equity firms that help management take companies private are not planning to make their annual bonuses from the dividends that the companies in their portfolio pay. Nine times out of ten, the way they will make their haul is by conducting an IPO. Again. In the words of colorful CEO of Seagate, Bill Watkins, “When you go private, the only thing you think about is going public again.”
It is true that private-equity investors are willing to out-pay public boards of directors, surprising though that may seem at first blush. That gives you some sense of who is losing out in a going-private transaction. The private-equity firms are all about money. If they can make their money – which they achieve by buying low and selling high – they will pay a CEO $100 million just as easily as $20. To the extent they are able to buy low, it is no mystery who is getting the raw end of the deal: the previous shareholders.
The private equity inflation of CEO salaries is merely the free market at work. For all the outrage over obscene CEO pay – and I share it – I have yet to see a good proposal for how to rein it in. The U.S. public markets will continue to thrive because they hold the promise of making investors – along with avaricious, overpaid, under-talented CEOs – lots of money. The moment private companies cannot go public is the moment CEOs no longer will run to work for them. It is that simple.
Link here.GOLD IS NOT A “BARBAROUS RELIC”, CENTRAL BANKING IS
How many times have you heard gold described as the “barbarous relic”? It is a favorite phrase of gold-bashers everywhere who are trying to make gold the object of derision. Gold is not a barbarous relic because gold communicates value today as effectively as it did 50 years ago and much better than does the United States dollar. In contrast to national fiat currencies today, gold tends to hold its value. The purchasing power of gold remains relatively unchanged. In fact, this precious attribute of gold is timeless because the above-ground stock of gold grows approximately at the same rate as world population growth and new wealth creation.
There is indeed a barbarous relic: central banking itself. Central banks are barbarous in part because they conspired to put an end to Newton’s brilliant invention – the gold standard – that safeguarded sound money for 200 years. However, it is the process of central banking itself, as it has come to be practiced, that deserves the greatest public wrath. Why?
Central banking has been around for more than 300 years. In that time, an institution becomes either a venerable object or an obsolete relic. If central banks once served a useful purpose, it was when they were governed by the discipline of the classical gold standard. Having abandoned Newton’s rules, central banks now are abusive to free markets and antithetical to sound money. The reasons that make central banks barbarous also make them an unwanted relic. Central banks are a relic of empire, nationalism, and war. Central banks have survived not because they advance commerce or contribute to raising mankind’s standard of living but, rather, solely because they are disingenuous, slavish parasites, dutifully serving the omnipotent state, no matter how mindless or harmful the state’s bidding might be. Central banks pursue reckless policies that erode – and in some cases destroy – the value of their currencies. Because of that recklessness, central banking has become dangerous as well.
When confronted with attempts by anti-gold propagandists to bash gold, we now know how to respond. The barbarous relic is central banking, and any central bank that prevents the restoration of sound money increases the danger that the relic poses to the public interest. Not far in the future, when the U.S. dollar collapses as just one in a long list of fiat currencies that have collapsed before it, people will look back and ask themselves how it was possible that barbarous institutions like central banks could have hoodwinked so many people into thinking they were good institutions acting in the public interest.
The answer is that central banks have created the illusion of prosperity. Because people think that they are well off, they have no reason to question basic tenets that they are led to believe. For this reason, people are easily cozened into believing that gold is the barbarous relic, that central banks are doing a good job, that officially measured inflation is low, and that their financial future is secure. However, nothing could be farther from the truth.
Link here.THE GOLD : SILVER RATIO
Many investors in commodities use ratios to determine if one resource is incorrectly valued compared to another. These relationships, based on historical prices, can often give us vital information on, e.g., oil vs. natural gas, corn vs. soybeans, and – especially – gold vs. silver. While certainly not the most important factor in determining the possible returns in a commodity, these ratios can help guide our analysis.
Having been used as money for thousands of years, there is much data to reflect upon the ratio of gold vs. silver. The ancient Greeks set a ratio that fluctuated in a narrow range of 10:1 to 13:1. From that point on, much evidence exists that the gold/silver ratio climbed steadily for thousands of years, crossing the 20:1 barrier before the U.S. civil war broke out. Since that time, the ratio rose sharply, and has revisited the previous levels only briefly during the last commodity boom of the 1970s. Much of the data from 1934 to 1968 is relatively worthless, as the government of the U.S. dictated the price of gold, while the value of silver was allowed to fluctuate. Nevertheless, it is clear that over the centuries, the value between these 2 commodities has been on a steady increase.
Today, the ratio between gold and silver stands at relatively high value of around 50. Since this is above the trendline, it is likely that silver will outperform gold over the next several years. While this conclusion could be drawn from a historical persepective, it coincides with fundamental factors as well. Silver is bound to outperform gold in a commodity bull market. The opposite is true in a bear market. Investors should consider carefully their time spectrum. With metals having experienced several years of outstanding gains, some consolidation may be needed before jumping back into the silver game.
Link here.INDIA’S GROWING INTERNET
The U.S. is home to approximately 300 million people. More than 210 million of them are Internet users. Every month, these people spend an average of 32 hours online, logging on to an average of 64 unique websites, according to the Nielsen NetRatings. I think it is safe to say that the online market in the U.S. is mature, if not completely saturated. But what about some of the more emerging, faster-growing economies of the world?
Take Asia, for instance. With more than 3.6 billion people, the continent is home to approximately 54% of the world’s population. But only about 10% of them are online, according to Internet World Stats, vs. about 25% of the rest of the world. However, Asia’s online population is growing by leaps and bounds. The number of Chinese online increased by about one-third during 2006 to 132 million people. Overall, China’s online population has increased 486% since 2000. But India’s Internet population has grown by a staggering 700% since 2000. And there is still plenty of room for it to expand.
More than 1.1 billion people live in India, but only 40 million – 3.5% – are online. In mature Asian Internet markets, such as Hong Kong, Japan and South Korea, there is a saturation rate of about 68%. If India were to reach 50% saturation over the next several years, that would mean more than 500 million new Internet customers. Compare this to the 210 million Internet users in the U.S., and you can see the gigantic potential. The government is even helping things along by reducing barriers for telecom providers. Also, Internet access is surprisingly affordable. According to the Internet & Mobile Association of India, a monthly broadband subscription can cost as little as 199 rupees, or about $4.50.
On top of this, there are three other factors that are paramount to the success of online growth in India. The first is cheaper computers. India’s IT and Telecom Ministry is heading an initiative to cut the cost of PCs, with a goad of making computers available for less than 10,000 rupees – or $226. This would help more of India’s emerging middle class find their way to the Web. Next is the increase in website registrations under the “.in” domain, which now surpass 150,000. This shows that more local content is being created, and more relevant content will attract more Internet users.
