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PROS AND CONS OF COUNTERFEIT MONEY
Have you ever thought that counterfeiting money could be good for the economy and that the counterfeiter could be considered an economic genius or even a national hero? I received an e-mail from Nic Corsetti, a friend of mine, describing exactly how that might happen. From Nic:
“Let us say that I invent a printing press that allows me to produce counterfeit money (say U.S. dollars) by the trillions – these dollars look EXACTLY like real ones, so no one can tell the difference, not even the government or the bank. So I start off the first year by counterfeiting $3 trillion:
“Obviously, this is a lot of work, so I hire a whole network of employees and consultants to help me achieve those lofty goals in a reasonable time period. The apparent benefits would be huge.
“This is such a good plan, I decide to let some of my best friends in on the action. So I pick 12 of my closest cronies and give them identical printing presses and instruct each of them to buy stocks, bonds, and real estate with their counterfeit money. I tell them to loan the money to anyone who asks. Now we are really getting somewhere.
“Even with all of that there is STILL NO INFLATION! Cheap imports keep prices from rising and the best part is that those foreigners keep taking this counterfeit money as if it were real money. No one can tell the difference, anyway. This goes on and on – we have really created a tremendous virtuous cycle where everything just gets better and better.
“After a few years of counterfeiting, I am quite certain that a ‘new era of goodwill and fortune’ would be announced and that I, Nic Corsetti, would rightfully be hailed as the first economic grand wizard to have permanently vanquished recessions. But what is the catch? Where is the hole in this story? If counterfeiting is such a great idea, why is it not legal? Actually, it is legal.
“I, Ben Bernanke, hope these printing presses do not break down and that people keep accepting these counterfeit dollars, or this economy might implode. This is my only fear right now.”
As proof of the ingeniousness of legal counterfeiting, Alan Greenspan has been hailed as an economic hero and knighted by the queen of England for his “contribution to global economic stability.” Printing presses do work (for a time), and Greenspan’s timing was perfect, as discussed in an “Interview With Paul Kasriel”: “[Greenspan] was fortunate in two very big ways. First off, he was fortunate to preside over the economy at a time when productivity was soaring and the global supply of goods was expanding rapidly because China had entered the world trading arena. In that environment, the Fed could create large amounts of money and credit without causing inflation other than in asset prices.”
By the way, so many others have acquired the magic printing presses that the Fed is now basically irrelevant when it comes to credit expansion and contraction. Synthetic money is now being created in massive amounts in numerous places. For example, GSEs are now running their own printing presses. Want a $500,000 mortgage? Boom, you got it. No one cares if you can pay it back, either. It is foolproof as long as home prices only go up. Multiply that by the hundreds of thousands and it all adds up, and much of it done with 0% down, and most of it based on the belief that housing prices only go one way: up. The day of reckoning comes when home prices sink. A collapse is now underway, and it has hit the subprime market especially hard. Those credit problems are guaranteed to spread.
Some may object to the term “synthetic money”, but the important thing is not what we label it, but rather the general idea of what is happening. And without a doubt enormous amounts of money (credit/debt) are being borrowed into existence with increasing leverage and risk. Broker dealers (via junk bond offerings) have figured out how to create their own synthetic money backed by essentially nothing. As yields collapsed, increasing leverage had to be used to generate the same returns. Such offerings have exploded along with mammoth growth in hedge funds all wanting a piece of the pie.
Some 20,000 hedge funds are now doing things with leverage because yields are too low. Various carry traders have created synthetic dollars of sorts by borrowing yen and investing in U.S. dollar-denominated assets such as U.S. Treasuries. This has been building and building and building on itself so that no one even knows how many printing presses are actually running. The day of reckoning on carry trades will come when the Bank of Japan is forced by the market to raise rates rapidly and there is a mad scramble to get out of dollars and back into yen. Rest assured, these events will be anything but orderly when they happen.
Initial sponsorship of “legal counterfeiting” came from the Fed and central bankers in general, but once Wall Street got hold of the magic printing presses, things have gotten more than a little out of hand. This is what happens when you have money backed by nothing and borrowed into existence. This is also what gold lovers see when they recommend gold.
Ponzi schemes can only go so far before they collapse on their own accord, and it is important to recognize what is happening now with stock buybacks, leveraged buyouts, and various carry trades for what it is: one giant Ponzi scheme. This scheme will end the way they all do when the willingness or ability to take on more debt stops and/or when the willingness to further speculate stops. When either of those happens, there will be a mad rush for the exits and no more buyers for “overpriced tulips” will be found. Be prepared.Link here.
Vampires, Money, and Economic Cycles
Jesús Huerta de Soto has written the ultimate vampire book (PDF). He tracks these bloodsucking monsters from the first documentary records in ancient times to the modern apologia for their maintenance at public expense. At last, there is a single book that scientifically explains the origin of vampirism, the magnitude of their drain on society, and proposes a systematic plan for their humane extermination.
De Soto goes through old legal arguments and shows that the right of a person to keep their own blood was established in Roman times. Also, he demonstrates that the concept of “fractional-reserve blood banking” violates all logically derived legal codes. Two people cannot both own and use the same hemoglobin molecules in different bloodstreams at the same time. No one would ever try to establish a system where two or more people owned the same property at the same time, you say? That is generally true. Grain elevator operators do not try to loan out 10 times more grain than they actually have in their bins. And if you make an autologous blood deposit for an operation, they will not loan your blood to ten different vampires so that it is gone by the time your operation comes around. But vampires do not control the grain or blood storage industries. They control the banking industry.
In Chapter Two, de Soto traces the history of the vampire bank, back into Greek and Roman times. Archaeologists have laboriously dug up the dusty records of many ancient banks. The records have a unifying feature: the banks, from whatever century, were fractional-reserve frauds, and every single one eventually defaulted. The histories of Athens, Ptolemaic Alexandria, and Rome show the effects of monetary expansion and contraction.
The author points out that one overriding factor pushes bankers into fraud. Of course there is always the desire for short-term gain, but that would generally be overcome by the desire for good reputation and long-term business. The deciding factor is the threat of confiscation by government. Banks with actual precious metal in their vaults were more tempting targets for gangsters like Alexander, Caesar, Herod, Cleopatra, etc. than “banks” which had loaned out their reserves a couple of times over. Fractional-reserve banks offered an opportunity for cooperation with the gangsters, in the form of armed force against depositors who wanted their money back.
The history lesson continues into the late Middle Ages, where we are shocked ... shocked ... to find that the Medici banks were not completely honest. They caused a decade-spanning economic collapse right before the Black Death. Then in a bizarre twist we have to suffer through the story of the Bank of Amsterdam and a 150-year period of perfect banking honesty. No panics, no cheating, no economic cycles, just steady economic progress through revolutions, wars, and disasters of every kind. It is the only known example of such length.
Chapters 3–8 could be called “You can’t eat your cake and have it too.” Here are the essential points about fractional-reserve banking:
BTW, this is where we are today. The Fed has printed piles of money during the Clinton-Bush years. The capital structure contains piles of misinvestments. Now, either there has to be a recession while we reorganize our resources to produce for the consumers that actually exist. Or the Fed can just keep increasing the rate of the presses and print us into a hyperinflation, like Weimar Germany or Chiang Kai-Shek’s China. If they cannot find businessmen to borrow and malinvest, they can always find politicians ready to launch expensive WMD searches ...
The last chapter of Money, Bank Credit, and Economic Cycles points out that we do not have to live like this. We do not let grain elevators lend out ten times more grain than they have, then back them up with tax-supported bailouts. We do not let vampires run the blood banks. If we did not let vampires run the money supply, then systematic malinvestment and recession would be a thing of the past. The cost of wars would be harder to conceal as well. No wonder vampires like fractional-reserve banks.Link here.
SUBPRIME LENDING IN CONTEXT
The profit motive is fundamental to capitalism. Not well understood, vulnerability to credit-induced profit distortions is a capitalist system’s Achilles heel. To be sure, profits malformations develop with differing severities throughout the Economic Sphere (real economy). Yet, within the Financial Sphere, grossly inflated financial profits over the life of the credit cycle evolve to the point of commanding the real economy and imperiling systemic stability.
More specifically, major credit booms are dictated by unyielding financial sector expansion, inflated profits, and resulting outsized power and influence. The longer they are accommodated the more entrenched they become. Coupling the impacts of surging financial earnings and pervasive asset inflation, credit booms generate a “profits” bonanza for those fortunate enough to be employed in key industries – and certainly provide a windfall for the owners, operators, financiers, and brokers of inflating assets. The interplay between Financial Sphere profits and asset inflation creates an increasingly powerful impetus for problematic resource misallocation and economic maladjustment.
Subprime lending is today a microcosm of our financial and economic systems’ vulnerability. Over the prolonged life of this boom, the subprime industry has expanded spectacularly, motivated by easy and seemingly unending profits. And, surely, few industries offer the capacity to grow earnings rapidly as lending to risky credits during a boom. The industry was instrumental in financing a historic homebuilding Bubble, in the process playing a meaningful role in the ongoing economic expansion. Subprime industry insiders have made fortunes, as have Wall Street investment bankers. And endless high-yielding mortgages have been a godsend to the collateralized debt markets, the leveraged speculating community, and derivatives markets generally.
