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2007 SHOULD BE GOOD, NOT GREAT, ACCORDING TO VALUE INVESTOR DAVID DREMAN
Rising oil, labor and commodity prices be damned. Last year’s market moved full speed ahead, with the S&P 500 rising 13.6% before dividends and 15.8% including them. The increase was kind to my forecast in the January 30, 2006 issue, which looked for the S&P to rise 10% or more including dividends. The caveat was that a sharp inflationary spike would stymie the market’s advance. That spike did not occur. I also predicted 2006 would be the year that large-cap stocks outperformed their small- and midcap brethren. I was right by a hair on midcaps, but the small-cap group bested the large-size companies. However, I think this call still looks good for the current year. Finally, I am pleased to note that the Russell 1000 Value Index outperformed the Russell 1000 Growth Index for the 6th straight year.
Last year I recommended 24 stocks (27 if you count 3 held over from 2005 and recommended again in the fall). They climbed a collective 9.6% (before dividends and after a 1% trading fee on new positions), versus 10% for equivalent amounts invested at the same times in the S&P. Put in the dividends and I would have scored much better. Over the past six years this column’s picks have averaged a 7% compound annual gain (not counting dividends), versus 2.7% for the S&P.
My best performer was UST, a stock that was on the sell list for most big brokerages. Despite the strong consensus that the market leader in smokeless tobacco was washed up, it posted reasonable earnings and sales growth and appreciated 48% since I recommended it in late February. Plus, the yield added an additional 5.9% to its performance. My other tobacco pick, Altria (MO), posted a 10% gain as well as a 4.5% yield. Two oils did well. ConocoPhillips (COP) rose 24% from the first time I recommended it and 22% from the second time. Chevron (CVX) rose 29%. UnitedHealth Group (UNH) turned into a bargain following a scandal over options grants that cost the chief executive his job. But United’s earnings are steaming ahead. The stock is up 22% since my June recommendation. Fannie Mae (FNM) also got cheap after an accounting imbroglio. Wall Street feared the company would be swept away by a tide of restrictive legislation. Not yet. The stock rose 22% after my January pick. Keep COP, UNH, Pfizer (PFE), MO and FNM. Sell UST, the smokeless tobacco company, because its multiple of 18 is close to that of the broad market.
Four oil stocks sank, including producers Anadarko (APC) and Apache (APA). Keep those two. The huge inventories they have accumulated in this warm winter will soon dissipate. The companies are cheap and could well become takeover bait. Anadarko has an enterprise value (common market value plus debt minus cash) of $45.3 billion. Also included in my bottom ten were CSX, 3M, Freddie Mac and Hartford Financial Services, all weak performers last year relative to the broader market.
So I am entering the new year with seven holdover recommendations. All are worthy of being bought now if you do not already have them. The others are not necessarily sell candidates – I am a believer in buying and holding – but not worth adding at this point. When the smoke clears I believe that 2007 will be a mildly positive year. Falling oil and commodity prices should help most of the stocks in the S&P 500, so I still do not think it is time to play Chicken Little. Earnings should come in somewhat higher than the estimated $81 posted by the S&P Index in 2006, though the gain will be smaller than last year’s expected 14%-to-15% gain over 2005. Stocks, at 17.6 times 2006 earnings (excluding nonrecurring items), are at their lowest valuations in almost a decade. Other markets such as bonds and real estate are just too risky at their current levels.
Keep the quality of your portfolio high and you should have a rewarding, if not sensational, year, with price appreciation of 5% or more and whatever dividend yield you bargain for.Link here.
CARLYLE CHANGES ITS STRIPESBy diversifying into a broad range of assets and deals, it aims to flourish long after the buyout boom fizzles – and also to stop providing conspiracy theory fodder.
In the two decades since private equity firms first stormed the business world, they have been called a lot of things, from raiders to barbarians. But only one firm has been tagged in the popular imagination with warmongering, treason, and acting as cold-eyed architects of government conspiracies. The broadsides got to be more than David M. Rubenstein, William E. Conway Jr., and Daniel A. D’Aniello, founders of Washington’s Carlyle Group, could take. “It was nauseating,” Rubenstein says.
Carlyle, founded 20 years ago in the shadow of Washington’s power centers, long went about its business far from the public eye. Its ranks were larded with the politically connected, including former Presidents, Cabinet members, even former British Prime Minister John Major. It used its partners’ collective relationships to build a lucrative business buying, transforming, and selling companies – particularly defense companies that did business with governments.
Carlyle might have continued happily in that niche except for the confluence of three events. (1) In the aftermath of the 9-11 terrorist attacks, conspiracy theorists seized on Carlyle’s huge profits, intense secrecy, and close dealings with wealthy Saudi investors. The scrutiny reached a crescendo in Michael Moore’s documentary Fahrenheit 9/11, which made Carlyle seem like the sort of company image-conscious investors like public pension funds might choose to avoid. (2) The tsunami of capital that has been sloshing around the globe for five years, providing almost limitless funding for the kind of dealmaking that is Carlyle’s specialty, has brought with it immense opportunity as well as stiff new competition. (3) The succession issue. Carlyle’s baby boomer founders can see retirement around the corner. And they badly want the firm, their legacy, to outlast them. At this make-or-break juncture, Carlyle’s founders, billionaires all, decided to refashion their firm radically.
Stage I of what some have dubbed the Great Experiment was largely cosmetic. The founders asked members of the bin Laden family to take back their money. They sat down with George H.W. Bush and John Major and discussed, improbable though it might seem, how the two were no longer wanted as senior advisers because they hurt the firm’s image. Out went former Reagan Defense Secretary Frank C. Carlucci as chairman. In came highly regarded former chairman and CEO of IBM, Louis V. Gerstner Jr., along with former S.E.C. Chairman Arthur Levitt, former GE Vice-Chairman David Calhoun, and former Time Editor-in-Chief Norman Pearlstine, among others, to underscore Carlyle’s commitment to portfolio diversification and upright corporate citizenship. Carlyle also pared back its defense holdings dramatically.
Stage II went much further and, indeed, might come to redefine the very nature of private equity. While other major buyout firms raise a few massive funds that hunt big prey – companies they can take private, rejigger financially, and, eventually, sell off or take public again – Carlyle has spread its money among no fewer than 48 funds around the world. Whereas the other giant firms – Blackstone Group, Kohlberg Kravis Roberts, and Texas Pacific Group – respectively manage just 14, 7, and 6 funds, Carlyle launched 11 in 2005 alone and 11 more in 2006. More importantly, Carlyle now deals in a broad swath of alternative assets that include venture capital, real estate, collateralized debt obligations, and other investing exotica. Carlyle seeks to exploit lucrative opportunities now and gain flexibility later when the booming buyout market slumps. The risk lies in getting it right. Having never managed such disparate assets before, Carlyle is on a steep learning curve.
Carlyle’s radical makeover has turned the firm into the biggest fund-raising juggernaut the private equity world has ever seen. By the end of this year it expects to have an unprecedented $85 billion in investor commitments under management, up 6-fold from 2001 and more than any other firm expects. Rubenstein sees the total swelling to as much as $300 billion by 2012. Thanks to the surging debt markets that easily translates into more than $200 billion in purchasing power, enough for Carlyle to take out, say, Yahoo!, Caterpillar, and FedEx and still have $100 billion left over.
So what, exactly, is Carlyle? Part buyout shop, part investment bank, part asset-management firm, it has set out on a course all its own. Carlyle is already massive. It owns nearly 200 companies that generate a combined $68 billion in revenue and employ 200,000 people. Last year it bought a new company approximately once every three days and sold one almost once a week – all while dabbling in increasingly esoteric investments. Bespectacled and tightly wound, Rubenstein, 57, sits behind a dark mahogany desk so spare it is hard to believe he ever uses it. The place has none of the typical trappings of the private equity elite. No photographs of Rubenstein with famous people (though he knows plenty). No artwork. No “love me” collages of degrees and awards. “[Carlyle] is a serious money-management business,” says Rubenstein, “and we have to operate it that way if it is to have duration beyond the founders.” Besides, he says, his austere offices in Washington and New York serve as reminders that he could lose everything at any moment. Rubenstein does not have much time to gaze at the walls anyway. With money flowing in so fast and opportunities increasing exponentially, the firm’s expansion is creating problems buyout shops have never had to deal with before.
Coping with the hypergrowth is Stage III of the Great Experiment. Carlyle has overhauled its management structure, decentralizing decision-making in a way that would shock the typical larger-than-life buyout baron. Now, instead of relying on the founders to bless every deal, it sprinkles investment committees around the firm, each made up of managers from different funds and backgrounds. The new setup allows Carlyle’s founders, known inside the firm as “DBD” for David-Bill-Daniel, to concentrate on what they do best. Rubenstein travels the globe 260 days a year to raise funds. The fiery Conway, 57, scrambles to put the money to work. D’Aniello, 60, is chief operating officer and, in many ways, the glue of the operation. Underneath DBD and Chairman Gerstner, a web of investment managers runs money while seasoned executives not only manage companies but beat the bushes looking for deals. Carlyle has promoted 50 of its people to the level of partner – a path that typically takes 12 years. Below them sit associates, who earn about $150,000 to start.
Central to Carlyle’s Great Experiment is old-fashioned risk management. The more diverse the assets, say finance textbooks, the better the risk-adjusted returns. Carlyle has long been known as one of the most risk-averse of the major firms. Its main U.S. buyout fund has lost money on only 4% of its investments, making it one of the most consistent performers in an industry that typically sees losses on 10% to 15% of its positions. Thus far, Carlyle’s aversion to risk has not come at the expense of returns. Since its founding in 1987 it has generated annualized after-fee returns of 26%, vs. the industry average in the mid-teens. But DBD is telling investors they should not expect such returns to continue.
