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THE YUAN DELUSION
China’s image is big on America’s radar screen. The Shanghai exchange’s 9% drop on February 27 triggered a global equity swoon. The huge Chinese trade surplus with the U.S. has spawned protectionist threats in Washington. China’s plan to diversify her $1+ trillion foreign currency and securities holdings, now mostly in dollars, scares investors. So does the fear that China’s large banks (not just the central one) will dump the greenbacks they hold.
Protectionists like Senators Lindsey Graham and Charles Schumer believe a floated yuan will appreciate and solve all problems. Treasury Secretary Henry Paulson is commuting to Beijing to negotiate an easing of currency controls, on the theory that the yuan would then rise. If these worthies’ dreams come true, will U.S. imports from China shrink, will exports leap, will manufacturing job losses cease and will the Chinese advantage of low labor costs reverse? Probably not.
Be careful what you wish for, Mr. Secretary. It is quite possible that an unleashed Chinese currency would go in a surprising direction: down. Why? The Chinese are extraordinary savers. They salt away half their economic output. Some of their savings, to be sure, is invested in the U.S., but much of it, especially of the middle class, is invested in China. Individuals have $2 trillion in Chinese bank deposits, largely because they have few options. The stock market is not so alluring now. Without currency controls the Chinese would no doubt diversify their portfolios into foreign securities, depressing the yuan in the process.
In China a vast army of unemployed people acts to hold wages down. Clearly, officials prefer a subdued yuan to keep the unemployed at bay by aiding exports. But even if the yuan rose, Chinese labor still would be far cheaper than American labor. 100 million of China’s 1.3 billion people are squatting in coastal regions looking for work. Also, 500 million are employed or underemployed in rural areas, many in low-paid farm work and other jobs. If work were available, China could boost employment by 430 million people. But that work will not be available soon. Even with the 8% annual real GDP growth rate targeted by the government, it would take 20 years to provide jobs for the underemployed.
China depends on a prosperous, income-happy U.S. to keep its economic engine going. But the collapse in the U.S. subprime housing market will spread, sinking the American consumer and the imports on which the Chinese economy depends. Next, China’s industrial capacity-building boom will break under the pressure of government restraints and a U.S. recession, leaving gobs of export-driving excess capacity aimed at the U.S. Red-hot domestic investment will cool, reversing direct foreign investment inflows and further depressing the yuan.
So regardless of whether the yuan floats, U.S. manufacturing jobs will continue to drop. They have collapsed 43% from their June 1979 peak to today. In high-cost, high-tax New Jersey the erosion since 1990 is 43%. A floating yuan will not bring back the old machine shops. Not a chance.Link here.
BORING ALL THE WAY TO THE BANK
Few kids grow up saying they want to work in the chain saw, coffin or insurance industries. But I see opportunity in businesses like these. There are a lot of public companies making or marketing mundane things, and doing very well at it. Their boring brands do not necessarily make headlines, but they make bottom lines. These businesses generate a lot of cash and increase earnings nicely. Sometimes the stocks also are cheap.
I hunt for industry leaders, caring less about a company’s glamour factor and more about how it is doing relative to its peers. Market share is hard to establish, and managements that have built wide moats around their businesses are less likely to see their castles overthrown. What matters to me are defensible business models, durable brands and the well-executed research and development needed to sustain success. Growth may not happen in great leaps, and you will not get rich quick with these slow-and-steady Eddies, but year in and year out they typically provide dependable earnings growth to buffer Wall Street’s moodiness.
A prime example is Blount International (NYSE: BLT, 12), pronounced “blunt”. Blount is a dominant player in chains, guide bars and sprockets for chain saws, boasting half of the world’s market for this business. Blount has a wonderfully recurring revenue stream since saw chains wear out: 71% of Blount’s sales in this area are from replacements. The average professional logger may go through one saw chain every 10 days. Also, the company is the second-largest manufacturer of timber-harvesting equipment – big tractors that clip tree trunks and haul them away. Management inked an 8-year alliance in 2003 with Caterpillar, giving Blount valuable access to Cat’s extensive global dealer network. Disappointingly, 2006 was a tough year as residential construction faded, bringing down demand for timber. Earnings and sales fell for Blount. In my view this is a temporary cloud that should dissipate in the year ahead. Currently shares of Blount’s stock trade at a 29% discount to my private market value estimate of $17.Link here.