Today, subprime loan exposures have been disbursed throughout our system’s financial institutions, securitizations, and derivative markets to an extent never before imagined. It is my view that, at least for the most part, subprime is not a viable business over the entire life of the business cycle. Invariably during the boom – with cheap finance too readily available and a broadening cadre of aggressive lenders, financiers, and speculators actively pursuing their share of ballooning profits – subprime loans will be under-priced and grossly overextended. There will be dire consequences. And the more protracted the boom, the greater will be the systemic impact of the mispricing and overexpansion of subprime finance. Inevitably, there is no escaping the reality that the industry is a Ponzi Finance Unit, acutely dependent upon new liquidity to sustain lending volumes and, hence, asset prices, borrower solvency and loan quality.
Importantly, amidst credit euphoria, the overextension of loans will inflate collateral values (home prices) and boost the general economy. With home prices up, unemployment down, and credit all around, few will be forced into default and foreclosure. Subprime profits will be distorted both by inflated revenue growth (surging loan volumes, gain on sale at inflated prices, and attractive spreads on retained portfolios) and by artificially low credit losses. The outstanding performance of subprime securitizations and related derivatives will entice only greater speculator interest and sector liquidity overabundance, pushing up the price (down the yield) of risky mortgages. In the real economy, easy finance and housing price inflation spur overbuilding, overspending, and a misallocation of resources.
Subprime lending notoriously understates future credit costs and overstates current profits/returns. And as long as individual lenders and the industry overall each year expand the scope of lending, rising revenues (from new loans) can remain somewhat ahead of mounting credit losses (from old loans). But the longer this inflationary process is allowed to proceed the greater will be the unavoidable (Ponzi) bust. Actually, it is my view that with our entire credit system now operating as a Ponzi Finance Unit, the “prime” mortgage market functions with similar dynamics as those noted above for subprime.
We are in the midst of a unique credit cycle. The ability for originators to sell loans and immediately book profits; for investment bankers to buy, securitize and immediately book profits; and for leveraged speculators to acquire various securitizations and other derivatives and book easy profits have all made this credit boom unlike any other. In particular, the ability to securitize loans in the highly liquid ABS/MBS marketplace, as well as insure/speculate on credit performance in booming derivatives markets, has – or perhaps in the case of subprime, had – radically altered the capacity to prolong the credit cycle.
Today, subprime mortgage originator profits are collapsing. Lending volumes are sinking, “gain on sale” is reversing to loss, credit losses are surging, and the liquidity necessary to operate is disappearing overnight. This has initiated the ugly downside of operating as a Ponzi Finance Unit. The issue of early payment defaults – where investment bankers/securitization pool operators return problem mortgages in droves back to the originator – is rapidly bankrupting this thinly-capitalized industry. And the more acute the risk of insolvency, the greater the incentive for investment banks to rush to dump problem loans while the originator still retains some liquidity (think “bank run”). Last week, California originator ResMae filed for bankruptcy after Merrill Lynch sought to return $520 million in mortgages.
This has enormous ramifications for the industry. Subprime credit conditions are in the process of tightening. How tight only time will tell. Subprime borrowers this year facing payment resets will confront a changed industry. Those with second mortgages or hoping to add a home equity loan will face much tighter lending standards. Desperate borrowers stretched the truth in 2006 to get new mortgages approved. Such tactics will not be so easy in 2007. The weakest originators are disappearing and those left will, at the end of the day, be much more prudent and disciplined. Scores of borrowers will be left in the lurch.
But like everything else associated with this most extraordinary credit cycle, the analysis is infinitely more complex than what meets the eye. We are undoubtedly in the midst of a major liquidity event for the subprime originators. Additionally, the riskiest CDO and securitization tranches (and related derivatives) will suffer heavy losses. This is a decisive credit event for the subprime industry, likely marking a major reduction in new subprime loans and escalating credit losses. Thus far, however, there is little indication that the (paramount) market for “prime” mortgages is being impacted much at all. And when it comes to the subject of overall system liquidity, the current level of tumult could prove less than significant.
In a differen, perhaps more typical, environment, recent subprime developments would prompt a nervous reaction from the markets. But today we operate in a most extraordinary backdrop of rampant global liquidity excess. Clearly, a strong inflationary bias permeates credit systems around the globe. More ambiguous but equally important, indications point to continued robust expansion in securities finance, at this stage of the credit cycle a liquidity-creating behemoth. Markets have no doubt how the Bernanke Fed will respond to mortgage problems that risk heightened systemic stress, and this confidence certainly underpins leveraged speculation. The sound of collapsing mortgage companies is music to the ears of the more ambitious.
For now, it would appear the overall Financial Sphere profit motive is little diminished by subprime woes. There is a pocket of fear, yet the vast financial world is still largely dictated by greed. Importantly, however, faltering profits in subprime will entail a change in the flow of speculative finance – at least at the margin, a potentially disruptive development for related securitizations and derivatives. How the unfolding subprime debacle influences the flow of finance to “prime” mortgage and corporates is decidedly up in the air.
But another swath of the now enormous leveraged speculating community is in the process of being clipped, leaving the leveraged players at least somewhat more vulnerable. And perhaps even the Wall Street firms will decide to ratchet risk exposures down a tad at the margin. It is worth noting that the yen rallied abruptly this week, placing yen “carry trade” bets on somewhat less sure footing. The dollar index closed down almost 1% for the week, slipping again below 84. The ongoing global equities market melt-up does not alter the troubling reality that monetary disorder is in full swing. We should expect global markets to be unsettled and worthy of careful analysis. Subprime may not be a factor precipitating meaningful liquidity destruction, but it could nonetheless play a role in further destabilizing a highly unstable financial system.Link here (scroll down).
Investors in mortgage-backed securities fail to react to market plunge.
It is amazing how long it can take investors to see that the wheels are coming off a prized investment vehicle. Denial is a powerful thing. But when an imperiled favorite happens to be a pool of asset-backed securities – especially those involving home mortgages – denial can be compounded by outright blindness to the real risks of that investment.
That may explain why, even as everyone concedes that the subprime or low-grade mortgage market has fallen into the sea, the vast pools of mortgage-backed securities (MBSs) built in part on those risky mortgage loans still appear to be on solid ground. Investors, chasing the buzz of ever higher yields, have flocked into the MBS market in recent years. Nobody wants to think that the possibility of a wide-ranging subprime debacle is also a harbinger of looming problems for investments tied to those loans. But the reality is that these vehicles – and the collateralized debt obligations that hold them – are not as secure as many believe. And that has broad implications for the capital markets.
Consider how torrid the issuance of these securities has been in recent years. In the last three years, for example, big banks and brokerage firms almost doubled the amount of residential loans they issued, going to $1.1 trillion last year from $586 billion in 2003. Many of these loans have been packaged into collateralized debt obligations (CDOs) and sold to pension funds, hedge funds, banks and insurance companies. For example, 81% of the $249 billion in CDO pools in 2005 consisted of residential mortgage products. CDOs are made up of different segments – known as tranches – based on credit quality. Because buyers of these securities were looking for yields, subprime loans make up a large portion of most collateralized debt obligations.
Wall Street, of course, has coined major money in this area. Mortgage-related activities at the major firms generate an estimated 15% of total fixed-income revenue, according to Brad Hintz, an analyst at Sanford Bernstein. But few seem worried about what might happen to these players if tremors in the subprime market worsen, or if supposedly more-creditworthy loans in the upper tranches begin to go bad.
One of the arguments for why mortgage loan pools have held up even as the subprime mortgage industry has collapsed is that their collection of a wide array of debt obligations provides a margin of safety. In addition, downgrades on these loans from the major rating agencies have been relatively modest. This is puzzling, given the wreckage in the subprime market – lenders going bankrupt, stocks of issuers falling, default rates on new loans well above historical averages. Last year, Moody’s, for example, downgraded just 2% of the home equity securities rated by the agency. Among the 2005 and 2006 issues, many of which are defaulting at high velocity, Moody’s has put less than 1% of the total subprime deals rated in those years on review. “[W]e have increased our loss expectations by 25 to 30 percent,” said Debashish Chatterjee, a senior analyst in the residential mortgage-backed securities area at Moody’s. “We see the ratings outstanding on deals securitization in 2005 and 2006 and have taken steps to provide credit enhancement on them.”