Carlyle’s focus on small and midmarket, less than $1 billion, deals has also set it apart from the other megafirms. Carlyle’s specialty is turning small deals into big successes. Even its most ardent former skeptic praises the approach. Stephen L. Norris, one of the firm’s original five founders, split in 1995 in a bitter fight over Carlyle’s direction. “I was wrong,” Norris says flatly. “David is a billionaire, and I’m not.”
But overheated debt markets have changed Carlyle’s formula, at least for now. When interest rates plunged earlier in the decade, deal financing got much cheaper, and Carlyle took full advantage, making successively bigger purchases. Founder Conway acknowledges the worry. “Our business right now is being propelled by the rocket fuel of cheap debt,” he says. “Rocket fuel is explosive, and you have to be careful how you handle it.” Daniel F. Akerson, co-head of the firm’s U.S. buyout fund, says one bank last year offered to give Carlyle twice the financing it needed for an acquisition. “That’s the craziness of it.”
Such easy access to capital now can set up big trouble later on. To paraphrase Alan Greenspan, the worst of deals are made at the best of times. Right now almost all dealmakers look like geniuses. But history tells us that when the cycle turns, many who are riding the current wave of hope and euphoria will be washed out to sea. If interest rates rise, opportunities to refinance debt will disappear. Cash flows will shrivel. There will be bankruptcies. Carlyle has a longer and more lustrous record than most firms, but there is no doubt it is getting increasingly audacious in its financial footwork.
Back in 1987 no one would have imagined that Carlyle’s founders would one day count themselves among the private equity aristocracy. Rubenstein was an unhappy lawyer whose main calling card was a stint as a domestic policy adviser in the Carter Administration. Conway had dealt with junk-bond czar Michael R. Milken as treasurer and chief financial officer of MCI Communications but had little experience buying companies. D’Aniello’s expertise was handling hotel financings at Marriott Corp. “People laughed at us,” Rubenstein recalls.
The biggest question facing Carlyle is whether it can maintain the discipline and top-notch performance it has been known for through this period of hypergrowth. The tension between Rubenstein rushing out new funds and Conway racing to find the financial expertise to keep up is palpable. With so much money flowing in, finding and keeping talent has become an obsession. D’Aniello, who oversees Carlyle’s real estate and energy investments, has been moonlighting as the firm’s management guru. He has hired human resources staff to attract top people, implemented 360-degree performance reviews, started succession planning, instituted Carlyle’s annual management retreat, and spearheaded an initiative called “One Carlyle”, designed to encourage teamwork across borders and silos. What could be more corporate-sounding?
“We do not want isolationists,” D’Aniello says of the employees he is trying to attract to sustain his firm long into the future. “We also do not want crybabies. And we don’t want mercenaries – people who are here to put a notch on their own gun. We want people to help us build a cannon.”Link here.
PREFERRED STOCKS ARE A FIXED-INCOME OPTION WORTH CONSIDERING
Why would a fixed-income guy like me not be in love with bonds? The big problem with bonds is limited liquidity. Buy bonds in lots of less than $100,000 face value and you will have limited choices and likely get shafted on bid/ask spreads. Solution? Buy preferred stocks instead. The classic preferred, going back a century, was stock that had a fixed but not guaranteed dividend. The directors could suspend the dividend but could pay not a dime to common shareholders until the preferred holders had been made whole. A fairly large number of these “cumulative” preferreds are out there. But the category is now enriched with a wide variety of other securities types.
Preferreds range all the way from pure debt obligations (differing from bonds only in having a $25 denomination and in trading on the New York Stock Exchange) to near substitutes for equity (preferreds that automatically convert into common shares in the near future). Your portfolio should dip into the category at several points along this spectrum. One thing to keep an eye on is whether the preferred you are contemplating qualifies for the 15% Qualified Dividend Income federal tax rate (QDI), which expires Dec. 31, 2010. There is no way to know whether a particular issue qualifies for the 15% levy without asking, but the general rule is that this favorable rate is not available if the issuer either is a real estate investment trust or pays the distribution as interest – which the company reports by deducting the sum on its own corporate return.
If the preferred you want is QDI, put it in your taxable account. If it is interest, put it into your retirement account. At the bond end of the spectrum are two varieties of securities that differ only slightly. One is called a PET (preferred equity traded) bond. Most PETs come out with $25 par values and most of them are traded on the NYSE alongside the stocks. In the other variant, corporate bonds are stuffed into a trust (usually by a brokerage firm) and shares representing the bonds are sold to the public. Distributions are taxed like interest, so put these in your individual retirement account. You can spot the brokerage-sponsored trusts by their oddball acronyms: CBTC, Cort, Saturn and pplus.
For equity exposure, get a convertible preferred, one that can (in some cases, must) be converted into common stock. Many of these are QDI. “Mandatory” issues have a specific date when they must convert. To make them attractive, they generally feature a variable conversion rate based on the price of the common stock. Should the underlying common not have moved much, investors get an extra amount of common. Some of the conversion rules are baffling. And unless you are comfortable with the company’s stock, do not buy the convertible. Better are optional preferreds, which leave the conversion decision in the hands of the investor.
My 27 picks last year returned 1.2%, after deducting 1% for trading costs. Equal investments in the Lehman Brothers U.S. Universal Index (or, when I was recommending a stock, the S&P 500) would have gotten you 4.9%. My worst picks were Canadian energy trusts, damaged by the Canadian government’s U-turn policy to begin taxing such energy trusts in four years.Link here.
HOW A TINY SOFTWARE OUTFIT FELL VICTIM TO NAKED SHORT-SELLING
Most investors have never heard of Sedona Corp. (OTCBB: SDNA.OB), a piddling Pennsylvania outfit that sells customer relationship management software for small U.S. banks and credit unions. But to a rogue band of short-selling hedge fund managers, Sedona was prime meat. And so from early 2000 through 2003 Sedona shares gyrated wildly on the Nasdaq, crashing from $10 to less than a buck. Helping run down the shares were the brazen trades of raiders who later were accused of an illegal – but flourishing – practice known as naked short-selling.
In two civil cases filed by the S.E.C. and in a criminal case pursued by the U.S. Department of Justice, regulators and prosecutors have pieced together a lurid tale of greed, replete with tape-recorded conversations of traders moving in for the kill. Regulators are investigating dozens of other examples of naked short-selling and possible insider trading. Many of these deals involve companies that raised money as Sedona did, in so-called PIPEs, or private investments in public equities (see related story). A PIPE has the supplier of capital directly or indirectly getting newly issued shares at a discount. If the discounted pipe shares are a good indicator of where the stock is headed, the higher-priced existing publicly traded shares cry out to be shorted. Depending on who is doing it and when, those short sales may be verboten. The case involves Ladenburg Thalmann, a New York City boutique investment bank that is a prominent player in the PIPEs business, Refco Inc., the now defunct brokerage investigated by the SEC for how its traders hammered at Sedona stock, and investment adviser Rhino Advisors, which helped line up investors in the Sedona PIPEs. In 2003 Sedona sued these companies and other defendants in federal court in New York. The case is pending.
Naked short-selling is a controversial tactic that was supposed to have been stamped out in the late 1980s. Hundreds of companies have collectively lost $100 billion in market value since 1997 because of naked short-selling related to PIPE deals, asserts former Under Secretary of Commerce Robert Shapiro, a paid consultant to attorneys for Sedona. Dozens of large- and midcap companies have been targets, but smaller companies are especially vulnerable. “There is a belief that it’s not that big of a deal,” says Peter Chepucavage, a former SEC staffer who helped write the current rules meant to clamp down on the practice. “But where it’s deliberate, it can have a terrible impact on a company.”
In short-selling a trader borrows shares and then sells them, hoping to replace the borrowed stock with replacement shares purchased later at a much lower price. In naked short-selling the sale is booked, but the shares are not delivered. The buyer of those shares has, in effect, only a brokerage firm chit saying he is entitled to the shares. This buyer fully participates in any appreciation (or depreciation) in the shares, but he does not have any voting certificates to hold on to. The naked gambit’s rise is seen on the New York Stock Exchange. Each day on the Big Board some 50 million shares lack “proper settlement”, meaning the trading firm fails to deliver the shares within three days, as required by SEC rules. Some volatile stocks, including Martha Stewart Living Omnimedia, Novastar and Krispy Kreme, have settlement “failures” that persist for weeks or months.
Sedona was a far lesser light, but it drew a pack of short-sellers anyway. The small company recruited a new chief executive, engineer Marco Emrich, in 1999 to push into banking software. He set out to raise $12 million in financing. Within a few months he had lined up the debt, scored a distribution deal with IBM and landed 65 bank customers. Emrich dreamed of $30 million in sales by 2003. In early 2000 Sedona took its first $3 million PIPE – short-term bonds convertible into stock, courtesy of Ladenburg Thalmann. Sedona was so desperate (or naive) that it signed off on a dangerous conversion feature: The more the stock went down, the more shares the bondholder was entitled to upon converting. Soon after, trading volume in Sedona shares spiked 16-fold. Were bondholders shorting the stock, hoping to profit by running the stock down? If they did any short sales before converting, they were violating the terms of the securities they bought.