The third success factor is a bit unusual, but it cannot be easily ignored. While a majority of Indians log on for email, chat and job searches, matrimonial sites are rapidly increasing in popularity. Statistics show that 15% of Indians go online for matrimonial searches. Matrimonial sites are so popular that even some major players are placing bets on their success. Yahoo! and Canaan Partners invested $8.65 million in BharatMatrimony.com, one of India’s largest dating websites. Execs at BharatMatrimony said that they expect to register 2.5 million users in 2006-07, as compared to 1.5 million that were registered in 2005-06.
While the online trends in India are obvious, the best ways to properly invest in the country’s coming Internet age are hazy at best. I will sort out some of the strongest companies in the coming weeks.
Link here.WHAT IS BEHIND THE CRASH IN CRUDE OIL?
Is it enough to point the finger of blame for the latest crash in crude oil on the arrival of global warming? Unusually warm weather in Russia, Europe, and the U.S. weakened global demand for heating oil by 23% below normal last week, and a 30% drop in heating oil demand is also expected in the days ahead.
Quite often, markets seem designed to fool most people most of the time. Global economic growth and oil demand growth are usually linked, so given expectations for global GDP growth of 4.4% in 2007, it is logical to expect global demand for crude oil to increase by at least 1.2 million barrels per day (mmbd) this year. However, that would fall short of 1.8 mmbd of new oil supplies that OPEC expects to come on stream from Angola, Brazil, Canada, Kazakhstan, and Russia this year. Non-OPEC oil output rose to 3% higher than a year earlier in Q4. OPEC-10 said it would address the net increase in global oil supply in 2007, by lowering its oil output by 1.2 mmbd to 26.3 mmbd in November, and then lower oil output again in February by an additional 500,000 bpd to 25.8 mmbd.
On January 5th, U.S. crude oil prices had already plunged 10% over three days and touched a low of $55 per barrel, on news available to insiders, but not yet known by the public at large. OPEC was cheating on its pledge to cut its oil production in December. Ironically, the two biggest cheaters in OPEC were the two most vociferous price hawks, Iran and Venezuela. It is hard to believe OPEC will meet its pledge to cut oil output in February, when the December agreements have not been fully kept.
However, the sudden plunge in crude oil prices to $55 per barrel, was all the more puzzling, when one considers that U.S. commercial oil stocks had fallen from 341.1 million barrels on November 17th, to as low as 319.7 million barrel last week. The sharp drop in U.S. oil supplies suggested that OPEC was honoring its pledge to cut output 4.3% in November, and to defend U.S. oil prices at $60 per barrel. While the media focused on the balmy weather to explain the sudden 10% plunge of crude oil to as low as $55 /barrel on January 5th, what initially triggered the drop was a surprise move by Saudi Arabia to slash the price of Arabian Light, its finest blend, to a $7.50/barrel discount to West Texas Sweet, for its U.S. customers, the deepest discount in 10-months. Why did Riyadh to decide to tip the delicate balance between fear and greed in the oil markets to the bearish camp, by slashing its U.S. oil price?
So far, Russian kingpin Vladimir Putin has not joined the OPEC cartel in cutting oil production, and instead, is pumping oil at full speed. Despite cheating by OPEC and record high Russian oil output, strong oil demand from Asia is expected to put a floor under crude prices at some point. China surpassed Japan in 2004 as the world’s second-largest oil consumer after the U.S. Beijing’s plans for its strategic oil stocks, whose capacity will reach 100 million barrels by 2008, will present more volatility for oil markets. The 30% fall in oil prices to $56 might spur China into action.
Traders in Oil company shares were completely blindsided by the 3-day rout in crude oil prices to $55 per barrel. The Amex Oil Index (XOI), which contains 12 global energy companies including BP, Chevron, and Exxon Mobil had been climbing alongside a rising S&P 500 in Q4, betting that crude oil prices would stabilize between $60 and $64 per barrel. The distortions of the global liquidity glut that pushed the S&P 500 to a 5½-year high had also pushed XOI far out of alignment with the price of crude oil. XOI has tumbled by 8.5% since its top.
Gold was held hostage to movements in crude oil for most of 2006, until Q4, when it was able to shake-off the yoke of “black gold”. But much like traders in the XOI, gold traders were operating in Q4 under the assumption that OPEC would act to stabilize the price of crude oil in the $60 zone. With a stabilized crude oil market, gold traders were free to focus on the plight of the deficit ridden U.S. dollar, speculative fever in China for gold and red-chip stocks, and central bank diversification out of the U.S. dollar, and into other currencies, including gold.
Gold had managed to climb to as high at 11.25 barrels of crude oil per ounce of gold last week, from 8.5 barrels in August. But the sudden and unexpected plunge in crude oil and other base metals, took its toll on gold and silver last week, tumbling to their lowest levels in more than two months as schizophrenic hedge funds bailed out of precious metals after the dollar surged on a doctored U.S. jobs report. Adding to gold’s woes, the euro did an abrupt U-turn and fell to the psychological $1.30 level, where bargain hunters emerged. The doctored jobs report allows the Federal Reserve to avoid rate cuts for the first quarter of 2007, and delays a speculative attack against the dollar. Still, the euro is underpinned by expectations of a ECB rate hike to 3.75% in February, to counter explosive Euro M3 money supply growth.
In an age of near universal cynicism on the part of traders and citizens towards government statistics on inflation, it is entirely natural for official government inflation data to be widely at odds with the reality faced by consumers and businesses, and regarded with utter disbelief. Yet it is hard for even the most strident of gold bugs to admit that the recent sharp drop in crude oil and other commodities will not put a damper on inflationary expectations.
Nowhere on Earth is there more deep disbelief and skepticism about inflation data than in Japan, especially after Tokyo’s financial warlords shaved 0.4% off the core inflation data with the stroke of a pen last August. That slick maneuver handcuffed the Bank of Japan from raising its overnight loan rate and enabled Tokyo to buy more time to keep the stock market afloat with a cheap yen policy. But Tokyo gold prices were also climbing to near record highs of 77,000-yen/oz. last week. However, the warlords might finally be relenting to a BoJ rate hike. That triggered a sharp downward reversal for Tokyo gold, signaling an interim top for gold. Whether a BoJ rate hike can put a lid on Tokyo gold remains to be seen, since Japan’s interest rates would remain the cheapest on earth and negative when adjusted for inflation.
Crude oil briefly bounced following an article in the Sunday Times of London, indicating that Israel has drawn up plans to destroy Iranian uranium enrichment facilities with a tactical nuclear strike. But speculation of a future war between Israel and Iran is baseless. That is the majority opinion of Tel-Aviv traders and the crude oil markets these days. The Tel-Aviv-100 stock index rose to a record high last week, up 15% from a year earlier, close behind the MSCI Emerging market index which gained 19%. Israel’s economy expanded by a healthy 5% last year, losing 0.9% of growth due to damages from the summer war with Hizbollah. The earliest clue of an impending war between Israel and Iran can be found in the Israeli shekel exchange rate. Yet the shekel gained 10% against the U.S. dollar to a 5½ year high in 2006. Nearly $20 billion of foreign direct investment flowed into Israel last year, bolstering the shekel, led by a $4.5 billion investment from Warren Buffet.