WHEN TO BET ON A LESS-THAN-SURE SHOT STOCK
Prudence and diligence are held up as virtues for investors. If you bought Enron without reading all the footnotes, you have only yourself to blame. While that sounds good, there is often a high price to pay for waiting for every last detail. Time can be very costly, and making money is hard when situations are clear to everyone. The better course? Process what information is available a little faster than others, even without complete certainty, and then act.
On a practical level, this means we are often better served by quick analysis that is 80% right than by slow analysis that is 95% right. Of course, eventually we need to go back to understand the details. However, it should not be a precondition for action. Stock prices reflect what everybody thinks, and we try to bet on realities that differ from those assumptions.
Suppose all investors waited for all the facts before trading. If we were right 80% of the time and moved before the hesitant crowd, we would without question come out ahead. In reality, not everybody does wait, but enough people are slow enough that there is often a time lag between the release of corporate information and its full reflection in stock prices. This is especially true for small companies, which often are not followed by analysts and get little or no news coverage. If you shoot out of the blocks with a small company, you likely will get it cheap before others discover the bargain. And occasionally a bargain can be had when some bad news arises that may mask the underlying favorable long-term picture.
Institutions like pension and mutual funds cannot react quickly because their orders are so big that they move the stock price on the basis of their size. Also, to move up the corporate ladder professional investors take great pains to have all the details in order before acting. Analysts are punished more for being wrong than they are rewarded for being right. Thus, they tend to be slow and not to deviate too far from peers.
Oceaneering International (NYSE: OII, 39) makes remote-controlled submarines that oil producers use to repair and maintain oil drilling platforms in the deep sea. When Hurricane Katrina hit in August 2005, those who know the company well would conclude that Oceaneering was in a good spot to get lots of work cleaning up the damage. But the day after the hurricane, OII’s shares traded down 1%, in line with those of many oil companies. The market took a while to digest the effects of a hurricane on this oil services company, then the stock reversed direction. Since then it has nearly doubled. The Katrina cleanup is still in progress, so demand for Oceaneering’s vessels has stayed strong. It would have obviously been better to buy in 2005, but at 17 times trailing earnings this remains a good stock to buy now.
More recently a couple of very good companies have suffered some ill fortune that has hurt their stock price – temporarily. To me they look like good buys. Admittedly, these are high-growth companies with above-average risks.Link here.
STOCKS: IS NOW THE TIME TO SPECULATE?
The stock markets reminded people at the end of February what a crash might feel like. Now a month on, the Dow is still about 250 points below where it was when it dropped precipitously 400 points in one day. Since stocks make up a large portion of many investors’ portfolios, now might be a good time to consider whether speculating in stocks is a smart move. In Conquer the Crash, You Can Survive and Prosper in a Deflationary Depression, Bob Prechter takes a strong position. Here is a brief excerpt (from Chapter 20).
Perhaps the number one precaution to take at the start of a deflationary crash is to make sure that your investment capital is not invested “long” in stocks, stock mutual funds, stock index futures, stock options or any other equity-based investment or speculation.
In 2000 and 2001, countless Internet stocks fell from $50 or $100 a share to near zero in a matter of months. In 2001, Enron went from $85 to pennies a share in less than a year. These are the early casualties of debt, leverage and incautious speculation. Countless investors, including the managers of insurance companies, pension funds and mutual funds, express great confidence that their “diverse holdings” will keep major portfolio risk at bay. Aside from piles of questionable debt, what are those diverse holdings? Stocks, stocks and more stocks. Despite current optimism that the bull market is back, there will be many more casualties to come when stock prices turn back down again.
Not only will many stocks fall 90 to 100%, but so will a substantial number of stock mutual funds, which cannot exit large equity positions without depressing prices and which have the added burden to you of 1% (or more) annual management fees. The good news is that we will finally find out who the few truly good fund managers are and which ones were heroes by virtue of being around for a bull market.
Do not presume that the Fed will rescue the stock market, either. In theory, the Fed could declare a support price for certain stocks, but which ones? And how much money would it commit to buying them? If the Fed were actually to buy equities or stock-index futures, the temporary result might be a brief rally, but the ultimate result would be a collapse in the value of the Fed’s own assets when the market turned back down, making the Fed look foolish and compromising its primary goals. It would not want to keep repeating that experience. The bankers’ pools of 1929 gave up on this strategy, and so will the Fed if it tries it.Link here.