Just months after the first Sedona PIPE the company’s shares had fallen from $10 to $3 and lower. Emrich arranged a second $3 million PIPE in November 2000, and the shares spiraled down in a similar pattern. By the spring of 2001 the traders at Refco were in full assault mode, captured on tape-recorded phone calls that federal prosecutors later subpoenaed. An investment adviser is heard exhorting brokers to use “unbridled levels of aggression” in shorting Sedona shares. A broker boasts to a colleague, “Want to short something illegally for 12 months? You got my number.” Clueless for the most part, Sedona executives were thunderstruck by an anonymous, 300-page dossier dumped on their doorstep in September 2001. It detailed manipulations in Sedona and some 60 other stocks. Sedona took the report to the S.E.C. Enforcement of rules aimed at curbing naked short-selling is weak. Last year regulators fined firms a combined $5 million for violating rules in the stock-lending business, which yields $10 billion of revenue annually for Wall Street.
Sedona has survived, barely, by taking a $1.5 million loan and equity investment from an outside investor, a Louisiana real estate developer named David Vey. “I was a little ” Vey says, “and this seemed like an exciting endeavor.” He since has increased his stake to 43%.
“We felt abused,” says Michael Mulshine, a former board member. He quit in June 2003 after getting a phone call at home on a Saturday morning from someone who warned, “People can disappear over things like this. We refused to walk away.”
The company is running on sales of less than $2 million a year now. Emrich still toils away. “We lost four years of our lives on this,” he says. “Are there companies that should not exist? Probably. But not Sedona.”Link here.
HEDGE FUND LOST 30% IN JANUARY ON METALS BET, INVESTORS SAY
Red Kite Metals, part of a $1 billion hedge fund run by RK Capital Management LLP, lost about 30% in January as metals prices tumbled, said two investors in the fund. The slump followed a 9.4% decline in copper last month, said one of the investors, who declined to be identified because details of the fund’s performance are confidential. David Lilley, a London-based partner who on January 20 said he was bullish on copper, would neither confirm nor deny the loss.
RK Capital, co-founded two years ago by Michael Farmer, was one of the best-performing commodity funds in 2006 as prices for copper, zinc and related metals surged. Copper and zinc sank on February 2 on concern Red Kite investors would demand their money, forcing the hedge fund to sell contracts to raise cash and driving prices even lower. “Size is important in commodity markets,” said Kimberly Tara, CEO of Geneva-based FourWinds Capital Management, which invests in commodity funds. “If your assets are large in relation to the markets you trade in, you have to take big positions. Those positions then become transparent and expose you to larger risks in the market.”
Jim Rogers, who predicted the start of the commodities rally in 1999, said more hedge funds may collapse after the demise of Amaranth Advisors LLC last year. “I don’t know who has got what positions and in what, but I know when some of them start blowing up, it is going to have huge ramifications,” Rogers, the chairman of Beeland Interests, told journalists.
Farmer, 62, was previously joint chief executive of MG Plc, formerly the world’s largest copper-trading company. The Wall Street Journal reported that Red Kite has asked investors to give more notice before they withdraw from the fund. Copper prices on the London Metal Exchange declined for a 6th consecutive month in January as global inventories increased of the metal, used in wires and pipes. Lilley said on January 20 that prices will rebound on rising industrial and housing demand in China and the U.S. The metal has fallen far enough from its May 2006 record to have reached “fair value”, and investors should buy now, Lilley said then.
Two hedge funds shut down last year because of wrong-way bets in commodity markets. Amaranth Advisers, based in Greenwich, Connecticut, lost $6.6 billion on gas trades, the biggest hedge fund collapse. MotherRock LP, a $400 million fund in New York, also shut after bad bets on energy prices.Link here.
GROUNDHOG DAY ALL OVER AGAIN
Here we are firmly planted in the New Year 2007, and yet the words from Crosby, Stills & Nash’s 1970 Déjà Vu album run through my head: “We have all been here before, we have all been here before.” The economy, the war, the government ... we have all been here before. Some of the things you have lived through before, you wish would just go away, such as:
It feels like we are all stuck in a remake of Groundhog Day, the Zen-like Bill Murray movie in which his character, a cynical T.V. news reporter, relives the same day of his life in Punxsutawney, Pennsylvania, until he learns how to change his selfish behavior. Have we not learned our lessons yet? Can we not stop reliving the past and waking up to the clock radio playing, I Got You Babe, by Sonny and Cher?
It reminds me of my stint as the business editor of a daily newspaper. For three years running the week before Valentine’s Day, the editor would turn to me wide-eyed during our morning editorial meeting as if he had just thought of the greatest story idea ever: “Are you doing a story about the price of roses going up for Valentine’s Day?” he would ask. The third year, I wanted to scream out loud, “No!” It was my Groundhog Day story.
I cannot be the only one bored to tears by yet another story about the housing bust, painful as it is for people caught in the middle of it. I crave some new stories to read. Any new corporate successes rather than scandals out there? Will a dozen roses and a box of fancy chocolates get cheaper in the next two weeks? How about that inverted yield curve – maybe it will revert to its normal status of higher interest rates for long-term debt.
Alas, in lieu of new stories like these, the best I can do is to offer a different perspective on the same-old, same-old stories, taking my cue from a New Yorker cartoon in which one trout says to the other trout that has a fishhook stuck through its mouth: “Nice lip piercing.”Link here.
THE MYSTERIOUS TROUBLE IN THE U.S. TRUCKING INDUSTRY
The economy’s message is: Keep on truckin’! Or maybe not. Even though GDP growth in the 2006 fourth quarter was much better than expected, the stocks of trucking companies, usually an important leading indicator for the economy overall, are mysteriously struggling.
Transport stocks are canaries in the coal mine. Here is a very long-term chart of the Dow Jones Transportation Average (DJT) vs. the Dow Jones Industrial Average (DJIA). Since they move the goods, a slowdown in transport companies’ business usually previews an overall slide. But here is where it gets weird. In theory, the fortunes of all the components of the Transport Index, which include shippers, truckers, railroads, and airlines, should move somewhat in tandem. Most goods that are sent by ship, rail, and air have to go on a truck at some point. It would be strange for one link in the freight chain to be doing well while others are dragging. But truckers, who carry 70% of all domestic freight, are doing poorly. The American Trucking Associations’ Truck Tonnage Index fell through 2006. And in Q4 2006, the index was down noticeably from Q4 2005, even after accounting for the temporary post-Katrina spike.
The earnings report of several firms in the DJT index also point to trucking struggles. The culprit fingered has been lower volumes. In October and November, which are usually great months for truckers (all that pre-Christmas shelf-stocking), Arkansas Best noted, “ABF experienced a sudden and dramatic reduction in business that mirrored conditions throughout the trucking industry.” But even as truckers encountered speed-checks, railroads closed the books on a record-breaking year. How can that be?
For starters, the two sectors are operating in slightly different economies. Railroads are benefiting from economic trends that do not particularly help truckers. Coal, an increasingly popular energy source, is hauled almost exclusively by trains. Industrywide coal carloads rose 5.9% in Q4 2006. At Burlington Northern, coal revenues were up a whopping 22%, thanks to heightened activity at the Powder River Basin. A second rapidly growing energy source, ethanol, also helps rail companies while doing nothing for truckers. Ethanol cannot be pumped through existing oil pipelines. And it makes far more sense to ship the fuel in 30,000-gallon tank cars than in tanker trucks. Ethanol shipments tripled between 2001 and 2006 and are expected to rise 33% in 2007.
Another, less cyclical, explanation that might account for truckers’ travails. The U.S. economy is remarkably dynamic. From year to year, the sectors that make the largest contributions to growth can vary. In the late 1990s, telecommunications and information technology were hugely influential. In recent years, housing emerged as a major contributor to growth. Housing is an industry that requires the movement of huge amounts of physical goods – lumber, cement, Home Depot merchandise. In 2006, housing slowed down, and financial services firms made outsized contributions to growth. These companies move money around the globe, not goods. Whether Goldman Sachs makes $10 billion or $2 billion trading currencies, it probably ships the same amount of goods by truck: none.Link here.
THERE IS NO WAY TO REFORM THE OPTIONS RACKET, SO IT IS TIME TO KILL IT
The SEC last week threw yet more dust into the eyes of investors on the knotty question of stock options valuation, when it issued a letter to Zions Bancorporation allowing them to value management stock options by means of a tiny parallel issue in the “market”. While appearing to be only a modest expansion of the range of options valuation techniques, this ruling opened the door to a whole new round of chicanery by corporate management and Wall Street by which investors might be defrauded. For the first time, it brought sharply into focus the fundamental question. Since management stock options allow such a myriad of ways by which management can enrich itself secretly at shareholder expense, why should they be permitted at all?
It has always been the contention of big companies in the tech sector and elsewhere that Black-Scholes and other valuation models put too high a value on executive stock options. Google, in its IPO document, was able to spread the cost of one year’s options over 5 years, thus dividing the theoretical cost of its huge 2003 pre-IPO options grants by five. Other companies have applied arbitrary discounts by which the cost can be massaged into insignificance, or have insisted to analysts (who have generally gone along with the scam, since it is their interest also to inflate earnings) that options costs should not really be counted, so that in earnings, etc. calculations one should pretend their cost is zero. However the holy grail of dodgy options valuation has been the stated preference of the SEC for an options valuation method which was market-based. If an artificial “market” could be created by which options would be under-priced, their value could be underreported also in financial statements.
In this respect, the Zions deal was very neat. I am compelled to smile at the elegance with which they achieved their objective, although rather in the manner that a TV viewer smiles at a particularly neat scam perpetrated by Tony Soprano. Zions issued a new security “Employee Stock Option Appreciation Rights Securities” (ESOARS) related to the bank’s 2006 options grants, which would pay no interest or dividend, but receive the intrinsic value of any options that were exercised into shares, when they were exercised. As a mild concession to reality, any options that were forfeited prior to vesting would have their underlying ESOARS repaid with interest.