Israel cannot play Russian roulette and attack Iran, because its nuclear facilities are inhabited by Russian technicians, and Israel imports 60% of its oil from Russia. Its energy supply from Russia is of extreme importance for the functioning of its economy. Therefore, Ahmadinejad holds the trump card, while his chief ally, Russian kingpin Vladimir Putin controls most of Israel’s oil supply, and can bring the Israeli economy to its knees. Tehran is rewarding Moscow with a contract for LUKOIL, to give it a role in producing oil from Azadegan, one of the largest unexploited oil fields in the world.
Iran is home to approximately 10% of the world’s oil and is the second largest exporter in OPEC, producing 3.8 million b/d. At the same time, Iran sits atop the world’s 2nd-largest reserves of natural gas. Today, 85% of Iran’s export earnings, as well as half of its budget and a quarter of its economy is derived from energy exports. Despite oil exports of 2.5 million barrels a day however, Iran currently imports more than 40% of its annual consumption of gasoline. Yet given a difficult investment environment and concerns over its nuclear program, Iran has been unable to upgrade its oil facilities, nor increase production capacity for the past few years. While hydrocarbon revenue increased 28.3% last year, government expenditures grew a massive 39.6%. Tehran provides subsides for many staple items and housing, which total $25 billion a year. The latest plunge in crude oil, perhaps inspired by Saudi Arabia, is likely to put a squeeze on Iran’s budget surplus, which could turn into a deficit if oil prices fall towards $45 per barrel. Tehran cannot afford to cutback on oil production and reduce its oil income, without cutting back on subsidies and risk riots in the streets.
Iran’s all-out commitment to nuclear invincibility is also worrisome to its Sunni neighbors, who now fear that U.S. troops might withdraw hastily, leaving an Iraq dominated by Iranian-backed Shi’ite militias. While apparently ruling out the military option for 2007, the Europeans and the U.S. are quietly engaging in economic warfare with Iran, by demanding that international banks and oil companies pull out of dozens of Iranian projects, including development of Iran’s two massive new oil fields Azadegan and Yardavan. UBS Bank and Credit Suisse of Switzerland recently announced they were suspending most new business with Iran, and British-based HSBC said it would no longer accept dollar transactions from within Iran. The U.S. is expected to announce sanctions against Bank Sepah, a big Iranian commercial bank. Can economic warfare succeed in toppling Iran’s Ayatollah Khameini before he gets the bomb in 2009?
If U.S. military intervention against Iran has been ruled out for 2007, the big question is whether Saudi Arabia is behind the latest plunge in oil prices, to wreck havoc on Iran’s budget and economy? Meanwhile, Iran is banking on strong demand for crude oil from Asia to put upward pressure on the price, and there will be plenty of jawboning from Ahmadinejad.
Link hered.COMMODITY CRASH FLASHES WARNING FOR WORLD GROWTH
Somebody, somewhere, is using far less oil and copper then they were six months ago. Less wiring, less piping, and less plastic. Trucks are moving fewer goods. If demand is slipping for the two great staples of modern economics, it is hard to credit IMF claims that blistering world growth near 5% will carry on into 2007.
Brent crude has crashed 11% since New Year to $54.79 a barrel. It is down a third since May, despite an OPEC cut of 1.2 million barrels a day, falling output in non-OPEC (Norway, Britain, America, and Mexico) and saber-rattling by Iran. The slide matches the onset of the 1998 Asian crisis and the 2001 dotcom bust.
Copper – or “Dr Copper” to those calling it the best macro-forecaster in economics – is looking just as bruised. It crashed through resistance to $5,749 a tonne last week, a third below its peak in May. Stocks at LME warehouses have doubled since October. “People are saying it’s all over as far as copper is concerned and clearly it is,” said Jim Lennon, a strategist at Macquarie Bank. The broader CRB commodity index fell to a 20-month low last week, with a hair-raising technical chart.
Unless you believe that traders and commodity funds now so dominate oil and copper that they trump day-to-day use in industry, homes, and transport, then the world economy is not as robust as it looks. Commodities are famously synchronized with the business cycle, peaking as growth peaks. They give us a barometric reading weeks before the data collected by bureaucrats. They never lie. The culprits behind the mid-2006 commodity slide are well-known. 17 rate rises by the Federal Reserve squeezed credit. U.S. property went over a cliff. Car sales skidded, falling below 17 million for the first year since 1998. Yet the icy draft had already blown through, or so we were told. Alan Greenspan, retired but ubiquitous, assured us recovery had begun. Investors took their cue, pushing the Dow index to fresh record by New Year.
Recall the infamous minutes of November 2000 when the Greenspan team said the economy was growing nicely, and the biggest risk was “heightened inflation pressures”. Within seven weeks, the Fed held an emergency session to slash rates by 0.5%. The tech-bust was under way. Governor Edward Gramlich said later, “Everything was pointing up and, all of a sudden, everything started pointing down.”
Was everything really pointing up? Or did the Fed ignore the warnings of the bond markets because it was in thrall to a defective forecasting model? By then, the yield on 10-year Treasuries had been below 3-month notes for seven months, a red alert. Today the yield curve has been inverted for six months. This winter’s oil and copper crash may prove to be a false alarm. Michael Lewis, commodity chief at Deutsche Bank, said crude would snap back on the first cold wind. Robin Bhar, UBS metals analyst, said de-stocking by China’s State Reserves Bureau had hammered copper over recent months, setting off speculative attacks by “black box traders” once the price fell through support. “China's stockpiles are so low they are going to have start importing again,” he said.
The “New Paradigm” of commodity bulls and market optimists is that the emerging powers are now rich and resilient enough to go it alone, whatever happens to America. The bloc’s share of global GDP has jumped from 22% to 28% since the Asian crisis. They hold 72% of the world’s $4.5 trillion reserves. They alone account for the net rise in commodity use since 2004. It is a highly compelling case. But would you bet the farm on it?
Link here.Polar Bears and Commodity Bulls
If polar bears are an endangered species, commodity bulls are at least a threatened species. Endangered does not mean extinct, of course. It just means that the environment has become increasingly hostile ... and threatens survival. Commodity bulls will survive for a while longer, we suspect, but probably not before their population shrinks a bit more.
Link here.Seven new commodity ETFs hit market.
Last year, investors witnessed the launch of the world’s first ETFs based on silver, U.S. crude ETF, gold mining stocks, steel makers stocks. There were even rumors of a platinum ETF. Now Deutsche Bank and PowerShares have teamed up to launch seven new commodity ETFs on the American Stock Exchange, including ones based on agricultural products and base metals.
The funds, which track commodity prices, are based on versions of the Deutsche Bank Liquid Commodity Index subindices to minimize the negative impact of contango – a condition that could cost investors when they roll over their positions into new contracts if their next-to-expire futures contract is trading at a lower price. The funds also seek to and maximize the pluses of backwardization, when the next-to-expire contract is trading at a higher price than ones that expire later. The funds will enter into long exchange-traded commodity futures positions, and will earn interest on collateral U.S. Treasuries securities as well as cash.