But credit enhancement does not necessarily involve cash. Instead, the cushion can be additional mortgages or loans, which may also become vulnerable. It is becoming clear, however, that subprime mortgages are not the only part of this market experiencing strain. Even paper that is in the midrange of credit quality, one step up from the bottom of the barrel, is encountering problems. That sector of the market is known as Alt-A, for alternative A-rated paper, and it is where a huge amount of growth and innovation in the mortgage world has occurred. Alt-A used to consist of mortgages issued to professionals like doctors with unpredictable incomes. Now Alt-A is dominated by so-called affordability mortgages – adjustable-rate interest-only loans, 40-year loans and silent-second loans. In 2006, according to UBS, interest-only loans, 40-year mortgages and option-adjustable-rate mortgages comprised more than 75% of Alt-A issuance. 3.16% of these loans are already delinquent by two months or more.
Last week, Standard & Poor’s put 18 classes of securities from 11 residential mortgage pools on watch for a downgrade. Alt-A loans were among those on the watch list, but S&P said its move to credit watch status on these mortgages would have no impact on outstanding CDO ratings. Relying on rating agencies to analyze the risk in collateralized debt obligations may be unwise, however. In May 2005, Alan Greenspan noted the complexity of CDOs and the challenges they pose to “even the most sophisticated market participants.” He warned investors not to rely solely on rating agencies to identify the risks in these securities.
That is also the view of Joshua Rosner and Joseph Mason. The two recently published a paper, “How Resilient Are Mortgage-Backed Securities to Collateralized Debt Obligation Market Disruptions?”, analyzing CDOs. Mason and Rosner find that insufficient transparency in the CDO market, significant changes in asset composition, and a credit rating industry ill- equipped to assess market risk and operational weaknesses could result in a broad financial decline. That ball could start rolling as the housing industry weakens, the authors contend. They say it is only a matter of time before defaults in mortgage pools hit returns in CDO pools. Of greater concern, they say, will be the effect on the mortgage market when investors, unhappy with poorly performing CDOs, sell them and move on to other forms of collateral. After the manufactured housing market collapsed in 2002, managers of CDOs avoided the sector.
A similar shrinkage could occur in the residential mortgage sector as defaults mount. “Decreased funding for residential mortgage-backed securities could set off a downward spiral in credit availability that can deprive individuals of home ownership and substantially hurt the U.S. economy,” the Mason and Rosner paper said. So far, the pain from subprime defaults has been muted. Market participants are cheered that lenders are finally tightening their loan standards, albeit a bit late. Unfortunately, the damage of the mortgage mania has been done and its effects will be felt. It is only a matter of when.Link here.
Tough times ahead for housing and sub-prime lenders.
I would love to sit here and jump on the bullish housing bandwagon that dominates Wall Street. Really, I would. But I am not a fan of flushing my money down the toilet. In reality, the housing market has not bottomed. Sub-prime lenders are doomed. You can continue to listen to the delusional madness pouring from the mouths of Street analysts, and the mainstream press, or you can listen to the homebuilder CEOs and the sub-prime lenders that have gone belly up because of a weak housing market. It is your choice. But I would go with the latter, though.
Even JP Morgan’s CEO, James Dimon, is bearish on the sector, saying, “Mortgages are the one area of sub-prime lending where ‘we really see something taking place that looks like a recession ...’” That is just an inkling of the tumultuous future for sub-prime lending. MortgageDaily.com believes “The sub-prime sector still has another year of tough times ahead.” Countrywide Financial says, “We’ve got another eight, nine, 10, 12 months of headwinds. You’re seeing 40 or 50 (sub-prime companies) a day throughout the country going down in one form or another. I expect that to continue throughout the year.”
A recent Center for Responsible Housing report projects that “2.2 million borrowers will lose their homes and up to $164 billion of wealth in the process.” Even MarketWatch.com has reported, “Signs of credit deterioration from the slowing U.S. housing market have already shown up in recent results of other banks as more borrowers fall behind. Foreclosures jumped 35% in December versus a year earlier, according to recent data from RealtyTrac. For the fifth straight month, more than 100,000 properties entered foreclosure because the owner could not keep up with their loan payments, the firm noted.”
Better yet (at least for those on the short side), there is still plenty of negativity that has not been priced in. We are looking for further downside for six companies with connections to sub-prime lenders. One thing is for certain – the worst is not over for sub-prime lenders.Link here.
THE DEBT THAT HOUSE BUILT
The American consumer is a modern-day miracle-worker. Possessing assets worth little more than two loaves of bread and five fish, along with a few lines of credit, he manages to feed an $11 trillion economy. The bread and fish do not multiply, of course, but the lines of credit multiply without limit, which means the U.S. economy never misses a meal. But what if, one day, lines of credit failed to multiply? And what if home-equity lines of credit, in particular, disappeared like Egyptian soldiers under the Red Sea? How would the U.S. economy fare?
The answer seems rather obvious. Bad things would happen. And yet, nothing bad ever seems to happen to the debt-powered American economy. No financial plagues ever sweep across the land. Therefore, the American economy’s recent history of miraculously tranquil, stress-free growth inspires many an economist to predict more of the same. We hope they are right. But we doubt they are.
The nearby chart tells the grim tale, or at least most of the tale. Investment in residential construction, also know as homebuilding, is plummeting, as is the growth of personal spending. A careful examination of the chart reveals that the residential construction trend tends to lead the personal spending trend. Thus, since investment in residential construction is plummeting, we should expect a corresponding drop in personal spending, and in overall economic activity. Since 1948, observes Chris Puplava of financialsense.com, “whenever residential fixed investment falls to or below a -10% year-over-year rate of change, we have seen a recession, with only two exceptions: 1951 and 1967. Residential fixed investment is currently at a negative 12.6% year-over-year rate, marking only the eleventh time this has happened in more than five decades. ...”
The “why” of this relationship between falling residential investment and recession is fairly intuitive: (1) Residential fixed income falls only during times when home prices are soft. (2) Home equity represents more than half of household net worth, and close to 75% of middle class household net worth. If residential investment is falling, then home prices must also be falling. And if home prices are falling, most Americans, especially middle class Americans are feeling poorer. (Falling home prices also eliminate the opportunity to obtain a “cash out” home mortgage.) If Americans are feeling poorer, and cannot gain access to fresh lines of credit, will they not curtail discretionary spending ... at least to some extent?
“Private households in the United States embarked on their greatest borrowing binge of all time, fostered and facilitated by the rampant house price inflation and a most aggressive financial system,” observes Dr. Kurt Richebacher, editor of the Richebacher Letter. “Over the five recovery years since the end of 2001, their overall indebtedness surged by 66%. This compares with a much slower debt increase in the prior recovery years from 1995-2000 by 43.9%.” Household debt has been soaring, he explains, because home values have also been soaring, thereby enabling homeowners to “extract equity” from their homes. “Therefore, what has been happening on the balance sheets of private households, has been a race between booming ‘wealth creation’ through rising house prices and soaring indebtedness.”
So far, housing-driven wealth creation has been winning. But the housing-market hare is starting to lag behind the liabilities tortoise ... which is why the vibrancy of the U.S. economy may be faltering before our eyes. “The growth rate of real U.S. GDP has been steadily falling,” Richebacher notes, “from an annualized rate of 5.6% in the first quarter of 2006 to 2.6% in the second and further down to 2.0% in the third quarter.” And most early economic indications from 2007 imply that the new year may not be a happy one.
The housing slump may not deserve all the blame for America’s weakening economy. Just most of the blame. “Housing and its importance as a major contributing factor in GDP ... has turned from a tailwind into a headwind, as residential fixed investment has contracted,” observes Chris Puplava. The slump in housing deepened during the final three months of last year with sales falling in 40 out of 50 states. Not surprisingly, therefore, housing-related employment is tumbling from coast to coast. “It’s a whole new world,” one mortgage lender told Northern California’s Contra Costa Times. “We’re hunkered down for a cold winter. We’re not sure when spring will arrive. The chill of winter has also descended upon the retail sector. Retail trade employment recently turned negative. Clearly, the coincident declines in both real estate employment and retail employment imply a commensurate decline in overall economic activity.
In Q3 2005, mortgage equity withdrawal (MEW) crested at $1.02 trillion. That is quite the ATM! Since peaking, MEW has fallen to $730 billion in the Q3 2006, still a sizable number, though it is the rate of change that is important. As MEW is seeing a negative rate of change, it is contributing negatively to consumer spending. This can be seen above with the change in retail sales contracting almost in lock-step fashion with MEW. Both have been trending closely since 2000, although not prior to then – illustrating housing’s dominant role in the economic expansion since the last recession. “But even if consumers completely stop borrowing more debt,” Puplava warns, “their financial obligations are likely to continue climbing ever higher as their net worth decreases due to falling home prices and their debt burdens rise from ARMs resetting at higher interest rates.”
Woe to the American consumer ... and to America’s consumer-driven economy.Link here.
BUILDING SLUMP? NOT ON THE COMMERCIAL SIDE
The residential housing market may be hibernating this winter, but hard hats around the country are increasingly busy setting I-beams and rivets on new towers, warehouses, industrial parks, and retail space. Some snapshots:
Residential construction fell 2% last year, but private commercial construction rose 16%, and public construction was up 10%, according to the U.S. Census Bureau. The last time the business was this strong was seven years ago, says Kenneth Simonson, chief economist for the Associated General Contractors.