Since the value of ESOARS depends entirely on the option exercise choices of a random collection of Zions employees, possibly motivated by their own cash flow needs or sheer irrationality, their value was appropriately depressed. Indeed, since they are pretty well impossible to value, it is reasonable to suppose that a prudent investor would not buy them at any price. You can be pretty sure that the option “valuation” given by the ESOARS issue will be depressed far below any possible theoretical valuation of the options.
Since the SEC has blessed ESOARS as an options valuation method, we have a new bonanza for Wall Street, of tiny illiquid issues of securities, thoroughly under-priced, sold to insiders and traded in no transparent fashion whatever. Instead of – theoretically – maximizing the valuation of a new security, Wall Street will be paid to minimize it. Doubtless they will be very successful in doing so, and investment bank partners will earn yet more largesse from investing in half-price stock option equivalents in client companies. Meanwhile, insiders will have found yet another new way of cheating shareholders. Oh, and an extra twist. Shareholders will be diluted, not only by the original options grants but by the ESOARS issued to hide their value, but will not know about it until several years later when the options are exercised and the ESOARS pay out.
Given the appalling history of chicanery and double dealing involved in management stock options, I have come to believe that Congress should ban their issue altogether. The principal theoretical purpose of stock options is to align the motivations of corporate management with the interests of the stockholders. However, stock options manifestly fail to do this. Instead, they provide incentives for earnings manipulation that an all-too-fallible management cadre is eager to seize. Since options accounting allows management to undervalue remuneration they receive, options grants to management are generally considerably larger than would be appropriate in a balanced incentive system. Large options holdings incentivize management to engage in risky corporate activities that raise short term earnings and stock prices, and to falsify earnings. On one side of management’s decision you have a theoretical abstraction of sound accounting principles. On the other you have large amounts of short term real money in their pocket. Money will win pretty well every time.
There is no cure for this problem. The theoretical models for options valuation are themselves flawed. By failing to distinguish between the truly random and the merely unknown, options valuation models produce the phenomenon of “fat tails” whereby out-of-the-money options pay off much more frequently than the models predict. If model parameters are set to cover these less-rare-than-predicted events, they overvalue at-the-money options in a normal share price environment. Since the models are flawed, management is incentivized to game the system. Since so much of management’s compensation comes from gaming the system on its options grants, corporate governance is degraded.
There are other, better ways to align management’s interests with those of the shareholders, but the tax code is against them. Grants of shares, which would provide management with an equally good incentive to maximize the share price, albeit one that was neither leveraged nor short-term oriented, suffer from the enormous problem that the grant is taxed as income when it is made. The recipient executive incurs a tax liability without receiving the tax to pay it. There is thus a tax code solution to this problem, which can be achieved without opening yet another loophole for top corporate management to minimize its taxes at the expense of the ordinary working stiff. Share grants should be taxable as income on only half of their value, recognizing that such a grant carries a considerable price risk. That 50% basis can then become the capital gains tax base for the shares, making capital gains tax payable when the shares are sold on the profit above 50% of their original value. The favorable initial tax treatment makes the manager somewhat prefer a share grant to an outright cash receipt, which is as it should be. In the company accounts, the full value of such share grants would be treated as an expense in the year they are made, and the recipients would then become shareholders on an exact par with all other shareholders, with no corporate tax or accounting consequences when they sell the shares.
If this tax change is combined with an outright prohibition against issuing stock options to management, the gaming of financial statements to transfer wealth from outside shareholders to management would be ended. In addition, management would soon become substantial shareholders in the company, and would thus be incentivized to maximize long term shareholder value in the appropriate manner. It is thus best to cut the Gordian knot, ban stock options, and force corporate management to remunerate itself in a more transparent fashion.Link here.
THE TRUTH ABOUT STOCK BUYBACKS
In an ideal world, stock buybacks blow dividends away hands down. Dividends have their place. Some investors will always be attracted to that cash every quarter. But ideally, buybacks are extremely efficient ways to distribute wealth back to the shareholder. There is not immediate income tax hit as there is with dividends. A lot of high-profile companies such as IBM, Intel, and Oracle are reducing share counts and giving loyal investors a bigger slice of the pie.
But what is happening when a company keeps buying back their stock, and shares outstanding keep going up? One of the causes could be that the company is buying back stock in an attempt to counter the exercise of employee stock options. And if you watch how investors react to these kinds of buybacks, they clearly hate them. This type of buyback is a knee-jerk reaction to try to maintain a consistent share base. Watch out for companies with share bases that increase despite massive buybacks. If management buys its own stock back when it is expensive, it is destroying shareholder value, plain and simple.Link here.
CHINA’S BUBBLE VULNERABILITY
At the start of 2004, a man walked up to the offices of China’s stock market regulator in Beijing and tried to set himself on fire. His reason? To complain about the collapse in share prices. Fast forward two years and the country is in the grips of a bout of stock market fever. Having seen the market rise 130% in 2006, bringing to an end a five-year slump, thousands of investors are signing up every day to open brokerage accounts.
The Shanghai stock exchange has even warned that record trading volumes could destabilize its electronic trading system. Having spent several years being criticized for the prolonged market slump, regulators now face the opposite problem – trying to prevent a bubble developing in the equity market. In recent weeks, several warning signs have emerged that the market is over-stretched. The surge in share prices saw Industrial and Commercial Bank of China become, at one stage, the second largest bank in the world behind Citigroup – only a few years after it was considered to be nearly insolvent.
Chinese shares listed on the Hong Kong market have a price-earnings (P/E) ratio of 18. The same companies on the Shanghai market have a p/e ratio of 33. For the regulators, such figures bring back bad memories. The previous collapse in the mainland market, beginning in 2001, came after a large gap opened up between valuations in Shanghai and Hong Kong.
Reforming the stock market has been one of the main pillars of government economic policy over the past two years. Officials want to encourage flotations to take some of the strain off the banking system, which has been the main source of capital for Chinese industry. Yet a slump in share prices could stifle new-found investor confidence in equities and limit the amount of capital raised from the market. “What China really needs is 20 years of steady 15% increases in the market, but it got 130% in one year,” says Jonathan Anderson, an economist at UBS. “If continued speculation leads to a sharp fall, it could close off that IPO pipeline.”
The problem for Beijing is that the market is highly vulnerable to bubbles. China has 34,000 billion yuan ($4,372 billion) in bank deposits that receive a meager 2% return and there are strict limits on how much money citizens can take out of the country. So when confidence in equities is high, there is a huge surge of liquidity into the stock market that bids up domestic share prices to unrealistic levels.
With big companies already listed in Hong Kong increasingly looking at mainland listings, Shanghai could see 200 billion yuan in IPOs this year and outstrip Hong Kong. A government reform of the shareholder structure of listed companies, which is gradually eliminating the large overhang on non-tradeable shares, will also release a new wave of supply on to the market. Up to 500 billion yuan of shares could, in theory, start to be traded over the course of this year. Although the authorities say they favour letting foreigners play a bigger role in the market, any further increases in the limited quota for foreign investment in mainland stocks are unlikely at the moment.
The government could also take further measures to mop up liquidity in the financial system by increasing bank reserve requirements and restricting new lending. Investors are also on the look-out for a strongly worded editorial in the People’s Daily or the Xinhua news agency that warns against putting more money into the stock market.
If all these measures do not calm the market, there is likely to be a serious debate about introducing a capital gains tax for equity investments. The Ministry of Finance has, for the first time, ordered that individuals with income of more than 120,000 yuan a year report stock trading profits, which some analysts see as a preparation for a new tax. The government has had some success in using a capital gains tax to reduce speculation in the Shanghai property market over the last year. Yet officials say there are fears that a capital gains tax would prompt an exodus from the market.Link here.
U.S. HOUSING MARKET – THE MOTHER OF ALL BUBBLES
I am really baffled by the e-mails I have been getting lately. A lot people have been blasting my predictions that the housing bubble will burst in 2007 and trigger a deep and painful recession. They point to the Commerce Department’s recent report that “new home sales rose 4.8% in December after 7.4% increase in November.” The tone of these e-mails is always the same: “Neener, neener, neener ... you goofed up, you numbskull. Admit you were wrong.”
The implication appears to be that the housing bubble is some kind of left-wing conspiracy conjured up by paranoid loonies. While that does fit my Bio to some extent, the housing bubble is not a conspiracy theory and there is overwhelming proof that the aftershocks will be excruciating. Remember, the “happy talk” in the real estate section of the newspaper is designed to soothe jittery nerves and help sales, not give the reader an accurate picture of a market which is sinking quickly. The hoopla over the “rise in new homes sales” ignores the real story which appears in many of the same articles, that is, “In 2006 existing home sales declined by 8.4%, the biggest drop in 17 years, and new homes sales fell by a whopping 17.3%, the largest in 16 years.” This is the real scoop although it is predictably hidden in the fine print. It signals the beginning of a long, downward spiral which will increase unemployment, shrink GDP, and send millions of homeowners into foreclosure and out onto the streets.
True, I do not have a crystal ball and I am not proficient at reading the entrails of dead animals, but I have put together some of the relevant facts and I think they make the case more convincingly than the cheerleading realtors who appear in the Sunday newspapers. Some of Wall Street’s heavy-hitters know that trouble is brewing and are finally putting out the red flags. Two weeks ago Goldman Sachs indicated that “the U.S. Federal Reserve will need to slash rates 3 times this year as the housing slump goes from bad to worse and the American consumer begins to buckle.” ... “We believe that housing will soon become the ‘straw that breaks the camels back’,” said David Kostin, the investment bank’s strategist. Goldman Sachs said homeowners had treated windfall gains from rising house prices as if they were “recurring income” using home equity withdrawals to subsidize over-stretched lifestyles. This artificial boost to spending has already dropped from 7% to 4% of GDP over the last year, and is likely to halve again in 2007. Mortgage equity withdrawal will fall from 13% of “discretionary household cash flow” in 2006 to 7% this year, causing spending power to contract for the first time since the dotcom bust.