Link here.WHO WILL BE LEFT HOLDING THE HOUSING MARKET BAG?
Commentary about the future direction of the housing market is coming from every direction these days. As long as mortgage rates remain in their current range, the worst-case housing market scenario will be avoided. The cheap financing available today may bail out many of the 2004 and 2005 homebuyers who made the mistake of entering into “teaser” adjustable-rate mortgages. This includes those who, with the assistance of irresponsible mortgage lenders, “shoehorned” themselves into houses they could not afford under conventional financing arrangements.
But this does not mean that every bad financing decision will be papered over by cheap, plentiful liquidity. A certain amount of housing speculation-related losses are already “baked in the cake.” The bill will be coming due as 2007 unfolds, and it will show up in continued worsening of foreclosures and losses at the most aggressive lending institutions. There are already several signs of significant shifts in psychology in lending practices, as outlined here.
Bankers will continue tightening lending standards as they become less certain about the value of the collateral against which they are lending. The lending environment in 2007 is most likely to be one in which those with good credit scores and incomes will be granted continued access to the liquidity pipeline. But those with subprime credit scores will likely find the lending window slammed shut. Soon enough, we will find out how many homebuyers were granted mortgages solely on the popular belief (circa 2005) that house prices in even the most undesirable locations “always go up.”
I recommend reading the Center for Responsible Lending’s recent report entitled “Losing Ground: Foreclosures in the Subprime Market and Their Cost to Homeowners” (PDF). It provides a glimpse into the potential future regulatory environment facing mortgage lenders. A few more regulatory wrenches are likely to be thrown into the freewheeling machinery of the “mortgage-industrial complex”. Needless to say, this will not be good for the slowly deflating housing bubble.
When studying the housing bubble’s formation, it is crucial to take a good look at the federal government’s historical promotion of homeownership. The first influence that comes to mind is the obvious effect that Fannie Mae and Freddie Mac have had on mortgage banking. They constantly replenish the firepower of mortgage originators, allowing originators to rake in fees for each approval. Due diligence on risk now rarely goes beyond checking off credit score and income range boxes, often over the phone or online.
As part of the Great Depression-era New Deal, the Federal Housing Administration (FHA) was created to stoke the housing market. It accomplished this by providing default insurance for lenders leery of lending to homebuyers who were not able to afford the high down payments required for mortgages at the time. As with all government programs, politicians never respect the costs or consequences beyond the next election cycle. In hindsight, the consequences are clear. The artificial influence of government-subsidized housing is resulting, and ultimately will result, in a gross misallocation of resources. Like the Federal Reserve, the FHA interferes in the free market. The consequences have been supercharging the business (and now housing) cycle. Just as the Fed thinks it knows better than the market what the optimal short-term interest rate should be, the FHA has developed into yet another conduit through which the federal government subsidizes the entire housing market, granting first-time buyers an artificial boost in home purchasing power.
Decades of housing market inflation attracted several private companies to enter the mortgage insurance business. They viewed it as a “no-brainer” investment to take on the risk of default in return for modest monthly premiums. The private mortgage insurance (PMI) industry was invented in 1957 by Max Karl, the founder of Mortgage Guaranty Insurance Corp. He observed a disconnect between those who could not afford a 20% down payment on a house and lenders who, for good reason, avoided extending mortgages with greater than 80% loan-to-value ratios. Until Mr. Karl’s entrepreneurial venture, the FHA had a monopoly in the mortgage insurance business.
Memories of the Great Depression were still fresh in the minds of bankers in those days. They respected the importance of avoiding overexposure to mortgage debt in a long economic downturn where job losses were involved. But Mr. Karl clearly saw an opportunity to bridge the gap between mortgage buyers and mortgage sellers by assuming a portion of default risk in return for premium payments. Instead of assuming the risk of property destruction or auto accidents like traditional insurers, mortgage insurers would shoulder the risk of default on the part of homeowners with less than 20% equity in their homes. This has undoubtedly contributed to the nonstop buying pressure on housing over the past 50 years.
This sounds like a cash machine-type of business, provided that premiums are priced at a highly profitable level (“piggyback” loans and the FHA are a threat to this) and housing prices do not increase far faster than incomes (they have). Most importantly, the willingness of lenders to extend mortgages must not fall short of the level required to keep prices elevated in areas characterized by high default risk (this appears to be happening right now). These three conditions are not running in favor of mortgage insurers, so it is time to consider how bad losses can be.
The PMI industry provides a crucial role in the process of bringing homeownership within reach of buyers who lack the savings for the traditional 20% down payment. Down payments are important to minimize moral hazard. Other than the damage that personal bankruptcy imposes on credit scores, homebuyers who put no money down have nothing to lose by defaulting on the mortgage and turning the keys over to the bank. The lack of savings and the innate American desire for homeownership among middle-class households has led to great demand for PMI. Large institutional buyers of mortgages, like Fannie Mae and Freddie Mac, usually require loans to have a loan-to-value ratio of no higher than 80%. Nearly all first-time homebuyers must either get a second loan to help fund this 20% down payment, or purchase PMI.
In return for PMI premiums that typically add a few hundred dollars per month to the mortgage payment, mortgage insurers expose their capital to a certain percentage of default, usually in the 25-30% range. Importantly, this is the “top” 25-30%. Beyond this first line of defense, shouldered by the mortgage insurer, providers of mortgage credit must absorb any losses that remain. For bankers and mortgage-backed security investors, PMI represents “credit enhancement”, because it substitutes the insurer’s creditworthiness for that of the homeowner. Industry sources peg the average insured mortgage at about $175,000, so I am referring to the creditworthiness of first-time homebuyers, not the wealthy.
So the industry’s risk exposure is concentrated on first-time buyers who bought with down payments in the range of 5-20% as the market reached the speculative stage in recent years. A historically consistent price consolidation would wipe out most of these down payments, putting many of these mortgages underwater. From there, the only step to widespread defaults would be a slowing job market.
Many will recall the stories of mortgage brokers stretching to the limit of their fiduciary duty – recommending no-documentation, interest-only, pay-option, and even negative amortization mortgages to clients with little warning of the fine print behind them. In 2004, as the Fed began to “tap on the brakes” of monetary policy, mortgage brokers hit the gas pedal to the floor with very loose credit conditions. Countless billions in new credit was created to grant homebuyers the purchasing power they needed to hop aboard the great housing market gravy train. So who is left “holding the bag” in the aftermath of the greatest housing bubbles in history? History will be the ultimate judge, but mortgage insurers played a crucial role in support of the bubble and have yet to experience their day of reckoning.
The largest player in the PMI industry is MGIC Investment Corp. (NYSE: MTG). MGIC insures $173.4 billion worth of mortgages as of September 2006. The company competes with six other major industry players including PMI Group, Radian, Triad Guaranty, Genworth Financial, United Guaranty Residential (an affiliate of AIG), and Republic Mortgage (an affiliate of Old Republic).