Behind the commercial-construction push is a combination of powerful economic forces. For one, gigantic investment pools – some from overseas – are looking for places to invest. Also, an enormous growth of imports into the U.S. is spurring a rush to build new warehouse space. Moreover, developers are building new communities that offer environmentally friendly spaces to work and require less commuting time. These complexes also offer nightlife and restaurant options.
In some areas, commercial rents are rising, reflecting the growing demand for first-class office space. Some construction specialties were soaring last year. Construction for new hotels was up 52% compared with 2005, according to preliminary figures by the U.S. Commerce Department. Likewise, factory building rose 20%, and office building 18%. The pickup is so strong that it has absorbed many workers who had been involved in residential construction. Last month, for example, while 80,000 jobs were lost in residential construction, commercial contractors hired 180,000 workers.
The business is now so good that some construction executives are worried. “We are always concerned when there is so much money out there, it entices people to build what should not have been built in the first place,” says Alan Beaudette, chairman of the National Association of Industrial and Office Properties, who is also senior vice president of Lowe Enterprises Real Estate Group in Irvine, California. “[Five to 10 years ago], it was easier to find high teen returns on your investment, and that is now more difficult.”
The commercial construction market is driving up the price of essential building materials such as cement, steel, and gypsum. And it goes beyond commodities: There may even be shortages of contractors who can handle complex projects, says Bill Scott, executive vice president at Linbeck Construction in Houston.
Even some parts of the country where construction has lagged in the past are experiencing a boom. That is the case in Denver, says Michael Brendle, a design principal at the architectural firm RNL. A 22-story tower and five-story building – both being built to “green” standards – are going up in the downtown area. The developer is building them on “spec” – without major tenants signed up in advance. “It shows a lot of confidence in the market,” says Mr. Brendle.Link here.
WALL STREET’S NEXT INSIDER TRADING SCANDAL
In early February, the SEC confirmed that it was investigating whether the major brokerage houses were tipping off hedge funds to the trades the brokers handle for big clients like mutual funds. If that is happening, it would be a scandal. The SEC is also likely to scour trading records to see if the brokers are using information about clients’ moves to invest their own capital. If the SEC finds evidence that they are, the scandal would be enormous – and go to the heart of Wall Street’s profit machine.
A big question mark hangs over Wall Street: How is it that the top firms consistently beat the odds, earning spectacular returns on their own investments? Last year the five biggest U.S. investment banks – Morgan Stanley, Goldman Sachs, Merrill Lynch, Lehman Brothers and Bear Stearns – generated $61 billion from proprietary trading, about half their total revenue and a 54% increase over 2005. Those returns have raised eyebrows for years. “Even the greatest investors lose money at some point, but the Wall Street firms never seem to lose,” marvels Tiger Williams, chief of Williams Trading, a firm that attributes its success to keeping its hedge fund clients’ trades strictly confidential.
Some Wall Street insiders are pretty sure they know the secret. “Privileged information is the real currency that runs Wall Street,” says Doug Atkin, the former CEO of Instinet who now runs the research boutique Majestic Research. “With what the traders at the big firms know, my 11-year-old son could make tons of money.”
Here is a hypothetical example, gleaned from former Wall Street traders as well as outsiders who worked closely with them, of how some people think the Street exploits information. Say a fund company, call it Big Dog, wants to buy a million shares of Intel. A Big Dog trader calls a broker at a Wall Street firm – call it Megabux. The broker enters the order into the Megabux trading system. A dozen Megabux “sales traders” get the info on their computer screens. Their job is to find sellers for the shares. But first they call their top hedge fund clients, giving them the chance to buy some Intel before Big Dog pushes up the price. To cover their tracks, the hedge funds do not buy the Intel shares through Megabux, but they reward their benefactor with a lot of other big trades and by paying higher commissions than the mutual funds do.
That may not be the only way Megabux makes money on its knowledge of clients’ trading activity. The broker who takes the order can pass the info on to Megabux’s proprietary trading desk. The proprietary traders do not load up on Intel before Big Dog does – that would be [blatantly] illegal. But say they know that when Big Dog is interested in a stock, it usually ends up buying several million shares, and thus will soon purchase more. Megabux buys shares of Intel (or of a tech index fund that holds Intel, or other stocks in the sector) after the first order. When Big Dog returns for more, pushing up the price again, Megabux makes a quick profit. The practice is hard to trace and may or may not be illegal. But it still hurts investors in Big Dog’s funds by forcing Big Dog to pay prices that are inflated by the leaks. (The brokers have said repeatedly that they have safeguards in place to make sure such activity doesn't occur.)
Why would mutual funds put up with such abuse? “They need access to Wall Street’s research and clearing services and to IPO allocations,” says Atkin, so they have to keep trading with the big brokers. Even if mutual funds were to do all their trading on electronic systems like Liquidnet that promise anonymity, Wall Street has another potential source of intelligence – the hedge funds themselves. Some big banks have “prime brokerage” operations that clear and settle trades for hedge funds. The prime brokers see what hedge funds buy and sell every day, though they insist that they do not share that data with their proprietary traders. The SEC has demanded the names of the firms’ prime-brokerage clients. So we may soon learn more about whether those sumptuous profits are a result of rare genius ... or of an unfair edge.Link here.
MARKETS GET A BIT TOO CALM AND COZY FOR COMFORT
Conditions are so calm and orderly in the financial markets right now, it is enough to make a person squirm. Most days it is a pleasant business to check the progress of one’s stocks and mutual funds. Too pleasant. A sense of uncertainty and the natural messiness of life is missing.
I am hardly the first to raise these concerns. For months now, analysts who keep track of sentiment toward stocks have been decrying an overabundance of bullishness. In the domestic bond market, and in international markets for both bonds and stocks, skeptics complain that investors are not getting paid as much as they should for taking extra risk. Prominent investors regularly voice their misgivings. It hit home personally for me the other day as I exchanged e-mails with a newsroom colleague happily noting gains in a couple of his favorite funds. “I agree,” I told him. “It is a fun time to be a mutual-fund investor.”
Fun? There is a red flag if I ever saw one. It is not as though we are back in the 1990s, when stock prices soared in open defiance of all traditional rules of value. In those days “irrational exuberance” was on display for all to see. But today the P/E of the S&P 500 is 18, not 30. To find the signs of creeping complacency, you have to look a little deeper. For instance, the extra yield demanded by investors in lesser-quality – “junk” – bonds has lately dropped to its lowest level in almost a decade. The rate of default in these bonds has also lately gone to extreme lows, at less than 2% per year. Still, investors are paying little heed to the possibility that defaults might rise, as Moody’s has lately predicted they will.
Other elements of the story can be seen in the stock-index charts. The S&P 500 has not had a losing month since last May, and that was the only negative showing since the end of 2005. It has been more than four years since the index suffered a 10% setback. Between last May 8 and June 13 the S&P 500 dropped 7.4%, the small-stock Russell 2000 Index fell 14% and a Morgan Stanley index of emerging-markets stocks around the world tumbled 24%. Those chastening risk-reminders proved easy to shrug off, however, as all the losses were quickly recouped. The Russell 2000 climbed back above its early-May peak by November, and the emerging-markets index by early December.
A sense of calm and confidence also flows naturally out of the state of the economy and Federal Reserve policy. The U.S. central bank has now held short-term interest rates steady for more than seven months. When Fed Chairman Bernanke testified before two congressional committees last week, it was clear he was in no rush either to raise or to lower rates. Bernanke sees signs that inflation is headed lower still, and global economic growth remains strong. “[T]he weakness in housing market activity and the slower appreciation of house prices do not seem to have spilled over to any significant extent to other sectors of the economy,” he said.
The markets also owe their steadiness to some purely financial forces. The dramatic growth of credit derivatives has changed the way risk makes its presence felt in the bond market. Hedge funds, which play markets from both sides, have helped to diminish volatility by jumping quickly at every perceived pricing anomaly. Thanks also go to strong, steady flows of new money from sources as disparate as Asian central banks and mutual fund investors. Are any or all of these forces subject to change without notice? Of course. The future is bright, most likely, but it will not always be fun.Link here.
THE DUMB MONEY GETS DUMBER
“The warning signs of a stock-market correction have been looming overhead like a flock of seagulls over a freshly washed sports car,” observes our colleague Jeff Clark, the insightful editor of the Short Report. “Yet investors continue to drive with the top down.” One of the “warning signs” that troubles Jeff is the slumping share price of Merrill Lynch (NYSE: MER). Jeff observed, “This stock is one of the best leading stock market indicators I’ve ever seen. If the price action of MER is bearish, you can almost always bet the overall market is due for a fall. I even had a saying around my brokerage office, ‘As Merrill goes, so goes the stock market.’ ... Right now, the chart of Merrill Lynch looks bearish.”