Clearly, the wiz-kids at G-Sachs are not taken in by the 4.8% jump in new homes sales in December. They see the dark clouds forming on the horizon and are anticipating the approaching recession. The mainstream media are starting to be more forthright, too. The signs of a major economic downturn are everywhere for those who chose to look beyond the cheery predictions in the real estate section of the news. Next year, an estimated $1 trillion of ARMs (Adjustable Rate Mortgages) are due to “reset” which will cause stiff increases in monthly mortgage payments. We are bound to see a steady rise in defaults as well as a boost in new claims for personal bankruptcy.
This downward cycle is just beginning. In 2006, a mere $300 billion in ARMs reset pushing overleveraged homeowners to the brink of insolvency. Imagine what will happen in 2007 when $1 trillion of these explosive loans comes due. And, of course, as more people are unable to hang on and their homes go into foreclosure, inventory will continue to skyrocket. Peter Schiff summarized the situation this way: “The recent jump in bond rates suggests that things are about to get much worse for the housing market. Since January 5th interest rates have risen by over 30 basis points and gold has risen over $40 per ounce. My guess is that rather than a bottom of the housing market, bond investors around the world are beginning to appreciate the inflationary implications of a real estate crisis.
A substantial decline in real estate prices will either produce a severe recession on its own or exacerbate one that arises from other factors. In either case the result will likely be the Fed coming to the “rescue” with inflationary monetary policy. Inflation will push long-term rates higher, causing more loans to default. With credit destroyed and home equity and jobs lost, foreign creditors will rush for the exits sending the dollar into a tailspin. The Fed will be forced to buy all of the paper foreign lenders no longer want and that savings-short Americans cannot afford. Domestic money supply will explode sending consumer prices soaring. Schiff is right. A recession is just one effect of the deflating of housing bubble. The other effects are even more serious, including the anticipated “flight” of foreign capital from U.S. markets and an impending currency crisis which is liable to dethrone the greenback as the world’s reserve currency.
The source of our current problem is complex, deriving mainly from artificially low interest rates, currency deregulation and shoddy lending practices. Presently, Rep. Barney Frank (D-Massachusetts) who is the new chairman of the House Financial Services Committee is leading the charge to enact “nationwide lending standards to protect consumers from deceptive unfair and predatory mortgage practices.” Frank’s attempts at consumer protection are too, little too late. Mortgage debt has increased $4.5 trillion in just 6 years. As interest rates rise and ARMs reset there is no chance of a “soft landing”. By the end of 2007 we should have a much better idea of the magnitude of the damage.
Frank is right, though, much of the dilemma stems from goofball loans cooked up by mortgage lenders trying to bulk up their commissions. In 2000, a mere 2% of borrowers took out “nontraditional mortgages”, such as mortgages that allow borrowers to pay only the loan interest or just a part of the interest each month without paying anything on the principal. In 2006, that number jumped to 35% of all new mortgages! Also, Piggyback loans – which allow people to borrow the money for a down payment – currently represent 25% of all new mortgages. Think about that! The down-payment used to be proof that a loan-applicant was credit-worthy or financially responsible. Now, mortgage lenders have abandoned that standard in order to generate more loans. Finally, sub-prime loans now represent 20% of all new mortgages, whereas, in 2000, sub-primes were only 5% of total loans. These are the loans which are made to people with bad credit who typically pay considerably higher rates of interest. According to the New York Times, nearly 20% of these sub-prime borrowers will default in the next few years pushing 2.2 million borrowers into foreclosure.
Lenders are also at risk from loans which do not require strict documentation of income. In fact, 62% of all mortgage originations go to people who simply state their earnings on the loan application without providing any proof from tax returns. That is why they are commonly referred to as “liar’s loans”. A recent survey found that over half of mortgage-applicants who do not produce verification of their income exaggerate their earnings by more than 50%! It is expected that many of these borrowers have purchased homes that are way beyond their means and will have a difficult time avoiding foreclosure once their ARM reset. Liar’s loans are just one of the many ticking time-bombs which now litter the entire mortgage industry.Link here.
TENSE TIMES AHEAD AS CENTRAL BANKS END EASY MONEY
Life is likely to become a lot tougher for financial markets as central bankers press ahead with weaning the world economy off rock bottom interest rates. Central bankers are trying to persuade the world that inflation remains a danger and this campaign has provoked conflict with politicians, especially in the euro zone and Japan.
For a long time central bankers were heroes who revived the financial system with shots of liquidity after a series of shocks including the dot-com collapse, the 2001 attacks on the U.S. and the bursting of Japan’s bubble economy. But now they may become villains in the next chapter of monetary history as they end an era of easy money and relatively carefree investment. Higher rates and a fixation on not-so-obvious inflationary dangers can upset politicians, whose nerves fray when economic growth plateaus and voters’ jobs look less safe. This friction clouds the investment climate.
“We have left a stage in the cycle where central banks were the white knights coming to the rescue of the global economy, saving us from financial shocks and acts of terror,” says Marco Annunziata, chief economist at UniCredit bank. “We’re seeing a more politically challenging world coming for central banks,” says Adam Posen of the Peterson Institute for International Economics, a Washington think tank. “Without inflation being an obvious threat, the perceived cost of sticking to the priority on price stability opens them up for attack.”
The U.S. Federal Reserve and the Bank of England have already raised rates substantially. But the European Central Bank may yet make a couple more hikes and the Bank of Japan has only just begun increasing borrowing costs from zero. In theory, the timing is quite good for central banks to take the economy off steroids. Global growth is expected to slow just a bit this year, after the best 4-year run since the early ‘70s, according to the IMF. Yet, how can central bankers convince the rest of the world that inflation is such a danger when it has posed no problem in recent years, even when oil prices hit 1970s levels? With elections in France, and political power shifting in key G7 economies such as the U.S. with a Bush-hostile Congress and Britain, the difficulties of “normalizing” rates from ultra-low levels are potentially amplified. Annunziata’s argument is not that central banks are doing things wrongly but they were put in charge of monetary policy to worry about trends going beyond many politicians’ terms.
“The central banks could just sit back and let the economy grow faster than expected,” says Posen, but things are not so simple now as they go for more neutral interest rates that act as neither “uppers” nor “downers” to the economy. After a run of ultra-high liquidity in markets, what comes next is not clear. “It’s uncharted territory,” says Annunziata. When share prices touched new highs this week, some people in the financial markets were wary. “... I think, there is upward rate pressure. We think it is quite a dangerous period in the next six months,” said Teun Drasisma, an equity strategist at Morgan Stanley.
Intense speculation about whether the government meddled in a Bank of Japan decision to hold off on an interest rate rise in January shows the potential for conflict between bankers and politicians when the monetary policy mix gets complicated. Jibes at the ECB from both leading French presidential candidates may well be grandstanding but they reveal how easily central banks become targets for politicians, even when they are largely independent. Segolene Royal, Socialist candidate for the polls in April and May, has gone as far as saying the ECB’s mandate should be changed to include growth as a goal on par with price stability. Her center-right rival Nicolas Sarkozy has said as much. Daniel Gros, director of the Center for European Policy Studies, says the ECB is used to taking flak and that political criticism will get nowhere.
Posen believes the Bank of Japan is the most vulnerable of the big four central banks -- the U.S., euro zone, Japan and Britain – to political pressure, with the ECB at the other end of the scale, its independence guaranteed by treaty. That independence is perhaps necessary for the credibility of monetary policy, but it is a necessary evil, some say. “I think the French have a valid point when it comes to the thorny issue of accountability,” Dario Perkins, an economist who tracks the ECB for ABN Amro bank, said in a note. “When politicians make mistakes, they invariably lose their jobs. Yet civil servants and central bankers often manage to survive. They are not accountable for their actions and this is clearly undemocratic.”Link here.
U.S. GAO HEAD WALKER SAYS BALANCED BUDGET MAY BE FOLLOWED BY “FISCAL CANCER”
David Walker, the head of the nonpartisan Government Accountability Office, said that while the federal government may balance its books within the next several years, that will do little to improve a long-term budget outlook he likened to “fiscal cancer”. Walker said the government should be able to realize President George W. Bush’s goal of erasing the deficit by 2012. Still, the tide of red ink is likely to rise quickly in the ensuing years as the Baby Boom generation becomes eligible for government retirement aid, he said.
“We do not face an immediate heart attack, but we have been diagnosed with fiscal cancer and we need to start treating it,” Walker said in an interview. Walker said the nation will face $50 trillion in liabilities as the Baby Boomers start receiving Medicare and Social Security benefits. While the president’s budget understates the costs of both the war in Iraq and of fixing the alternative minimum tax, he said he has seen “real progress” in the administration’s attitude toward fiscal matters. “Think about where the administration’s position has gone in the last few years – it has gone from ‘deficits don’t matter’ to ‘deficits matter and they are coming down’ to ‘deficits matter and they are coming down but we have got this large growing imbalance we need to deal with,’” Walker said. “That is real progress.”
Walker also said he “would not be surprised” if Iraq war costs ultimately top $1 trillion. The Congressional Budget Office estimated last month that the government has spent $503 billion for the war on terror since the 2001 terrorist attacks. Walker was critical of the administration’s reliance on private contractors, saying they are used for jobs that ought to be reserved for government employees, such as conducting oversight of other contractors. “There are lots of conflicts that occur there,” he said. “Public servants have a duty and loyalty to the greater good. Contractors typically don’t.”Link here.