Not only must MGIC price its premiums to compete with six other major private players and a reinvigorated FHA, but also “piggyback loans”, or “80-10-10s”, have grown to replace much of the demand for PMI in recent years. The standard example used to illustrate this is financing 80% of a home purchase with a traditional 30-year fixed mortgage, 10% with a second ARM tied to the prime rate, and 10% with a cash down payment. Since financial engineering has become a comparative advantage of the U.S., there will likely be more products that develop into significant competition for PMI in the market for down payment financing.
MGIC’s assets consist primarily of a $5.2 billion bond portfolio. The portfolio’s duration is 4.9 years, which means that if interest rates across the yield curve increase by 1 percentage point, the portfolio’s value will decline about 4.9%. The company faces the risk of having to take major asset impairments if rates continue spiraling on future inflation fears. Under a worst-case scenario for MGIC, a huge wave of defaults would consume its premium inflow, forcing the company to tap into its bond portfolio to pay all claims. The company’s insurance rating would be downgraded to a level that would effectively put it out of business – an insurance company has no perceived value if it cannot pay the claims on policies it has written.
Because of the uncertainty of future mortgage default rates (and the PMI claims that ensue), MGIC management must estimate “loss reserves”, a huge determinant of earnings. This makes the risk of underreserving a threat to future earnings. If default rates pick up far more than management is currently anticipating in its reserve estimates, future EPS estimates will be slashed and the stock will likely decline accordingly. The year-end 2005 level of $1.1 billion in reserves against risk in force of $44.8 billion tells you that management expects a maximum of 2.5% of policyholders to default on mortgages over their insured lives. But a look at the subtotal of “losses paid” from the “Loss Reserves” table shows that payouts for claims have increased from $434 million in 2003 to $612 million in 2005. The increasing trend in “percentage of loans in default” over the past 5 years combined with the bearish macro housing environment is an indication management is likely underreserving.
Relatively few defaults occur in the first 12-18 months of a mortgage, so it may not be until the end of 2007 before MGIC discovers just how bad the defaults in its book of business will ultimately be. The pie chart showing insurance in force by policy year reveals that nearly 80% of the company’s current book of insured mortgages has been written since January 2003, with a large portion of it (33%) having been written around the top of the market in 2005.
The final threat to MGIC that I will address is low persistency. This is measured as the percentage of insured mortgages that remain on the books over the course of the year. Low persistency has plagued the industry over the past three years as the refinancing boom led to mass cancellations of PMI. PMI is usually no longer required once the loan-to-value ratio on a mortgage drops below 80%. The pie chart also illustrates this effect. Very few insured mortgages written before 2003 remain on the books. Nearly everyone with a mortgage refinanced during 2003-2005, and in the process, many either raised their equity stake above the conforming level of 20% or entered into a more aggressive financing arrangement (i.e., extracting equity and replacing it with a “piggyback” home equity line of credit).
At its most basic level, a company’s intrinsic value is equal to the cash that shareholders can extract out of the operating business in the future. Of course, the size of the cash flow will depend mostly on how large its obligations turn out to be – in the case of MGIC, covering defaults and overhead. In the case of MGIC stock, its valuation support (or lack thereof) is impossible to calculate with much precision. As the market revises its expectation of highly positive future cash flows to an expectation of highly negative cash flows, selling pressure will mount. The extreme uncertainty of future cash flows is probably why PMI stocks never get high EPS multiples. This is what I expect over the next 18 months: The odds of MTG running upward like a growth stock are tiny and the odds of the market fully acknowledging the risk behind this business are high.
The stock price of MGIC has fluctuated between the high-$50s and the low-$60s since August. During that time, MGIC has delivered earnings results pretty much in line with expectations. But cracks are beginning to appear in the foundation of the mortgage insurance business outlook, and mainstream media outlets are starting to report on it. In its 11/20/2006 edition, Barron’s published an article entitled “No MGIC Solution” by Jonathan Laing. Laing concludes that the company is far more exposed to credit risk than Wall Street is letting on, and goes on to explain how the consensus opinion fails to fully appreciate the importance of a steadily rising housing market to the health of mortgage insurers. He concludes the article by noting a respected financial services analyst’s negative outlook for MGIC.
Mortgage insurers must constantly add new customers from the yearly crop of new homeowners. This new premium income, added to the premium income from the existing book of insured mortgages, must be more than enough to offset the inevitable losses due to defaults in its existing book of business. While recent favorable tax legislation will widen the field of potential mortgage insurance customers, the potential time bombs in the existing book of business should remain the focus of investors in these stocks.
There is every reason to expect both continued slowing in the crop of new homebuyers, and growth in loss frequency and loss severity. A rapidly cooling housing market has taken away mortgage insurers’ ability to “mitigate” the losses it must pay to the banks upon foreclosure. Loss “mitigation” usually entails working with the bank to sell the repossessed house, or working out a restructured payment plan with the homeowner in default. MGIC turns the concept “risk-free return” on its head. This term is often used to describe short-term T-bills, since there is zero chance of the federal government ever defaulting on its debt (ignoring the principal erosion of inflation, of course). At its current price of $63, MGIC stock represents a case of “return-free risk”.
Part I, Part II.STALKING SICK PIGEONS
Your local landfill is now making compost out of all the predictions over the years about the “imminent demise of the American consumer.” One day, these predictions might actually come to pass, but the timing is very difficult to nail down. Despite a wilting housing market and rising personal debt burdens, American consumers continue to spend. But their spending habits are constantly changing. That means the world of retailing is always full of winners and losers. The winners tend to prosper, even when consumer spending is slow. The losers tend to struggle, even when consumer spending is robust.
The problem with predicting consumer retrenchment is that it ignores a basic facet of human nature: When given the option to consume without producing (via credit cards), most people will choose “yes.” Instead of keeping in mind the odds of a job loss or a slump in the housing market, most consumers wait until they run into the proverbial budgetary brick wall before they adjust spending habits. Will this be the year that many consumers collide with the budgetary brick wall? Maybe, but we would rather bet selectively against the consumer.
We would rather sell short the weakest of the retailing stocks. As the accomplished professional short-seller, J. Carlo Cannell, explained to the audience at this year’s Value Investing Congress, “Why should I go hunting in the rainforest for a puma when I can shoot a sick pigeon at the side of the road?” There are many “sick pigeons” at the side of the road in the retailing sector, waiting to be put out of their misery. Whether it is due to obsolescence, fads, market saturation, dumb acquisitions, or misguided corporate strategy, companies “get sick” all the time.
As this chart illustrates, the retailing sector has already been underperforming the S&P 500 for several years. This well-established downtrend probably reflects the pressures that many retailers endure: cut-throat competition, declining profit margins and cash-strapped consumers. If even the strongest of the nation’s retailers are straining to boost profitability, what becomes of the weakest?