MER has slumped nearly 6% since January 12th, which is one reason why Jeff suspects the S&P 500 might also begin slipping from its recent all-time highs. “Last May,” Jeff remarked, “MER peaked on the day the company announced record earnings. It then dipped below its 50-day moving average and ultimately lost 20%. The S&P 500 followed shares of MER lower and gave up 8%. Last month, MER peaked on the day the company announced record earnings. Last Friday, it dipped below its 50-day moving average. Does anyone care to guess what should come next?”
The latest Commitment of Traders Report from the CFTC provides additional evidence that the stock market is topping. The Commercial traders have been increasing their net-short position in S&P 500 futures contracts for several weeks. Commercials, often called the “smart money”, have amassed their largest net-short position since just before the stock market selloff of last May and June. Not surprisingly, the small speculators – a.ka., the “dumb money” – are taking the other side of this trade. This usually-wrong crowd has amassed its largest net-long position in several months. The smart money is not always smart, of course, and the dumb money is not always dumb. But when the dumb-money begins to exhibit extreme confidence and complacency, the smart money usually begins to look quite smart indeed.Link here.
Investment risk, 2007 edition.
I spend a lot of time talking about investment opportunity. Today I want to talk about its twin brother: investment risk. The biggest risk I see this year is not the potential for a housing crash, higher energy prices, rising interest rates, a faltering economy or even another major terrorist attack, although any of these are possible. The biggest risk right now, in my opinion, is complacency.
Over the last few years, financial markets have risen so far – and with so little volatility – that the general perception seems to be, “Come on in, the water’s fine!” This is not the way financial markets generally work. Ordinarily, equity investors enjoy superior long-term returns only because they regularly endure stomach-churning drops along the way. Lately, however, investors have enjoyed all gain and no pain. The DJIA, for instance, has gone 922 trading days without a 2% daily decline – the longest stretch in history.
The combination of low rates, high returns and minimal volatility are creating the impression in the minds of many investors that maybe riskier investments are not so risky after all. Big mistake. Money flows show that right now, investors favor growth stocks over value stocks, small-caps over large-caps, foreign markets over domestic markets, and emerging markets over developed markets. They are also plunking for corporate bonds over government bonds, and junk bonds over investment-grade bonds. Add in record volume in options and futures trading, highly leveraged speculation in the real estate market, and the ardent desire for Mom and Pop to plunk a portion of their retirement money in someone/anyone’s hedge fund, and you have the potential for some very unpleasant surprises.
I do not want to sound like Gloomy Gus. There are plenty of reasons for optimism. But a lot of folks who are taking big risks may not understand the potential downside, and in many cases are not being compensated adequately. The spread between high-yield bonds and Treasury securities, for instance, has narrowed to 3.25% from a historic average of 5%. The gap between bond yields in emerging markets and U.S. markets has decreased to 1.75%, down from 4% just seven years ago.
What is the solution here? I would start with a gut check. If we had a major market break, how would you feel?
It pays to heed the words of legendary fund manager Peter Lynch: “If you are going to panic, do it early.” Because – trust me on this – by the time it is splashed all over the front page of the paper, the horse will already be out of the barn. There is no avoiding risk. But you can manage it intelligently. Avoid letting the complacency that is affecting so many investors creep into your own investment outlook. Take a look at your overall investment posture, and recognize that the market never tires of throwing us the occasional curveball.Link here (scroll down).
A CLEAN SWEEP
Value, like beauty, is always in the eye of the beholder. And lately, a growing population of “beholders” are finding a thing of value in the long-term prospects for alternative energies – primarily wind and solar. Unfortunately, very few of these “cleantech” companies are statistically cheap. For example, the stocks inside the PowerShares Cleantech Portfolio ETF (NYSE: PZD) sell for an average of 100 times earnings! This is more than five times the S&P 500’s PE ratio. The cleantech sector, therefore, does not feature “value” in the classic Graham and Dodd sense of the word. An investor cannot buy one dollar’s worth of assets for 50 cents. Instead, the value that exists is prospective, based purely on the expectation of rapid growth.
The solar industry offers one very tantalizing example. The worldwide solar power industry has more than tripled its installed capacity of electricity generation over the last three years. Yet, despite this breakneck growth, solar power still provides only a miniscule percentage of the world’s energy needs. In fact, “renewable” energy sources – excluding hydroelectric – provide less than 1% of the world’s electric power. And even after including every hydroelectric plant in the world, the combined contribution from ALL forms of renewable energy totals less than 3% of the world’s installed capacity.
Clearly, therefore, the alternative energy industries enjoy tremendous growth prospects. Clean Edge, a U.S.-based industry observer, expects the respective markets for both solar and wind power to grow from their current levels around $11 billion per year to $50 billion each by 2015. Even so, identifying the fastest growing companies in these sectors is no easy task. Many alternative energy companies generate little to no earnings. Some never will. But since it seems relatively obvious that these companies will provide a growing share of the world’s power needs, investors might want to gain broad exposure to this diverse, rapidly growing group.
A variety of newly minted mutual funds and exchange-traded funds (ETFs) focus on “cleantech” and alternative energy stocks. The brand new Allianz-RCM Global Ecotrends (AECOX), for one, invests in companies with exposure to what it calls, “Eco-Sectors”. The fund, which commenced trading as of just two weeks ago, invests in companies that provide alternative energy, energy efficiency, pollution control, water treatment and water supply. In contrast to this upstart, the New Alternatives Fund (NALFX) has been doing its alternative thing for more than two decades. NALFX describes itself as “a Socially Responsible Mutual Fund Emphasizing Alternative Energy and the Environment.” The fund invests in every imaginable spect of alternative energy and pollution control.
Another relative “old-timer” is the Merrill Lynch New Energy TEC (London: MNE, US: MLGYF). This London-traded investment trust, which has been operating continuously for over five years, focuses on “companies which have a significant focus on alternative energy or energy technology.” The $240 million investment trust currently sells for about a 4% premium to its NAV. This trust trades infrequently in the U.S.
Within the universe of ETFs, the Powershares family operates a several alternative energy portfolios: The Powershares Wilderhill Clean Energy (NYSE: PBW) “invests at least 80% of its assets in common stocks of companies engaged in the business of the advancement of cleaner energy and conservation,” according to the fund’s website. The PowerShares Cleantech Portfolio (PZD) mirrors the Cleantech Index, which is comprised of 75 companies engage in the cleantech industries. Lastly, the PowerShares Progressive Energy Portfolio (PUW) mirrors the Wilderhill Progressive Energy Index. Although these three ETFs hold several positions in common, they each possess a distinct focus within the cleantech universe. For additional detail, click here.
Another “cleantech” ETF to spring from the investment banking womb was the Market Vectors Environmental Services ETF (Amex: EVX). This ETF invests primarily in waste management and other environmental services. A brand new cleantech ETF, whose name may be setting a Wall Street record for length and euphemisms, is called the First Trust NASDAQ Clean Edge U.S. Liquid Series Index Fund (NASDAQ: QCLN). According to the fund’s marketing materials, it will invest in “companies engaged in the manufacturing, development, distribution, and installation of emerging clean-energy technologies such as solar photovoltaics, biofuels, and advanced batteries.”
We will leave our brief survey of cleantech mutual funds and ETFs here. But we should offer a few words of caution, as well. Despite the compelling long-term growth story of alternative energy and clean technologies, investors cannot afford to ignore a couple of important risks. First, this sector is very volatile. Second, this sector is very speculative. The world of highly valued, “growth” stocks is fraught with risks ... particularly if growth fails to materialize. Finally, alternative energy stocks and funds tend to closely track the rise or fall of oil prices. This relationship is no mystery, of course. High oil prices render alternative energy technologies more attractive as long-term investments, while also inspiring demand for things like solar panels and wind turbines.
Out in the real world, therefore, alternative energy companies offer a bona fide alternative to traditional carbon-based sources. But on in the world of portfolio diversification, alternative energy stocks can provide a very poor alternative to conventional energy stocks. Despite the risks, however, the potential rewards loom large for cleantech companies. Rapid earnings growth usually produces beauty in the eye of the shareholder.Link here.
The Solar Revolution
Recently, an inquisitive reader wrote, “Your recent pick of Suntech (STP: NYSE) appears quite sound. I have read many good things since. However, one question did come up. That is the threat of thin-film solar technology. I would like to hear your comments on that.” Good question!
To begin, it just is not right to talk about solar technology without giving due to Stanford Ovshinsky, a noted inventor who has been obsessed with thin-film technology for decades. Mr. Ovshinsky, now aged 84, is a truly remarkable man. A self-taught genius with no college degree, he has been nominated for the Nobel Prize. In honor of his work with amorphous materials, the field of Ovonics was named after him. The Economist has wondered aloud if Mr. Ovshinsky could be “the Edison of our age” – comparing him to Thomas Edison, the man who perfected the light bulb and founded General Electric. Mr. Ovshinsky expects his own company, Energy Conversion Devices, to surpass GE in size and importance some day. You can find it on the Nasdaq, ticker symbol ENER.