DERIVATIVES BRING DRAMA TO DAVOS
As Stephen Roach, chief economist at Morgan Stanley, moved around the debates on the world economy at the recent summit in Davos, he admitted that some of the discussions were distinctly bland. With the world economy growing steadily, debates about big economic themes lacked real drama. However, in one area there was a raging debate. Is the fast-growing derivatives sector playing, or not, a role in distorting the cost of credit? “[T]his has probably been the fiercest argument I have had in Davos,” said Mr. Roach.
A cynic may suggest this reflects the fact that the global economy is so benign that policymakers now have the “luxury” of worrying about financial markets and esoteric instruments, as John Lipsky, the first managing director of the IMF, put it. Nevertheless, the focus on structured products does mark something of a departure for the Davos group, given that these issues have generally been ignored in previous years. The public and private meetings revealed sharp disagreement about three key points.
The first is whether regulators needed to worry about the fact that the structured finance and derivatives world is often opaque, particularly given the dominant role of unregulated hedge funds. Optimists say this lack of transparency need not matter, since counterparties handling derivatives – such as investment banks – have a high incentive to monitor risks. Pessimists pointed out that these banks were competing with one another to win business. Consequently, some banks “could be facing pressure to let their standards slip,” as one regulator said. Worse, the competitive climate may mean that banks lack the tools and the time correctly to monitor hedge funds – particularly since the instruments these funds are using can be opaque. That “makes it hard to see how much leverage is in the system,” one policymaker said.
A second point of debate concerned the degree to which new products are dispersing risk across the financial system. In theory, senior officials pointed out, the proliferation of structured products should mean that credit risks were spread across a host of investors. Since this enabled investors to diversify their own risks, credit shocks could be absorbed easily. But some policymakers suspect that banks might be reacquiring risk via the back door because their investment arms are buying repackaged risk products or lending to hedge funds. “Banks have offloaded so many of their risks through hedge funds,” said Michael Klein, co-head of investment banking at Citigroup. “But hedge funds have given some of this risk back.” Some policymakers fear that if a really big crisis were to hit, this dispersal might create a “contagion” effect.
The third, related, issue was how regulators should respond. Some observers said that policymakers needed to impose more oversight on hedge funds, private equity groups and over-the-counter markets. But others argued that this would be undesirable and impractical. Meanwhile, the issue of legal authority poses a dilemma, as Stanley Fischer, governor of Israel’s central bank, noted. For while banks such as the U.S. Federal Reserve managed to quell the crisis at Long Term Capital Management in 1998, markets are now so international in scale that they cannot easily be controlled by any single authority. That made it hard to gather data in the short term and made unclear who had responsibility for the system in a crisis, Mr Fischer said.
Policymakers are trying to deal with this in the Financial Stability Forum, a committee attached to the BIS. “Every second month we meet in Basel and that is something which creates comfort for us,” Jean-Claude Trichet, head of the European Central Bank, said. One key point on which there was consensus was that more needed to be done. Howard Davies, former head of the Financial Services Authority and now an academic, said that “international regulatory architecture is still organized as if the world had not changed. As a result, we have a regulatory architecture designed for a bygone age.”Link here.
A NEW GROUP OF GENIUSES WONDERS IF WARREN BUFFETT HAS LOST HIS TOUCH
On December 27, 1999, Barron’s asked “What’s Wrong Warren?” That article began, “after more than 30 years of unrivaled investment success, Warren Buffett may be losing his magic touch ... Buffett, who turns 70 in 2000, is viewed by an increasing number of investors as too conservative, even passé. Buffett, Berkshire’s chairman and chief executive, may be the world’s greatest investor, but he hasn’t anticipated or capitalized on the boom in technology stocks in the past few years.”
Six days earlier Berkshire Hathaway’s A shares traded for the meager sum of $58,400. Now, seven years later, they closed a few days ago over $110,000. That is a 90% return during which time the Dow was up 15%. And the tech-stock laded Nasdaq? Down 22% since then. But now we have a new bubble – in credit and liquidity. And now we have a new group of geniuses wondering if Warren has lost his touch.
“Mark Carhart looks out over the packed New York conference and tells investors that Warren Buffett has it all wrong,” says a January 31 Bloomberg article. “Carhart, 40, co-head of the quantitative strategies group at Goldman Sachs Group Inc., uses his July speech to poke fun at the Berkshire Hathaway Inc. chief executive officer’s penchant for investing in market-leading brands like Coca-Cola and Gillette. He cites study after study showing that big-name companies with high price-earning multiples or rapid growth rates make poor bets.
“Traditional stock pickers like Buffett, a fabled raconteur, do have one redeeming quality, Carhart jokes: ‘They tell great stories.’”
Carhart manages what is probably the flagship hedge fund of the world’s flag ship hedge fund business – Goldman Sachs – at a time when the hedge fund industry, and more broadly, the financial industry generally, is flying high. Goldman’s Global Alpha fund is a $10 billion investment pool for Goldman’s best customers, employees, and friends. But though the fund generated $700 million in fees for Goldman last year, its investors lost money, which is a story worth telling. Bloomberg continues:
“In the 2005 report filed with the Irish exchange, Global Alpha reported a gross return of 51 percent for the year. The report says only two strategies – global anomalies and the country bond selection – suffered losses of more than 1 percent.
“During the first quarter of 2006, Global Alpha rose a net 9.5 percent, according to the semiannual report filed with the exchange. The next quarter, a bunch of the fund’s strategies soured.”
What happened? No one outside of the firm knows for sure. Global Alpha uses proprietary trading models, based on the research and development of its own team of math whizzes, Ph.D.s and guessers. But in August, the fund lost 10%, and by the end of November it was down 11.6%. In December, it climbed again, but still ended the year with a loss of around 6%.
But what do you expect? Trading, hedging, and money shuffling does not create wealth. It only redistributes it. And at the heart of every fund – even an alpha fund – is nothing more than a series of bets. If those bets go well, money is redistributed to the fund and its investors. If the bets go against them, well their money is distributed to others.
Warren Buffett is the second richest man in the world. If he wanted, he could hire as many U. of Chicago Ph.Ds as Goldman – even more. But he knows that bets go both ways, and that each time you bet, the house takes a little more of your money. So, if you stay at the waging tables long enough, you will have no money left. Hedge funds, he says, are not an investment. They are a compensation system for hedge fund managers.Link here (scroll down).
CALM BEFORE AND DURING A CREDIT DERIVATIVES STORM
Timothy F. Geithner is 45, but he looks considerably younger, with an easy smile and hardly a wrinkle in sight. A former chief of the New York Federal Reserve Bank suggested that Timothy Geithner study the Long-Term Capital (LTCM) crisis.
“I think by nature Tim does not get stressed out,” said Robert E. Rubin, the former Treasury secretary who was one of his bosses before Mr. Geithner took the helm of the New York Fed in 2003. “He has a calm way in the face of whatever he is facing and an irreverent sense of humor.” He may need all the equanimity he can muster. High on Mr. Geithner’s to-do list is understanding and monitoring the $26 trillion credit derivatives market – twice the size of the U.S. economy – the fastest-growing financial market there is. Its explosive growth has greased the wheels of the global economy, increasing liquidity, spreading risk and minting money for Wall Street along the way. But it has surged at a time when volatility has been low, debt has been historically cheap and defaults have been virtually absent. When this market gets tested, no one knows for certain how it may react.
Even the heads of some of the world’s biggest banks seem overwhelmed by the size and complexity of credit derivatives. “It makes my head swim,” said Kenneth D. Lewis, the chief executive of Bank of America. If the brave new world of finance is daunting, the man in charge of it is not. With a boyish charm and a dry sense of humor, Mr. Geithner has taken advantage of the current calm waters of the financial markets to take an active stance, rallying Wall Street to peel apart the market of credit derivatives to try to understand its potential risks. His style is more like a cerebral Dr. Phil than Eliot Spitzer, who reveled in showdowns with Wall Street. Of course, Federal Reserve bank chiefs are typically less confrontational, charged with stability, as well as being a critical part of setting monetary policy. But he has been unusually productive in tackling issues widely viewed as uncomfortably complex. As Mr. Rubin put it: “He is elbow-less. It’s really remarkable.”
That has been amply illustrated in how he has persuaded Wall Street to take ownership of the issues surrounding credit derivatives – from the plumbing that makes the system function to more aggressive and creative stress-testing to the relationship between hedge funds and banks. His approach has aimed at helping them believe that they are masters of their own destiny rather than miscreants who need to be punished, while extracting improvements in the financial system along the way. “He has essentially put the plumbing of the business on equal footing with the revenue side, which is an enormous accomplishment,” said Thomas A. Russo, chief legal officer at Lehman Brothers.
If ever a market required creative thinking, the credit derivative market is it. “We’ve seen substantial change in the financial system, with the emergence of a very large universe of leveraged private funds, rapid growth in exposures to more complicated and less liquid financial instruments, all during a period of very low volatility,” said Mr. Geithner in an interview. “This means we know less about market dynamics in conditions of stress.”
A credit derivative is a contract by two parties that allows a participant to reduce its exposure to the risk of default on bonds, loans, government securities or corporate securities. The cornerstone of the credit derivatives market is credit default swaps, a sort of insurance policy that allows two parties to exchange the credit risk of an issuer. Originally introduced as an instrument to bet on defaults, it has evolved into a widely used trading tool, especially among hedge funds, to bet on interest rates and spreads.
Credit derivatives are intended to reduce risk by spreading it out to as many parties as possible. That is generally considered desirable. Yet the size of the market, the lack of a history with such investments during financial stress and the worry that the clearing mechanism – the plumbing of the system – will function when the markets hit the skids are red flags for people in the business who know how quickly the spigot can turn off. “The fact that the banks are stronger and risk is spread more broadly should make the system more stable,” Mr. Geithner said. “We cannot know that with certainty though. We will have a test of that when things next threaten to fall apart.”