Economist Paul Kasriel at the Northern Trust has come up with a recession indicator that has called six consecutive recessions with no misses and no false positives dating back to 1962. It does, however, have a single miss in 1960. The condition is an inverted yield curve as measured by the 10-year Treasury yield minus the fed funds rate, in conjunction with an annual rate of change falling below zero on the CPI-adjusted monetary base. With a small tweak in methodology as described below, we can pick up that isolated miss in 1960.
“The ‘real’ unadjusted monetary base (bank reserves plus currency) seems to provide fewer false recession signals than does real M2 growth,” said Kasriel. “That does not necessarily mean that the real base does a better overall job of forecasting real GDP, just that it does a better job of forecasting official recessions.” Real here means inflation adjusted via the PCE price deflator, and unadjusted monetary base means a nonseasonally adjusted monetary base.
Kasriel fully explains his theory in a March 22 article, “Recession Imminent? Both the LEI and the KRWI Are Flashing Warning”: “I have found that every recession starting with the 1970 recession has been immediately preceded by the following combination – a negative spread between the yield on the Treasury 10-year security and the federal funds rate (hereafter referred to as ‘the spread’) on a four-quarter moving average basis and a year-over-year contraction in the quarterly average of the CPI-adjusted monetary base. The monetary base is the sum of bank reserves and coin/currency, both of which have been created out of thin air, as it were, by the Fed. ... [The following chart] shows the historical behavior of the ‘Kasriel Recession-Warning Indicator’ (KRWI)... The KRWI has given no false signals in that when it has warned of a recession, there has been one. ... However, the 1960 recession was not signaled by the KRWI, because the spread remained positive, although it did narrow.”
For comparison purposes, I asked Bart at NowAndFutures.com to put together a chart showing the 10-year Treasury yield minus the three-month Treasury yield (as opposed to the FF rate), just to see what we could find. Bingo! A perfect 7 of 7 with no misses and no false positives. The two blue-gray ovals are conditions where only one of two conditions were met. The 10-year minus the 3-month spread by itself has no misses since 1960 (7/7), but it did have a single false positive in 1967. The CPI-adjusted monetary base was also 7 for 7, but with a false positive in 2005. Together, they are perfect.
M' is an Austrian money supply indicator that I have been following for some time and started charting (with help from Bart) back in January. An annual rate of change in M' dipping below the 0% line is a pretty rare event, but does not necessarily lead to a recession. On the other hand, in each of the last six recessions, M' did have a significant dip (though not as severe as the one we see now). The CPI-adjusted M' gives off very strong but not perfect recession warning on a cross of the 0% line on an annual rate of change basis. In conjunction with an inverted yield curve, M' is a perfect 6 of 6 with no false positives.
Unless it is different this time, another recession is headed our way. None of these monetary indicators even takes into consideration the mess in housing, which is a pretty good leading indicator in and of itself. Those looking at M2 or M3 alone as proof of economic expansion or as some sort of inflation picture are missing the big picture. The economy is slowing far faster than most think by the three best leading indicators one can find. Financial speculation as evidenced by growth in M3 and the final buildout of retail stores already under construction are all that is keeping the good ship Credit Bubble afloat.Link here.
SPRING DOES NOT BLOOM FOR HOMEBUILDERS
Evidence continued to pile up that the housing sector remains in turmoil. There was a brief reprieve when the National Association of Realtors reported that existing home sales unexpectedly jumped 3.9% to 6.69 million annualized units, surpassing estimates by 39,000 units. It was also the highest number of existing homes sold since last April. The median price dropped 1.3% compared to last year, which was the 7th consecutive month of year-over-year price declines. Existing home inventory jumped 6% to 3.748 million homes, almost back to the record levels reached last summer.
New home sales in February were a completely different story. Sales of new homes dropped 3.9% to an annualized 848,000 units. Additionally, sales during the previous three months were revised down by a cumulative 172,000 units. The West was the only geographic area where sales increased. The number for sale increased by 1.4% to 546,000, which pushed the months supply up almost a full month to 8.1 – a level not seen since January 1991.
While there has been some realization that home sales might come under additional pressure due to the problems in the subprime market, there has not been any discussion on whether it could lead to a structural change. Prior to the recent surge in residential housings, home ownership rates in the U.S. hovered around 64% since at least 1965. It peaked in 1979 at 65.8% and slid to 63.8% in 1988 before recovering. As the stock market boomed, the number of homeowners grew as well. From 1995 the home ownership rate increased from 65.1% to 67.5% in 2000. However, as the stock market fell, more people bought homes with the ownership rate peaking in 2004 at 69.2% and has since declined marginally to 68.9% at the end of last year. As the subprime market becomes rationalized, there will likely be downward pressure on the home ownership rate. Every 100 basis points drop in ownership puts over one million homes on the market. There is a combined 4.3 million new and existing homes on the market. Going back to historical ownership rates would essentially add a similar number of homes that would need to be absorbed.