It is a wonderful story. There is just one fly in the ointment: Energy Conversion Devices has been consistently unprofitable for nearly half a century. No, that is not a typo. Since its founding in 1960 until now, the company has produced a grand total of five profitable years. As Forbes magazine wryly notes, “ECD may deserve a place in the Guinness Book of World Records.”
We wonder, what kind of man could convince investors to throw good money after bad performance for 40-plus years? A genius perhaps? It certainly helps to be effortlessly brilliant ... to be filled-to-bursting with grand, sweeping ideas ... and to have well-respected publications compare you fawningly to Thomas Edison.
The Ovshinsky story is, in part, a cautionary tale for technology investors of all stripes. There are a lot of brilliant men and women out there. Some are the real deal, with visions that can make you gasp and weep and jump for joy. But that does not mean their brilliance will ever turn a profit. These days, Mr. Ovshinsky actually is making a little money, thanks to decades of trial and error, perfecting his thin-film production technique. Does this mean Ovshinsky’s investors will finally see the light of day, after a Moses-like 40-year trek through the wilderness? It appears not. The company overall is still bleeding cash.
But anyhow, back to the technology. There is no question thin-film solar is hot right now. Stan Ovshinsky is far from the only one focused on it. The big draw for thin-film is directly tied to the price of silicon shortage. Any process that lowers the amount of silicon used can have a significant impact on production cost. There is plenty of silicon in the world. Silicon makes up more than 25% of the Earth’s crust. Silicon manufacturers –think of them like gasoline refiners, taking the raw product and making it usable – were caught by surprise when solar demand took off. Because it takes about three years to build a polysilicon plant, there is a multiyear lag built into industry response time. Now that the silicon shortage is a few years old, we should see new plants kicking into gear soon.
Given that there is merely a shortage of plants, and not silicon itself, the price of silicon is not going to stay high forever. When it falls back to earth, the thin-film specialists will have a problem: Their price advantage will erode. When the price of silicon falls, the efficiency advantages of crystal panels – their superior ability to maximize strong sunlight – will win the day. When British Petroleum decided to make a go of the solar business, it went with crystal panels because the “heavier silicon product” captures energy more efficiently in the presence of strong sunlight. Suntech Power’s main focus is on silicon crystal panels. It is developing a thin film technology facility – expected to kick into gear in 2008 – but this is more of a sideline.
In terms of imagining a solar future, there are two competing visions that come to mind. The first is thousands of solar-powered suburban homes, all of them with shiny panels on the roof or in the yard. The second vision is that of a vast, empty desert in which solar flowers bloom, covering thousands of acres as far as the eye can see. Will the electricity solutions of tomorrow be decentralized ... or centralized? Will the average home be self-sufficient and wholly off the grid, using off-the-shelf technologies to generate power ... or will utility companies still provide power to households through a power grid, leveraging alternative technologies at gargantuan scale to do so?
We believe in door No. 2. It is easier and, arguably, more efficient for a well-run utility to fill an empty desert or salt flat with solar flowers than it is for 10,000 homeowners to put up individual panels. Other alternative energy solutions, like wind and water power, also have efficiency advantages when applied at scale. Solar power, we expect, will ultimately prove to be a scale business. It will be dominated by big, bruising players with big, bruising elbows. When the price of silicon falls, as it eventually must, this reality will become even more apparent. As margins compress, scale of production will become ever more important for maintaining profitability. Little guys are going to get brushed aside, or steamrolled, or both.
This is another reason we like Suntech. If you look back at the history of automobiles and railroads, you see industries that started with dozens or even hundreds of players and eventually consolidated down to a mighty few. When the smoke clears, Suntech will be one of the few big players left standing. (If it does not get acquired at a juicy multiple, that is.) SunEdison, North America’s largest solar energy provider, has also come up with an ingenious plan for getting power-hungry businesses to “go solar”. Few businesses want to mess around with installing or maintaining the panels, and they do not like the idea of a big cash outlay to pay for panels upfront. “No problem,” SunEdison says. "Just sign this contract to pay a guaranteed rate for electricity for the next 20 years or so, and then give us access to that 10,000-square-foot roof of yours. We will install everything, maintain everything and handle all the repairs, too. All you have to do is sign.”
Now the business in question has the opportunity to lock in a favorable – fixed – price for its electricity, with no hassles and no upfront hit to the balance sheet. The headaches disappear, and a significant expense variable – future power cost – gets nailed down. The utilities that partner with SunEdison in rolling out this model will have no problem selling “power bonds”, or otherwise figuring out how to securitize these locked-in streams of revenue on Wall Street. Beautiful, no? It is not hard to imagine businesses and utilities alike going nuts over this new model. Demand may build slowly at first, but eventually it is going to accelerate. Did we mention Suntech Power has a multiyear supply contract with SunEdison?Link here.
WHY DOES AMERICA EARN SO MUCH MORE ON FOREIGN ASSETS THAN FOREIGNERS ON AMERICAN ASSETS?
There are some strange facts about the asset and trade positions of the U.S. economy in our globalizing world. The U.S. runs massive and growing trade deficits, is borrowing at a clip that would arouse the suspicions of a casino pit boss, and has been selling her assets to anyone who will buy. In the last 24 months the U.S. balance on goods and services comes in just shy of -$1.5 trillion. Across the same period we have sunk further into debt to the rest of the world.
As a result of all that short fall we have been selling assets and borrowing. The Net International Investment Position (NIIP) is the Bureau of Economic Analysis (BEA) broadest measure of U.S-owned foreign assets less foreign-owned U.S. assets. There has been a dramatic and sustained deterioration in the U.S. NIIP over the last several decades. Between 1986 and 1988 America transformed herself from creditor to the world to debtor extraordinaire. We have never looked back, nor have we been forced to.
We have enjoyed positive net income from our increasingly larger negative total holding of foreign assets. This has partially insulated us from instability, dollar plunges and rising interest rates. Declines in our currency get help from those most hurt – foreign owners of U.S. assets. As Greenbacks fall we increase our positive income stream because the value of our assets rises and the value of our liabilities falls. Our imports are linked closely to or pegged to the dollar and our export markets are less so. Thus, falling dollars impose massive cost on asset holders and trading partners, reducing the regularity and severity of episodes ... at least so far. Spiking interest rates and falling dollars have neither regularly nor, painfully recurred. There has been no forced rebalancing as economic theory suggests. Herein lays the source of much trouble and many sound forecasts gone awry.
Many have seen the growing negativity of net assets and predicted a coming dollar downdraft and violent rebalancing. Dollar slides have occurred, sometimes rapidly and to destabilizing effect. There have been episodes of rebalancing, but they are few and the trend is still clearly away from balance. U.S. NIIP has continued down, beyond the targets advertised as hard constraints. We have avoided the forecast costs. How? Why?
There are many and complex answers to this question. Key among the factors is our persistent ability to attract copious capital, at fairly low interest rates and with no risk premium associated with rising indebtedness. Our trade deficit net outflow of dollars get “recycled” as purchases of U.S. assets and loans to U.S. borrowers. The world buys our debt, at low yields and across maturities. And they hold, come hell or high water. Our foreign friends also undertake direct investment here. Their returns, even unadjusted for currency, are terrible. Our returns on foreign investment are much, much higher. Thus, our dwindling net assets are more than offset by vastly superior yields.
We are also allowed to borrow in dollars. Our foreign assets are over 75% non-dollar denominated. Our assets grow and our liabilities shrink in value as the dollar falls. Most importantly, we have managed to earn more with less and less net foreign assets than they have managed to earn with more and more net U.S. assets. The chart below reveals the amazing run we have had. In other times and places such arrangements have been referred to as tribute and were not handled through global “free” asset markets. Today they are. The post-1971 floating exchange rate period has been very kind to the U.S. Money comes to America for safety and to fund the world’s consumer demand. We invest according to portfolio theory, getting maximum cash returns, and they maximize across a broad range of non-cash-return considerations.
It was not until 4Q 2005 that our income receipts fell below our payments despite trillions more in assets held by foreigners. There it has stayed for the last three quarters for which final data is available. There are a few leading “explanations” for the superior returns of U.S. assets abroad. The least interesting is called the “Dark Matter” theory and basically explains away the size of our NIIP as a failure to accurately measure complex and non-quantitative U.S. assets held abroad. This merits little comment. More plausible are explanations focused on the privileged and unique position of the U.S. as the guarantor of liquidity and the printer of the global reserve currency. America is able to borrow cheaply and lend dear with lower risk premiums attached to her debt. This allows us to act as banker to the world skimming off an “intermediation” fee that allows positive returns on portfolio maturity and quality composition. This has some explanatory power. However, it would seem we are doing everything possible to cancel this advantage without appearing to lose the returns associated.