Regulators struggle to imagine what the shock could be, but do know that the reaction will be far different from crises of the past. When Long-Term Capital Management tottered on the brink of collapse in 1998, the credit markets in the U.S. were controlled by such a small number of institutions that the New York Fed had to make calls to 14 Wall Street banks to try to resolve the crisis. Today, the number of institutions would be vastly higher. Nevertheless, at the center of the universe of credit derivatives are still a handful of institutions that create, trade and manage much of the risk of these products and that also manage the risk of trading by lending to hedge funds. Mr. Geithner’s job, when he is not working on monetary policy, is to make sure they are prudently managing that risk.
When Mr. Geithner arrived at the New York Fed, E. Gerald Corrigan, a former Fed president himself, suggested that he look at the conclusions of the Counterparty Risk Management Group Report, the report compiled after LTCM. Mr. Corrigan thought it might be useful to look at those risks in the context of the rise of private money and the rapidly transforming credit markets. In 2004, Mr. Geithner’s staff conducted an extensive review of counterparty risk. But rather than dump its conclusions on the industry, he chose to stay behind the scenes while encouraging Mr. Corrigan to reconvene the group. In January 2005, Mr. Corrigan brought together a group that included some of the most senior executives on Wall Street. Six months later, the group produced a report that made 47 recommendations on issues from the very technical to the philosophical.
Central to the report’s findings were shocking weaknesses in the way credit derivatives were being assigned and traded around without any sense of who owned what. The so-called “assignment issue” was simple: credit derivatives were negotiated by two parties, say JPMorgan and Goldman Sachs. But banks were “assigning” the contracts out to others, like hedge funds, without telling each other. It was a little bit like lending money to a friend who is really rich who in turn lends it to her deadbeat brother and fails to mention it. “It violated the first and most sacred principle of banking: know your counterparty,” Mr. Corrigan said.
In September 2005, Mr. Geithner brought together the so-called 14 families of Wall Street and told them to fix the problems they had found. They set goals. Then he raised them. Standards were set, and backlogs came down sharply. One particularly effective tactic was to collect data from everyone and anonymously distribute it to the group so that every bank, and that bank’s regulator, could see how it measured up. The industry felt triumphant about being part of the solution. It was a classic “collective action” problem solved. The industry had set an abysmally low standard and no one would budge for fear of losing business, so someone had to move everyone.
Improving the processing of credit derivatives was only the first step. Soon after, he initiated a comprehensive examination of stress-testing, looking at how banks measure and test exposure to certain market players and market risks in different kinds of conditions, like the failure of one major firm. Working closely with European regulators, he is looking at the relationship between banks and hedge funds. The real test, of course, will be when a crisis hits, whatever the crisis may be.Link here.
WHERE HAVE ALL THE BOY SCOUTS GONE?
The economists, whoever they are, got it right in December. Incomes rose 0.5%, just as predicted. And spending rose by 0.7%, just as predicted. So, based on those numbers, consumers spent more than they earned. Just as predicted. A person might think correctly forecasting that an entire nation would spend more than it earned shows incredible foresight. But really the economists did nothing more than what they do best. No ... not eating a free lunch in a fancy hotel while predicting that GDP will grow 3% next year. Rather than taking a shot in the dark, they extrapolated a trend, such as the 20 months in a row before December that the savings rate came in negative.
But that is nothing. The savings rate was negative for all of 2006. And 2005 too. Two consecutive years! You could have guessed 2006 was negative because of the 21 months, and since there are only 12 months in a year ... But two years of negative savings shows impressive consumer resiliency. There are two other years when consumers spent more than they saved. But those years were 1932 and 1933, way back in the Depression when it was much easier not to save, particularly if you were the one of the one in four people out of a job. Consumers are far bolder today. Those Depression Era years should get an asterisk in the record books.
There are those, of course, who think consumers are acting rationally by spending more than they are saving. Optimists say: “Consumer wealth has been rising like a rocket. Why should Americans not leave behind them a trail of credit card receipts as long as a Ford Expedition?” Well, if you are accumulating wealth by growing your business it can make perfect sense to spend more than you make. Or if your portfolio of municipal bonds is churning out an income stream wider than the Ohio River, it might be okay to outspend your wages. That the market value of a residence has increased, however, is not necessarily a compelling reason to buy a flat screen TV. Because unless you sell out and move to a hut in the Amazon forest, there is no monetary windfall to justify more spending or debt service. In economic jargon, the argument goes like this: The price of your house is going up! You will have to pay more property taxes and insurance! Go spend some money! Yeah!
As the accompanying chart shows, all that borrowing to support all that spending has become increasingly difficult to service. But is the savings rate really negative? There are normal people – people who can witness a car crash without arguing that the economy is better off because the demand for cars just increased – who think that a more meaningful measure of the savings rate, while still pitiful, is actually positive. Andrea Coombes of MarketWatch did actual research on this topic for an October news story. She interviewed Alice Munnell, director of the Boston College Center for Retirement Research (CRR), who figures that the savings rate appears to be negative because baby boomers are beginning to spend down their retirement plans rather than contribute to them. Munnell and her cohorts calculated a savings rate that throws out the retirees, and arrived at a personal savings rate of 5.4% for the year 2003 – the latest data they had crunched at the time. Munnell acknowledges that even the adjusted savings rate has been declining.
So are Americans saving enough? Munnell and the CRR are trying to figure that out. At least on the surface, our retirement years are less secure because of the transition from defined contribution to defined benefit plans over the last 25 years. Other factors affecting the prospects for retirement identified by the CRR include:
The CRR found that a higher percentage of Americans in 2004 were at risk of a substantially lower standard of living in retirement than in 1983 – despite a 20-year bull market and a run-up in real estate. What they call the National Retirement Risk Index indicates 43% of households “at risk” in 2004 vs. 31% in 1983. The CRR blames the legislated changes in Social Security as well the mechanics of how Social Security replacement rates have declined with more two-earner households. The shift toward 401(k)s and less generous benefits generally, were second only to the Social Security effects in increasing retirement risk.
But perhaps just as telling as the long term study is the 2004-2006 update. Most of the factors making retirement a riskier proposition had no big affect on the most recent calculations. For example, stock prices, changes in Social Security, and pensions did not alter the index enough to be noticed. However, housing prices did change. In fact, between 2004 and 2006 there was a dramatic increase in housing wealth. That should be good news because retirees can tap home equity through a reverse mortgage and have the executor of their estate sell the house to payoff the debt. Still, the retirement risk index hardly budged. The change in housing wealth was offset by surging mortgage debt. So at least as far as the CRR was concerned, all that wealth creation was just cocktail party chatter. And now, housing wealth is shrinking but the mortgage debt is still there. Bummer.
All is not lost, however, according to Munnell and friends. While they really do believe that the higher level of their risk measurement “continues to raise serious concerns for future retirement security,” they argue that “Changing retirement and savings behavior can have a major impact.” That is, if we work a little longer and save a lot more, we can make retirement work. And that gets back to turning around the savings rate, however it is defined.Link here.
INCOME GROWTH AND CREDIT BUBBLE DYNAMICS
U.S. Personal Income expanded a record $658 billion during 2006 to $10.9 trillion. In percentage terms, this 6.4% growth was the strongest since 2000’s 8.0%. Growth accelerated from 2005’s 5.2%, 2004’s 6.2%, 2003’s 3.2%, 2002’s 1.8%, and 2001’s 3.5%. Total Compensation grew at a 6.6% pace last year, up from 2005’s 5.5% and the fastest growth since 2000. It is also worth noting that Income from Assets (chiefly Interest & Dividends) increased a record $138 billion during 2006 to $1.66 trillion, vs. 2005’s $92 billion increase. In percentage terms, its 9.1% growth rate was the strongest since 2000’s 9.7%. In combination, Compensation and Income from Assets – 84% of total Personal Income – expanded at a 7.0% rate during 2006, up meaningfully from 2005’s 5.6% to the strongest growth since 2000’s 8.4%.
Total Non-Farm Payrolls expanded 2.242 million during 2006. While down somewhat from 2005’s 2.541 million jobs created, last year’s job gains were still the second-largest increase since 1999’s 3.172 million. Goods Producing employment was little changed for the year, while Service Producing employment increased 2.531 million to 114.625 million. There are now five Service Producing jobs for every one Goods Producing job, up from a ratio of 4-to-1 ten years ago.
It is worth recalling that the economy lost 1.76 million jobs (1.48 million in the Goods Producing sector) during 2001, the year following the end of the tech/telecom boom. Income Growth slowed rapidly, falling from 2000’s 8.0% to 2001’s 2.8%, and 2002’s 2.5%. Let us briefly contemplate why the post-housing bubble backdrop is thus far following a much different course than that from the previous bursting bubble.
For starters, the bursting of the tech/telecom bubble precipitated a dramatic change in industry credit and liquidity conditions. A major reversal of speculative flows ensued, leading to a wave of insolvencies, (high paying) job losses, and an enormous evaporation of financial wealth (in equities, bonds and corporate loans). The booming tech/telecom industry abruptly lost access to new finance, a particularly problematic development for scores of companies with operating losses and negative cash-flows. Corporate (non-financial) debt growth slowed during 2001 to 4.7%, a rapid drop-off from 2000’s 8.2% and 1999’s 9.8% expansion. Speculative contagion effects were significant, as losses in telecom debt in particular led to heightened risk aversion in other sectors. Corporate debt managed a miniscule and insufficient 0.3% expansion during 2002, with the post-bubble debt crisis gathering momentum. Importantly, the bursting of the technology bubble was a major credit event with an almost immediate impact on corporate credit availability and marketplace liquidity. Corporate credit spreads blew-out suddenly during 2000 (junk spreads basically doubled to 700 basis point), only to spike to even wider extremes during 2001 and 2002.