While a recession may signify little more than an inventory adjustment and a 30% stock correction for the Wal-Marts of the world, it represents a death knell for some specialty retailers counting on a critical mass of consumers continuing to overspend on very discretionary items. Specialty retailers face lots of competition. There is a glut of specialty retailers. They also face rapidly changing fashions, fads and general consumer trends. One false move could mean lights out in a hurry.
How did specialty retailing reach this point of saturation? The top reason is the incredibly easy credit conditions of the past generation. Consumers have been given every opportunity to overspend. At the same time, the retailers themselves, have availed themselves of easy credit. They secured low-cost bank loans and other forms of E-Z financing that enabled them to pursue overly optimistic strategies or expansion plans.
Now, the E-Z credit tide should begin to reverse, or at least stagnate, favoring the retailers with the strongest balance sheets, best management teams, and most resilient product lines. Consumer spending that relies on ever-rising asset prices, like homes, is simply not sustainable over the long run. Since the housing boom promoted a one-time spending boost, the profits of retailers that benefited the most from this boost should be viewed as artificially inflated. The retailing business is about to become much more difficult, especially for sick pigeons.
Link here.SURPRISE, SURPRISE
Last week, Byron Wien, the thoughtful and well-regarded chief investment strategist of hedge fund Pequot Capital Management, issued his list of Ten Surprises for 2007. Mr. Wien has served up his economic, financial market and political surprises annually since 1986. Overall, the list of possible outcomes is somewhat benign, with a seemingly bullish bias. Reading between the lines, it would seem that Mr. Wien sees most investors as being unduly negative about prospects for the year ahead. That is despite the fact that risk premiums are at historic lows, bullish sentiment is at multiyear extremes, and a great many markets, including the stock market, are way past their sell-by dates.
Consistent with this latter view, I thought I would go through the list and provide possible alternative scenarios that I believe might be even more surprising to investors than what he is suggesting. Here is what I came up with (Mr. Wien’s original list items are quoted in italics).
Mr. Wien believes these surprises have at least a 50% probability of occurring at some point during the year. In previous years, more than half of the elements of the list have proven correct. Forecasting, of course, is always a difficult endeavor. Still, from where I sit, I believe Mr. Wien’s overly optimistic views for 2007 may be putting his enviable long-term track record at risk.
Link here.GLOBAL MARKETS FACE “SEVERE CORRECTION”, MARC FABER SAYS
Marc Faber, who predicted the U.S. stock market crash in 1987, said global assets are poised for a “severe correction” and it is time to sell. “In the next few months, we could get a severe correction in all asset markets,” Faber said in an interview. “In a selling panic you should buy, but in the buying mania that we have now the wisest course of action is to liquidate.” Faber, founder and managing director of Hong Kong-based Marc Faber Ltd., advised investors to buy gold in 2001, which has since more than doubled. His company manages about $300 million in assets.
The bullish outlook of traders in everything from bonds, equities and commodities to real estate and art suggests valuations are peaking, Faber said. Last year, the Morgan Stanley Capital International World Index of developed stock markets jumped 18%, while a survey of Wall Street’s biggest bond- trading firms predicted U.S. Treasuries will post the best gains in five years during 2007. Strategists at 14 of the biggest Wall Street firms all estimate that U.S. stocks will advance this year. The last time they were in agreement was for 2001, when the S&P 500 dropped 13 percent. “It’s going to have to be something unexpected and somewhat dramatic” to spur the type of pullback that Faber predicts, according to Wayne Wicker, chief investment officer at Vantagepoint Funds, which has about $28 billion in assets.
Faber, publisher of the Gloom, Boom & Doom Report, does have some favorites. Singapore and Vietnam are his top picks in Asia because stocks in Singapore are not “terribly expensive compared with interest rates” in the city-state, while Vietnam’s equities have “incredible potential in the long run.” Vietnam’s Ho Chi Minh Stock Index more than doubled last year and was Asia’s best-performing benchmark. Singapore’s Straits Times Index climbed 27%.
Faber recommends investors steer clear of shares in the world’s biggest developing economies after the emerging markets in 2006 outperformed their developed counterparts for a 5th straight year. “Emerging markets could get kicked in the next three months so I’d be careful of buying Russian shares,” Faber said. “I’d also be careful of buying China and India shares now.” Russia’s dollar-denominated RTS Index surged 75% last year, while the Hang Seng China Enterprise Index, which tracks Hong Kong-listed shares of Chinese companies, jumped 94%. India’s Sensex Index, which more than quadrupled in the past five years, is valued at 25 times estimated earnings. Faber also advises investors stay away from shares in Thailand, where he and his family are based. “Valuations in Thailand are very inexpensive but I wouldn’t buy tomorrow,” said Faber. “We have some political problems in Thailand right now. I’d wait for a couple of months.” The SET is valued at 10 times estimated earnings, the lowest among 14 Asia-Pacific markets tracked by Bloomberg. MSCI’s regional index is valued at 18 times. On a more positive note, Japanese stocks may prove good bets this year, Faber said.
Faber said gold should rally further on expectations that supply of the precious metal will decline and demand for it will increase to hedge against inflation. “The price of gold will continue to go up and probably very substantially,” Faber said. “In the long run, it’s very clear that central banks are basically increasing the supply of money and the supply of gold is obviously very limited.” He also tips oil prices to rise as political instability in the Middle East and other petroleum-producing areas threatens supply and global demand increases.
Link here.Why stocks will fall.
During the last half of 2006, I regularly got slapped around by the market as disbelief was suspended despite growing signs of escalating economic and geopolitical risks. Many argue in their recent emails to me – and I am paraphrasing the author Gay Talese – that I am something of a restless voyeur who sees the warts on the world, the imperfections in companies and industries. They argue that gloom is my game, the spectacle my passion ... and that normality is my nemesis. It seems to appear to many, based on some of their more recent communiqués, that my market observations resemble an account of the traffic from the point of view of the accidents. Not true.
I actually yearn for normality. To this observer, normal would be mean reversion in 2007 for home prices, consumer spending, credit losses, corporate profit margins ... and in stock prices. Indeed, with an odd year here and there being the exception (2000-02), we have been in a bull market for the past 25 years. During that period – and with perfect hindsight – the best financial advice regarding equities and bonds was also the most concise: The interest rate analyst could have confined himself to saying down and the equity market analyst to saying up.
The fact of the matter is that Wall Street investment strategists and analysts, commentators in the media, and portfolio managers (most of whom are mandated to be fully invested) are almost constitutionally incapable of an bearish market moment or criticizing the securities that they own. While three days of trading does not make a trend, the early signs for 2007 indicate that the times might be a-changin’ (toward normality), and I am looking forward to the opportunity of profiting from a more normal two-sided stock market.
Although the notion of a more normal market is in the eyes of the beholder – in my case, a bearish one – we do know that normal is not ignoring disturbing signs, not going without a 2% correction since July, not going without a 10% correction in more than 900 trading days. The hedge fund crowd – many of whom invest/trade at the altar of momentum – are now much longer than at any time in the advance, and despite last week’s modest correction, the remnants (i.e., short-sellers) have more or less folded their tents. From my perch, that is abnormal, as are the aforementioned positive skeins in share prices and the general notion that cash is trash!