A more rigorous and complex version of the history and measure of this oddity is well told with supporting data in World Banker to World Venture Capitalist, by Pierre-Olivier Gourinchas and Helene Rey. The first broad source of positive returns they identify has to do with the relative composition of U.S. versus foreign held assets. The second has to do with the returns on these assets. Here we discover that the U.S. has a preference for equity and foreign direct investment (FDI), while the rest of the world has accumulated $trillions in U.S. government debt securities. We hold riskier assets as a much larger portion of our portfolio. In addition, U.S. FDI investment abroad earns much higher returns than foreign FDI in the U.S. We run much more leverage, higher risk and therefore, earn higher returns. The U.S. functions like a leverage loving hedge fund, hunting down and eating alpha. What this says about the others in the global portfolio allocation game, I leave to you to decide. All are acting in self-interest and all are aware of what they are doing. None seem to see a palatable alternative.
Others have added valuable elements to our understanding of NIIP anomalies. Some suggest that profits are reported outside the U.S. where taxes are lower, artificially reducing the reported returns here. Many hold that foreignfirms buy here for political reasons or to gain access to our market. I would add funding our trade shortfall as a leading motivation. Many who buy and hold do so to defend favorable exchange rates, curry favor and provide credit to the U.S. State and consumer. This is a payment to continue the world economic and political order.
We need to address what it means that we are no longer above water in terms of the income from our negative net assets. It likely means building pressure on the dollar. If and when this occurs, it means pain to foreign creditors and possible political risk. The sheer size of our negative NIIP is flirting with offsetting the past advantage of positive net income. This signals the end of a support for our over indebtedness, although that may make time to manifest. It begs a bigger question for the rest of the world. Why is it so vital for them to subsidized us some much and for so long? What will happen to their swollen positions in low yielding dollar assets? Last but not least, if America is a leveraged hedge fund among nations, should Uncle Sam really be casting stones at the private sector firms mirroring U.S. macroeconomic strategy?Link here.
FLAT PANELS, THIN MARGINS
More than 100 flat-panel brands jamming the aisles of retailers such as Best Buy, Target, and Costco. The names on the sets range from the obscure (Sceptre, Maxent) to the recycled (Polaroid). The free-for-all is a boon to the millions of Americans who want to trade in their bulky analog sets. Thanks to the likes of recycled brands like Westinghouse, which undercut the prices of premier brands by 20% to 40%, LCDs are no longer a luxury item.
The average 27” LCD set now retails for less than $650, vs. $1,000 in early 2006, says iSuppli, while 40” models have plunged to about $1,600 from $3,000 during the same period. Anyone who can hold out a few months will get an even better deal: iSuppli projects that 40” sets will sell for less than $1,000 by yearend, and 27-inchers may hit $500. Sure, budget brands lack the cachet and features of a Sony or Samsung, but to most eyes the difference in picture quality is negligible. And reliability, analysts say, is improving.
For many in the industry, though, the competition is brutal. Prices for LCD sets are falling so rapidly that retailers who place orders too far in advanruary. 8 announcement that it will shutter nearly 70 outlets. The Asian companies that make the LCD panels that go into the TVs are getting slammed, too. With panel prices expected to fall 20% in 2007, the world’s dozen or so makers of displays are scrambling to sell at almost any price just to generate the cash to survive.
Chalk it up to the new dynamics of TV manufacturing in the age of globalization. The wide availability of standardized digital components from Asian suppliers has ushered in virtual manufacturers such as Westinghouse Digital, Vizio, and Syntax-Brillian. In the old-line TV business, the key technologies for cathode-ray tube sets were controlled by a handful of makers who owned their own brands. Nowadays, LCD makers will sell to anyone, and the rest of the needed parts – tuners and computer chips – are available from multiple suppliers. Contract manufacturers will happily assemble all the pieces at factories in China, Mexico, or Taiwan. So the only things you need to become an instant player are strong relationships with suppliers, connections at big retailers, and a handful of engineers to design the sets.
The Vizio brand did not exist three years ago. Now it is #6 overall in LCD sets, iSupply says, with 7% of the North American market. Vizio has a mere 55 full-time employees, but saw sales of $700 million last year. The private company claims its overhead costs are just 0.7% of sales, compared with 10% to 20% for big, diversified electronics conglomerates, and that it gets by on profit margins of just 2%. With LCD prices falling by 3% to 5% a month, Vizio’s biggest challenge is making sure it does not pay too much for orders placed months in advance. The company negotiates flexible terms with suppliers and manages to keep only two weeks of inventory on hand by constantly monitoring retailers’ shelves.
Some elite brands, meanwhile, seem to be weathering the storm. Both Samsung and Philips have nearly doubled their U.S. share since early 2005, while Sony has held steady. But Sharp has seen its share of the U.S. market dwindle from 18.6% to just 12%, mostly because it was slow to bring out the huge screens that consumers crave. Hitachi and Toshiba have also ceded ground. The biggest players say they still enjoy decent margins because they are getting more efficient as they boost output. For that reason, most industry heavyweights have room to slash their prices further this year. “Many of the smaller brands will get squeezed during the next 12 to 18 months,” says Tim Farmer, Costco’s V.P. for merchandising. By then, sales growth will probably slow because most consumers will have converted to digital sets ... which is when the real shakeout will begin.Link here.
CENTRAL BANKS FACE RISING PRESSURE FROM POLITICIANS
Alleged political independence is thrown into a harsh light.
When politicians tried to pressure former European Central Bank President Wim Duisenberg, he used to say, “I hear, but I do not listen.” These days, a growing number of central bankers worldwide are hearing a lot, and some are listening. The Bank of Japan refrained from raising interest rates last month in the wake of government pressure. The autonomy of banks from Ecuador to India is under attack. French presidential candidates are demanding the ECB meet a goal for growth. “Political pressure is definitely intensifying,” says Stephen Roach, chief economist at Morgan Stanley.
The central bankers under the gun have already helped deliver the strongest global expansion in 30 years and kept a lid on prices. If they wind up running “politically compromised monetary policies,” Roach predicts, “ultimately, you will get more inflation.” While lobbying central banks is one thing, meddling is another, says former Fed Governor Laurence Meyer. “The danger here is to inflation expectations,” says Meyer. “Market participants will have less confidence in central-bank independence in the face of political pressure.”
The BoJ’s standing has already suffered in financial markets after Governor Toshihiko Fukui and fellow policy makers unexpectedly left the benchmark rate unchanged at 0.25% last month. That came after Chief Cabinet Secretary Yasuhisa Shiozaki and other officials said the bank should consider the government’s view when setting rates. The perception that politics may be playing a role in monetary policy leaves traders in doubt about what the bank will do this week. Interest-rate swaps suggest a 61% chance of an increase, according to Credit Suisse Group. Before the bank surprised investors by leaving rates unchanged last month, traders saw as much as an 80% chance of an increase at January’s meeting.
Monetary policy is becoming especially politicized in economies without a strong tradition of central-bank independence. The central banks of Slovenia, which joined the euro last month, and Poland have become embroiled in political disputes over who should run them. Brazilian President Luiz Inacio Lula da Silva’s advisers argue his push to quicken growth is hampered by the policies of central bank head Henrique Meirelles. Ecuador’s central bank last month took out newspaper advertisements defending its autonomy after President Rafael Correa questioned the need for its independence. Thailand’s central bank now reports to military leaders who won power in a September coup. The Indian Finance Minister this month urged banks not to raise mortgage rates, putting him in conflict with the Reserve Bank Governor’s effort to slow the economy with higher borrowing costs.
Julian Jessop, chief international economist at Capital Economics Ltd. in London, says if political heat is building at a time of strong global growth, it will only intensify when the economy weakens. “The fear of politicians is that the boom will be brought to an end by aggressive central banks,” he says. Feeding those worries is a perception that the expansion has boosted asset values and corporate profits without providing similar benefits to workers, says Roach. Among the G7 major industrialized countries, labor’s share of national income shrank to a record-low 54% last year, while the share going to profits rose to 16% from 10% five years ago, he calculates.
Those pressures are currently on display in Europe, where the ECB is under fire as it signals plans to raise its benchmark rate. But ECB President Jean-Claude Trichet is better insulated from such pressures than are other central bankers. Power over the ECB is diffused among the 27 EU nations, and would require all 27 to renegotiate the treaty that created the ECB and set its goals. German Chancellor Angela Merkel said she supports ECB independence “with all my strength.” That has not stopped politicians from seeking other routes to influence monetary policy. The Luxembourg Finance Minister and his euro-area counterparts have been pursuing a bigger role alongside the ECB in managing the exchange rate. That would make it difficult for the ECB to raise rates if the finance ministers were trying to weaken the euro.
The U.S. Federal Reserve is not immune either. One casualty may be Chairman Ben S. Bernanke’s goal of establishing an inflation target, says Alan Blinder, former Fed vice chairman and now an economics professor at Princeton. “It is possible that Democratic hostility to inflation targets will cause Bernanke to put the goal of an inflation target on hold,” he says. The new Democratic chairman of the House Financial Services Committee, Barney Frank, says he is leery of any change that might compromise the Fed’s dual mandate of seeking both stable prices and maximum employment. “That is not going to happen when we are in power,” he said in January. “And we can prevent that from happening.” Frank told Bernanke at a hearing last week that he wants to be “kept involved” with the Fed’s decision-making. “There are people in this country who think the Fed somehow should be above democracy,” says Frank. “God forbid that anybody in elected office should talk about whether or not we need a 25-basis-point increase in the Fed. Somehow, that’s sacrosanct. No, it is not: It’s public policy.”