While we must wait another month for year-end data, 2006 corporate debt growth will undoubtedly have continued its trend of steady acceleration – likely surpassed 8% last year vs. 2005’s 5.5%, 2004’s 3.7%, and 2003’s 1.9%. In contrast to the bursting of the technology bubble, corporate financial conditions eased markedly with the onset of the housing bear market. Corporate credit availability and marketplace liquidity have never been as easy as they were last year, and now. With housing coming off the boil, the Fed was afforded the luxury of relaxing and allowing market perceptions of Goldilocks to take command. And with the majority of U.S. mortgage risk essentially nationalized through government and the GSE guarantees, there was little marketplace fear of contagion effects unfolding abruptly in the mortgage finance space. Indeed, credit spreads narrowed almost across the board, and corporate risk premiums virtually collapsed.
Instead of 2000’s abrupt and disruptive reversal in speculative flows away from corporate America, peculiar 2006 speculative dynamics saw a veritable onslaught of finance looking to corporate Credits for easy profits. Amazingly, manic conditions enveloped the credit default swap, credit “arbitrage”, leveraged loan and corporate bond markets, a development certainly exacerbated by the recycling operations of massive U.S. current account deficits and other outflows – by central banks and the “rest of world” into Treasuries and investment grade U.S. securities. Bubbles inherently create their own self-sustaining liquidity.
Returning to the post-tech Bubble backdrop, double-digit mortgage credit growth did bolster the general economy during 2000-2003. Housing inflation-induced borrowing and spending provided a key stabilizing force for the general economy (as well as current account deficits sufficient to liquefy the world). While there is now mounting stress in the subprime and mortgage broker/lender arenas, there has to this point been little spillover. In reality – and in notable contrast to 2001/02 – the corporate debt sector has, on the margin, benefited handsomely from housing travails. With corporate debt growth accelerating in the face of still robust total mortgage debt growth (likely near 10%), the combination of booming corporate, mortgage and financial sector borrowings created unparalleled loose financial conditions. Instead of the slowdown in housing-related spending pushing the real economy into recession, newfound restraint in this sector proved instrumental in creating an economic backdrop exceptionally conducive to financial excess.
Last year certainly provided a clear example of how the economy and financial sector are evolving, adapting and mutating systems. Importantly, when it comes to employment and income growth, I would argue forcefully that corporate credit and liquidity conditions hold sway. Some expected the bursting housing bubble to have a tech-like immediate and spectacular economic impact. But it actually proved more a case of ultra-loose financial conditions boosting income growth, in the process working to stabilize inflated home prices. Relatively stable home prices, then, proved sufficient to sustain the mortgage finance and credit bubbles generally.
As we now look ahead to 2007, there are notable crosscurrents, uncertainties and ambiguities. Labor markets are tight generally, with increasing pockets of exceptional tightness. There remains an inflationary bias in compensation, exacerbated by ongoing easy financial conditions. Corporate cash flows remain strong, fueled by unrelenting system credit growth. The booming stock market only heightens the sense of urgency for businesses to pay up for required skills and manpower. If one were to extrapolate from the current backdrop, a strong case could be made for an even stronger year of income growth. Yet one must these days be unusually cautious when it comes to extrapolating recent financial conditions.
There is a fundamental flaw in the goldilocks analysis, in that it ignores the enormous ongoing degree of credit, liquidity, and speculative excess necessary to sustain this boom. A tremendous amount of system credit growth was required last year to maintain elevated home prices, to inflate stock prices, and to drive robust income growth – never mind the $1 trillion or so that gushed out and further distorted global economies, markets and financial systems. Even greater excess will be necessary to sustain the credit and economic bubbles this year and next.
The markets are content to make and live with two bold assumptions: One, the environment is non-inflationary and will remain so. Two, there is little risk associated with the creation and distribution of this ongoing massive liquidity. Neither holds water. There is considerable risk going forward that upside income growth surprises will forcing the Fed to “de-pause” and perhaps even tighten financial conditions. I will suggest, however, that the greater risk lies with speculative dynamics and the inevitable reversal of speculative flows out of this nebulous bubble I will label “credit arbitrage” (multifarious activities that are essentially writing flood insurance during a drought).
I will conclude by theorizing that a good percentage of the 7 million “services” jobs added over the past five years owe much of their existence to rampant credit and concomitant asset price inflation. They are – seductively and dangerously – bubble manifestations similar to the tech employment boom that proved so susceptible and disruptive. For now, these dynamics ensure extraordinary uncertainty. Yet we should expect the eventual bursting of this bubble to initiate job and income losses that will make post-tech bubble dislocations look inconsequential by comparison.Link here (scroll down).
THE SPECULATION OF A LIFETIME
Here at Casey Research we come across three types of investors. By far the largest group would identify with the phrase “go along to get along.” They invest in “ideas” from their broker and mainstream financial rags. If feeling adventurous, they tune in to Cramer’s Mad Money for a hot tip. There is, in our view, much wrong with that approach. For starters, a broker is paid to move stock and generate commissions, a built-in conflict of interest. And once a stock gets written up in Forbes or shouted up by Cramer, it is the exact opposite of a “hot” story.
The second group are the dice-rollers. They buy touts from telephone salespeople and haunt the financial chat rooms looking for “home runs”. In their youth, they were the “opportunity seekers” who sent away for the kit guaranteeing a 6-figure income from the comfort of a living-room chair. There is not much one can do for them. They will either learn their lesson on the cheap and reform, or lose all or most of what they have.
The third type is the rational speculator. This rare breed understands the key tenets of serious investment success. In no particular order: You rarely get hurt paying less for an asset than it is worth, and just because no one seems to want it at the moment does not mean it is worthless. Risk and reward are linked. While not all risky ventures hold the promise of high returns (e.g., sending money to a Nigerian bank in the hope of receiving a fortune is all risk and no potential return), all investments offering high returns carry higher risk. Understanding this link, savvy speculators do their homework to understand the risk side and, where possible, reduce it.
Think contrarian. That is the polar opposite of getting your investment advice from mainstream media. When Doug Casey first spotted the spectacular upside for uranium stocks in 1998, nuclear power was being universally shunned. But Doug saw what others did not: (1) nuclear was the only practical mass power alternative, (b) uranium had fallen so out of favor, and its price beaten down so low, almost no exploration was being undertaken, even though (c) supplies were being drawn down to critical levels. In hindsight, spotting that speculative opportunity seems a no-brainer. And, if you had been thinking like a contrarian and avidly studying out-of-favor markets, it would have been.
There is one final tenet to keep in mind about speculation. Most people invest 100% of their money in the hope of earning a 10% return. A rational speculator, on the other hand, looks to invest just 10% to 20% of their money in investments that hold the potential for a 100% or better return. Over the last two weeks, I have heard from two old acquaintances whose retirement nest eggs – $millions in all – were wiped out by a series of bad trades in traditional stocks recommended by their mainstream brokers. A rational speculator, even after a complete wipe-out, would still have 80% to 90% of his money to start over with.
Now let me bring all these points together in a way that could hand you returns most investors would consider outlandish. In fact, it may be the best contrarian speculation of your lifetime. It starts by answering a simple question. When asked about the outlook for the economy, most investors will answer something to the effect of, "My broker at XYZ Securities thinks the broad U.S. stock market still has a good run ahead of it.” In other words, they leave their thinking about the future to their brokers, the individuals who tend the myth of the permanent bull market (perhaps gently interrupted by occasional “soft” landings).
Which brings me to the speculative opportunity. Simply and for some good reasons, take the contrarian side of the mainstream broker’s trade by investing in the sector that historically does best when the economy does worst: precious metals and, for serious leverage, carefully selected precious metals stocks. Remember, the potential is so great that no more than 10% to 20% of your portfolio is required. Here is what you will be betting on.
There are more reasons to make your contrarian bet on precious metals just now, but those should suffice, given the space available here. Your contrarian bet gets even more compelling when you consider that, historically, gold bull markets last a minimum of 10 years. Gold bottomed in 2001, so we are just a bit over 5 years into the current bull market. And, based on the historic dislocations in the global economy, we do not think that this bull market will be anything close to “average”.
The junior precious metals exploration sector has been energized by an infusion of new capital. Exploration and drilling programs are already running on serious targets. It has taken time and patience, but that patience is about to be rewarded, as exploration programs head into their advanced stages – where we can actually see which companies have found deposits big enough and rich enough to be mines. In that regard, 2007 should be a banner year. You definitely want to place your contrarian bets before the newest crop of discoveries are announced in the weeks and months just ahead. Historically, when you match up a bull market in precious metals with major mining discoveries, you get the kind of roar that can turn your speculation into a fortune.
The mere fact that you are reading this hints that you are thinking about jumping on the precious meals bandwagon – but keep thinking like a contrarian. The most important point is that not one in 10 U.S. investors currently owns a single gold stock. They know nothing about them, but they do have brokerage accounts and they do like a good story. As the U.S. dollar comes under pressure – as it must –- the story of gold and silver as alternative stores of wealth will begin to make the rounds, and it will be a story that tells very well. At that point, public interest will soar, and the contrarian bet you make today will start flying on afterburners.
Early pays. Early pays big. So the time to act is now, before the stocks get pricey ... not when you are hearing about junior precious metals explorers in Forbes or from Jim Cramer. At that point, the tide will already be cresting, and we will be cashing in on what now is shaping up to be the speculation of a lifetime.Link here (scroll down to piece by David Galland).
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