Link here.Q & A ON THE PSYCHOLOGY OF DEFLATION
Following are questions and comments in regard to “Significant Shifts In Psychology”. The volume of responses was enormous, but many of the questions keep getting asked time and time again in response to various posts. I decided to take as many of these questions as I could find. Typically, the questions or comments are about cultural differences in Japan, a belief that printing presses can always defeat deflation, that we are in some sort of 1970s rerun situation, public obligations will cause inflation, the Fed can reflate the housing bubble, and comparisons to the Weimar Republic. Let me address these questions and comments.
“To even compare the citizens of Japan to the U.S. is stupid, stupid, stupid, Forrest Gump!” ... “Culturally, the Americans are spendthrifts compared with the Japanese.” ... “Japan’s culture is older than 200 years, and culturally, they are different and it does matter.” ... “The comparison to Japan is hollow. North Americans have become drunk on excess and will keep spending until the repo vans appear in the driveway.”
Comparisons with Japan are not stupid at all. It is important to understand both current differences, as well as trends. The biggest differences are demographics (an aging population and immigration policies) and consumer debt. The former is a deflationary force in Japan, the latter a deflationary force in the U.S. Consumer debt is an enormously deflationary force when it reaches the point it cannot be serviced. We are at that point now, and we face additional deflationary pressures of outsourcing and global wage arbitrage.
Not that long ago the savings rate in the U.S. was 8%. That savings rate steadily declined to the point at which it went negative for 18 consecutive months. A negative savings rate cannot continue forever. There will be a trend reversal in the U.S. back toward the norm on saving and, sooner or later, a trend reversal back toward spending in Japan. The savings rate in the U.S. has only one way to go, and that is up. A reversal toward savings in the U.S. will actually be quite supportive of the U.S. dollar.
As for demographics, notice that the open-door policy of immigration in the U.S. shows signs of closing. If immigration in the U.S. slows, it will slow the need for housing. Japan will eventually open up to immigration for the simple reason it will have to. Trends change. Both Japan and the U.S. are showing major signs of reversal on many fronts. The deflationary forces are building in the U.S. just as they are slowly receding in Japan. So ... is it stupid to make comparisons with Japan, or stupid to not make comparisons to Japan?
The Fed cannot manufacture growth. The Fed CAN certainly manufacture inflation.
The Fed can print, and I never denied it. Whether or not it accomplishes anything depends on willingness of banks to lend and consumers and businesses to borrow.
The answer to any deflationary whiff is massive printing of dollars. The Fed can use this money to bail out failing banks, bail out failing hedge funds, buy trillions in mortgages. Since the money supply would otherwise be contracting, the result is no deflation. ... The banks and hedge funds and large pools of borrowed money will have their hands out for central bank bailouts. The central banks will print massive amounts of money to bail out these institutions. There will be unbelievable demand for money from the big financial institutions. That will result in no deflation whatsoever. ... The big financial houses will be lining up for loans, and this will counteract any deflation. Individuals and financial companies will need bailouts to meet their real obligations, and this will be inflationary.
If printing cured deflation, neither the Great Depression nor a 20-year bout with deflation in Japan would have happened. As Paul Kasriel commented, “Most people are not aware of actions the Fed took during the Great Depression. Bernanke claims that the Fed did not act strong enough during the Great Depression. This is simply not true. The Fed slashed interest rates and injected huge sums of base money, but it did no good. More recently, Japan did the same thing. It also did no good. If default rates get high enough, banks will simply be unwilling to lend, which will severely limit money and credit creation.”
When the S&Ls were bailed out, there was an enormous capacity for consumers and businesses to take on credit. Today, consumers are financially strapped and businesses have no reason to expand. Overcapacity is rampant, and the economy is running on fumes of financial speculation. This is 1929 revisited, not an S&L crisis. Individuals may need bailouts, but it is presumptuous to assume they will get them in time, if at all. In fact, if you look at the Bankruptcy Reform Act of 2005, you will see corporations intending to make consumers debt slaves forever. Oddly enough, the Bankruptcy Reform Act is doing in practice what some claim culture did to Japan (prevent write-offs).
The simple fact of the matter is the Fed has no ability to put money into consumers’ pockets, and even if it did, it certainly could not prevent consumers from paying down debts, rather than going on a spending spree. Besides, the Fed has shown no propensity to bail out consumers at the expense of banks. Does anyone remember Greenspan’s recommendation that consumers use adjustable rate mortgages right at the very low in yields?
When Social Security runs short of revenues, this will be an inflationary force. The entire situation of unfunded liabilities (not only in the U.S.) is likely to become a major political as well as economic problem in the next decade.
Running short of revenues means that taxes will have to be increased, benefits slashed, or alternatives found. None of those are inflationary, and I expect some combination of all of those to occur. Already, we see medical outsourcing, and that trend is in its infancy. That will reduce costs. I also expect the next Congress to allow drug imports from Canada. That will not only lower costs, but lower corporate profits, as well. As for domestic companies going insolvent, I agree. GM and Ford are high on the list. That would be a hugely deflationary event (destruction in credit) should it happen. Medicaid, etc., will become a huge problem eventually, but first things first. The consumer debt problem is a far bigger problem for the here and now.
Congress can create (useless) jobs. Congress can raise wages. Fannie Mae can revive the housing bubble. Congress can put money directly into consumer pockets (think $1,000 tax credit to every filer). Congress may be willing to cause inflation.
Fannie Mae has no power to reinflate the housing bubble. Congress can, indeed, create jobs. Japan tried that and built a lot of bridges to nowhere. It did not cure deflation, but instead took Japanese national debt from zero to 150% of GDP. Congress can also raise wages. But how many small businesses will go under if it does? Loss of jobs is not an inflationary thing, in that it will without a doubt increase bankruptcies. Congress can indeed throw money into people’s pockets with still more tax cuts or tax credits. If it does, would it help the right people? Enough to matter? Once again, we come up to the issue of will Congress bail out the little guy at the expense of banks? I suspect not, but it may try something. If it does, will it backfire? I suspect so. I find the belief that Congress will do something intelligent and that it will work to stop deflation amusing.
You sound very much like Robert Prechter – that mass social mood drives the markets and the stock market is the barometer of social mood. This is the same thing he has argued for a decade, with the stock market as the leading indicator of social mood, but he is a loser.
Prechter may be right about social mood, but he was horribly off on both his deflation call and his call on gold. He missed a huge disinflationary boom, otherwise known as “Autumn” on the K-Cycle. Thus, he was not off by a decade, but decades. As for gold, he seems to think it will do poorly in deflation, and I disagree.
Greenspan and Bernanke have learned to pump one of either stocks or housing and let the other down – mutually cancel out the negative effects. Possibly, pump one of them too much higher to gain a net positive effect on social mood. This is what is happening today.