Harvard’s Kenneth Rogoff, former chief economist at the IMF, says that is an important point for central bankers keep in mind. “Central banks need to earn their independence every day.”Link here.
HIGH CALORIE PROFITS
At the start of each new year, anyone and everyone is giving his predictions for the coming year, and your editors are no exception. So it is likely that even only a month or so into 2007, you have heard over and over again how gold is going to explode, oil is continuing to rise and the dollar will fall precipitously. Well, you have heard all that from the smart analysts, anyway. All of those markets are, in my opinion, some of the best ways to profit in 2007, but there are others. One commodity that often gets overlooked by the average investor is the main ingredient in something most of us love: cocoa.
“Those Who Trade Headlines End up Selling Papers!” The above is an old saying among traders, but it is not always true. One headline that is quite common is, “Cocoa Rises in London as Peace Talks in Ivory Coast Falter.” Cocoa is one of those commodities we find only in very specific parts of the world, and unfortunately, most of them are quite dangerous. The epicenter of cocoa trading is the Ivory Coast. The Ivory Coast is not a very hospitable place and is constantly in a state of flux, like much of Africa. Cocoa is the mainstay crop of the Ivory Coast and is responsible for the majority of GDP in the tiny country. Disruption in the government – and I use the term loosely – virtually brings exports to a halt.
When this happens, cocoa prices in London tend to ramp up, sending the New York market higher too. Usually, this occurs after a breakdown in peace talks between rebels and the government of Ivory Coast. Rebels in the West African country have rejected attempts by the government to hold direct negotiations with them, rather than following a peace plan backed by the UN. Basically, the Ivory Coast has been split into a rebel-held north and a government-controlled south since 2002. The constant uncertainty regarding the political future of the Ivory Coast and the fear of smaller physical output volumes from the major producing countries are the prime drivers for prices.
Do not expect to hear about this on Bloomberg or CNBC, or even from a little bird. Cocoa is one of those commodities that flies way under the radar for average investors and the media. So the fighting goes on and is showing little sign of stopping. But what is bad for the Ivory Coast could be good for your portfolio.
In my new book, A Maniac Trader’s Guide to Making a Fortune... A Not-So-Crazy Road Map to Riches, out soon from Wylie and Son, I stress the step-by-step way to trade markets just like this. I hope you will give it a read. As I discuss in the book, cocoa trades in London and New York and is a fairly liquid and active market. Both exchanges offer futures and options. The margins on the futures are quite reasonable, and the market trades several months of the year. This trade is very dependent on conditions in the Ivory Coast and, obviously, worldwide demand. Demand for cocoa is on the rise as countries like India and China import more and more of the commodity, as tastes for luxurious items are no longer relegated to the once-minority elite.
Cocoa prices gained 8.4% in London and almost 12% in New York since the beginning of last November 2006, when the U.N. operation in Ivory Coast said it was “seriously concerned” by clashes that had occurred in Abidjan, the commercial capital of the country. I expect that if demand remains constant and fighting and uncertainty remain in the Ivory Coast, prices will rally another 20-30% this year. That is a sweet something for savvy investors like you in 2007.Link here.
BLOW FOR BEER AS BIOFUELS CLEAN OUT BARLEY
The rapid expansion of biofuel production may be welcome news for environmentalists but for the world’s beer drinkers it could be a different story. Strong demand for biofuel feedstocks such as corn, soyabeans and rapeseed is encouraging farmers to plant these crops instead of grains like barley, driving up prices. Jean-François van Boxmeer, CEO of Heineken, warned last week that the expansion of the biofuel sector was beginning to cause a “structural shift” in European and U.S. agricultural markets.
One consequence, he said, could be a long-term shift upwards in the price of beer. Barley and hops account for about 7-8% of brewing costs. Barley, which is used for making beer, whisky and animal feed, has seen prices prices soar over the last 12 months. Futures prices for European malting barley, which is used for brewing and distilling, have risen 85% to more than €230 ($320) a ton since last May. Barley feed futures have risen by a third to C$180 (US$155) a tonne on the Winnipeg Commodity Exchange over the same period. Meanwhile, barley production in America fell to 180 million bushels in 2006, the lowest level since 1936. The value of the crop was the lowest since 1970. This decline is partly due to the fall in the land area used for growing barley, which dropped to the lowest amount since records began in 1866.
The rise in barley prices has also been driven by the Australian drought, which cut the country’s crop by two-thirds, and heavy rains in Europe last summer which reduced the quality and yield of the harvest. The U.S. department of agriculture estimates global barley production will reach 138 million tonnes in the year to August, level with 2006 but down 10% vs. 2005. Global demand for barley has risen 2% to an estimated 145.5 million tons this year, the 4th year in the last five in which demand has exceeded supply. As a result, global stockpiles have shrunk by a third in the past two years and left the barley trade vulnerable to further supply problems this year.
“In the US, land that was cultivated for growing barley has been given over to corn because of the ethanol demand,” said Levin Flake, a grains trade analyst at the USDA. The U.S., which in the 1980s was a leading exporter of barley, is now a net importer as barley acreage has shrunk from more than 13 million acres in 1985 to 4 million this year, said Mr Flake. The USDA expects U.S. barley acreage over the next 10 years to remain flat. That might not be the case for the price of beer.Link here.
HOW TO MAKE MONEY WITH SMALL-CAP GOLD
In late June 2006, we highlighted a peculiar situation. It was a situation where the price of gold had risen 32% to $583 per ounce in the previous 12 months, but three interesting small-cap gold stocks were selling for the same prices they were when gold was trading around $430 an ounce. We presented our readers with three stocks: a small-cap, a mid-cap, and a large-cap. Buyers of shares of the small-cap and the mid-cap only had to wait two months before they were up 30.5% and 45.3%, respectively. The large-cap was actually down half a percent for the same period.
The stocks that performed so well were IAMGOLD (IAG: NYSE), which is now the 10th largest gold company in the world, and Kinross Gold (KGC: NYSE), the 8th largest. These situations for quick profits dont happen very often, but when they do we need to jump on them. Well, there is a very real chance that the gold bull market is poised to continue. Even if you only look at it from a chart perspective, much of 2006 saw gold trading sideways with higher trends now looking likely.
But no matter what you believe about gold’s immediate future, there are some things you need to know before you go out and buy a gold stock. These four are critical:
INVESTING WITH THE LITTLE MAN
Shares of your most coveted small-cap stock creep ever closer to hitting the magical triple-digit mark, like a broken man inching his way towards the edge of a cliff. You have followed this winner for three years. You have watched the business grow. The 1,000 shares your broker picked up for $15 have soared more than twofold. They are set to go even higher. But breaking the proverbial high water mark of $100 per share will take much more than some trivial rumor prophesizing another sexy multi-billion international M&A deal. You see, most investors fear shares trading above the $100 plateau. It scares them.
No one really seems to know why. Rationally speaking, buy and sell decisions should be made relative to some intrinsic value. But as we all know, that seldom seems to be the case. Everyone in the business seems to have their own magical formula for predicting price movements. Traders stare at charts. The value guys covet balance sheets. And a select few move solely on the word swirling around the office watercooler.
I gravitate towards the balance sheet. But that is not for everyone. Each investor needs to find his own particular style. But despite one’s particular method to his madness, one thing is for sure. Most independent investors avoid shares trading in triple digits. I like to call this utterly ridiculous phenomenon the “Little Man Syndrome”. No one wants to be the little man. No one likes to log on to his discount brokerage account and see the fruits of your $10,000 bonus displayed in 80 shares of PetroChina. You would rather open your account to find 15,000 shares of some, obscure, cash-burning penny stock whose name you can barely pronounce, running a business even the brightest mind would find difficult to comprehend.
Managements know this. They know you want 20 shares for the price of 10. That is why they invented the stock split. The point: Investors prone to the Little Man Syndrome are, by default, also prone to follow small-caps. So the next time you are huddled around the watercooler listening to Doug from marketing spout off about some unknown Argentinean gold mining stock, and the little man conveniently appears on the edge of your shoulder, gently whispering it is a good idea to park $10,000 of junior’s college fund to snag 20,000 shares, please put down the Kool Aid and walk away.
You see, it is time to separate yourself from the investing masses. It is time to protect your assets so they can grow. Successful investing will require a combination of patience, realistic expectations and – most importantly – buying shares of businesses at the right prices, regardless of how high that price may be. As investors, we are looking for a margin of safety – companies trading near or below their intrinsic value with an established earning power. That is basically it.
I admit that, more often than not, small-caps make for a good story. There is nothing wrong with a good story. Just make sure the good story stems from a good business at a good price.Link here.
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