To propose that the key is to prop one up and then the other and that will accomplish something is basically absurd. For starters, housing is far more important to most people than stocks. Given that most houses are not paid off, there is also a huge liability should prices decline, as is happening now. This has the effect of contracting credit. Stock prices simply cannot in any way, shape, or form counteract a complete debacle in housing. If defaults get big enough, regardless of what anyone tries to do, credit spread will widen, and that will undoubtedly be bad for stocks. It is just a matter of time.
Again, I am stunned by the massive faith people seem to have in the Fed and the government to do something intelligent that will keep the bubble expanding in an orderly fashion. I am also stunned by the belief that propping up the markets can possibly work in the long haul. Housing created jobs, and borrowing against home prices kept people spending. “What now?” I keep asking. The problems here are extreme. In a nutshell: We need a bubble in the U.S. that creates U.S. jobs (as opposed to jobs in China), with rising wages that allow the servicing of that debt, and a continued expansion of credit by willing and able lenders and borrowers both. How likely is that?
You actually ignore an enormous amount of 1990s monetary theory by Bernanke and Co. about how they would have dealt with Japan’s deflation.
It is Bernanke who fails to understand the Great Depression, even though it was his favorite study. You can listen to a man who proposes dropping money out of helicopters, but I prefer to listen to someone like Paul Kasriel or professors John Succo or Scott Reamer on Minyanville. Bernanke does not understand either the cause or the cure of the Great Depression. That is the simple fact of the matter.
How can purchasing U.S. government debt instruments be a good investment when almost by definition there will be massive defaults?
How can government bonds possibly NOT be a good investment? Seriously, is the U.S. going to default on Treasuries? It is quite literally next to impossible. There is a theoretical risk that the U.S. will print money to pay back debts, but that is not what was asked (and I have addressed that elsewhere). In deflation, government bonds, cash, CDs, and most likely gold will be about the only things that do not get hammered senseless. Look at it this way: By definition, cash in deflation increases in value. Treasuries and CDs pay interest, but cash does not.
What is your assessment of the causes of prior hyperinflations in the U.S., Weimar Germany, and Zimbabwe or France?
There is an enormous difference between the current U.S. condition and the Weimar Republic. For starters, M2 has only been growing at an average annual rate of 6.9% since 1969. The monetary base is not expanding anywhere near that fast. These amounts have little to do with hyperinflationary conditions. Credit has increased at a far faster rate recently but, concomitantly, so has debt. When individuals or companies are no longer able to service their debt, bankruptcies and foreclosures happen. If bankruptcies and write-offs happen faster than credit and money expand, the result is deflation.
The Weimar Republic underwent massive printing to pay war reparations required by the Versailles treaty after World War I. The key issues here are an expansion of credit in the U.S. versus a massive expansion of the monetary base in the Weimar Republic, war reparations, and occupation of Germany by France after the war. Is France demanding war reparations from the U.S. and occupying Chicago until it gets them? Comparing the U.S. to Zimbabwe is even more ridiculous.
The last hyperinflationary (using the term loosely) period in the U.S. was in the ‘70s and ‘80s, when gold soared over $800, oil prices rose dramatically, and interest rates hit 18%. That was caused by a massive wage/price spiral. Conditions today are nearly opposite. I debunked the ‘70s rerun theory in “1929 Revisited”. Today wages are falling on account of outsourcing and global wage arbitrage. Overcapacity is rampant, and the ability of consumers to take on additional credit is limited. Debt servicing is a huge issue now.
The dollar will collapse, causing hyperinflation.
Collapse against what? People seem only to look at the situation in the eyes of the U.S. dollar. There is massive credit expansion right now in Europe, the U.K., China, and emerging markets (and has been for years on end). Credit is actually expanding faster in Europe now than the U.S. The problems in the U.S. are severe, but Japan, Europe, and the U.K. all have their own problems. Japan has a national debt 150% of GDP. The U.S. is not close to that.
In addition, people keep forgetting the dollar has already collapsed. What else do you call it when the dollar falls from 120 to 80? Did that collapsing dollar cause either hyperinflation or the price of imported goods to massively rise? I think not. What did happen was a bubble in credit lending caused a massive increase in the price of housing, and that bubble is now collapsing. Speculation in anything and everything is still running rampant – everywhere – all with leverage. The unwinding of that leverage is likely to be supportive of both the dollar and Treasuries. A reversion toward savings in the U.S. will also be supportive of the U.S. dollar and Treasuries. A flight from junk will be supportive of U.S. Treasuries.
If and when the Fed starts fighting deflation by lowering interest rates, I believe, but cannot prove, that gold will be the beneficiary. But it will not be just a gold rise against the U.S. dollar, but a rise in gold compared with all fiat currencies. The dollar is likely to crack in due time, but now does not seem to be the time. Even IF the dollar were to crack now, it is debatable as to what effects that might cause on the prices of goods and services in the U.S. Besides, a focus on the dollar is secondary to credit and debt servicing issues. Yes, the dollar will ultimately collapse, right with every other fiat currency. Collapse against what? Gold.
Your question, “Is the Fed willing to cause hyperinflation?” implies that the Fed could cause hyperinflation. If that is true, could it not by definition stop deflation by causing enough inflation to offset whatever deflationary forces arise?
If the Fed initiates a massive printing campaign and banks do not lend (because they are not willing to or consumers are not willing to borrow), the printing in and of itself simply would not do much of anything. As noted before, the Fed by itself cannot create jobs, raise wages, force banks to lend, deposit money into people’s accounts, or cause a psychology shift to make people or businesses want to borrow. The Fed, in conjunction with Congress, could theoretically cause hyperinflation, but only to the detriment of banks and themselves, and, in fact, everyone else, too. Once again, if deflation were so easy to avoid, the Great Depression and the Japanese deflation would not have happened.
In conclusion, I am amazed at the near universal belief that everyone seems to have in the Fed and the government. To be fair, some think the Fed will overdo it to the point of causing hyperinflation. Either way, people give the Fed far too much credit and intelligence, when history proves otherwise. Yes, the Fed has, for what seems like forever, been willing to blow bigger bubble after bigger bubble. Here is the key: It was able to do so because banks were willing to lend and consumers were willing to borrow.
It cannot go on forever, simply because the ability to service debt at some point becomes impossible. The pool of real funding (savings) dries up, and financial speculation on its own accord stops being supportive of the real economy. Financial and asset speculations of this magnitude throughout history have never ended well. There were deflationary crashes in Japan, the Great Depression, the South Seas bubble, the John Law Mississippi bubble, Tulip Mania, etc. In each case, the bubble collapsed after sentiment changed toward speculation. Once sentiment changed, it was never again revived.
The root cause of the bubbles was a massive expansion of money and credit in conjunction with massive speculation by the public. Given that the cause of those bubbles was that expansion of credit and speculation, it is incredulous to believe that the Fed or the government can cure the problem by throwing still more money at it. That has never worked before in history, and it will not be different this time, either.
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