As the housing market has stumbled over the past several months, the rest of the economy has remained stable. This has started to change over the past month or so and data released over the past week confirmed that the economic backdrop has started to weaken. There are growing indications that economic growth is on dangerous footing. One of our biggest concerns has been that due to the amount of leverage on the household balance sheet, any slowdown in consumer spending will accelerate quickly. While the subprime mess will likely have larger fallout than most economists are forecasting, it is the Alt-A market that bears attention. If that market comes under pressure, that will likely be the straw that breaks the camel’s back.Link here.
U.S. workers saddled by houses that will not sell.
When Patrick Greenish accepted a job offer as an art director in Charlotte, North Carolina, last July, he assumed that his house in Orlando, Florida would sell quickly. His new employer offered to let him telecommute for a month until the sale was complete. But when the month ended, the “For Sale” sign remained firmly planted in his front yard. Even so, the company expected him to be working in Charlotte. “I had to leave everybody at home while the house was still on the market,” Mr. Greenish says, referring to his wife and two young daughters. “It was a bit hard on everybody.”
That kind of challenge is becoming more common as a soft housing market is changing the landscape of relocation. Some potential employees are turning down new jobs or transfers they cannot sell their house or would have to take a heavy loss. And companies that offer relocation benefits are spending more for employees’ moving expenses.
“It is costing companies an exorbitant amount of money to cover the loss on sale to get an employee moved,” says Andrew Drescher, a relocation consultant with Relocation Benefits in Vienna, Virginia. Many Fortune 1000 companies typically pay closing costs, he says, as well as giving employees payment for money they lost by selling their house quickly. But small firms often cannot afford that. “It is greatly affecting the ability of smaller companies to recruit top talent out of higher-priced markets.”Link here.
Subprime mortgage bond sales plunge as loan delinquencies soar.
Sales of bonds backed by subprime mortgages are tumbling as investors and bankers, concerned about rising delinquency rates, pull back from what had been one of Wall Street’s fastest growing businesses. About $64.8 billion of securities backed mainly by loans to people with poor credit or high amounts of debt were issued this year through March 22, down 36% from the same period last year, according to Citigroup.Link here.
The other side of a bubble is flat.
This is not an abandoned Arkansas mining town. The only mining done there was the financial kind back when Texas Savings and Loans prospected for builders and vice versa. Ironically called “thrifts”, more than 500 S&Ls went bankrupt around the country back in the 1980s. Much of this was bad luck. For example, some S&Ls loaned money to condo builders who offered to pay condo buyers to hurry up and make their purchases. Others made large political contributions or bought perfectly good Lear jets which did not provide a return on assets sufficient to maintain profitability. Often, lavish parties did not translate into the profitable business relationships imagined by S&L executives. Bottom line, expectations were not met, and thrifts folded like American Idol contestants under a Simon haranguing. Luckily for depositors, their money was insured by the federal government, and lucky for the federal government, it was able to float a bunch of bonds to pay off the depositors. In 1995, Business Week figured the tab for the S&L mess came to $150 billion, before interest on all that government debt.
The previous picture is actually some of the remains of a subset of the S&L scandal in the “I-30 Corridor” just east of Dallas. The I-30 Corridor scandal involved a house painter-turned megadeveloper, a conviction for stealing $100 million from five S&Ls, and ultimately, the decision to scrape dozens of condos clean to the foundation. 20 years after the scandal, all that is left are concrete and weeds. Luckily, just down the highway, the I-30 scandal is invisible beneath the recently constructed Bass Pro Shop. For those not familiar with this retailer, the typical Bass Pro Shop offers sportsmen 42 hectares of hunting and fishing gear, including enough camouflage to clothe the Swiss Army should they ever need to hide from anyone. Bass Pro is part of a a new I-30 Corridor development that is expected to include restaurants, other retailers, and a 144-room hotel to house sportsmen too hired to drive home after the turkey call seminar. The whole shebang was made possible by a package of incentives that included tax rebates and $24 million in bond money, not to mention a slew of home equity loans that allowed hunters to upgrade from walking the deer lease to riding a four-wheeler.
Because mortgage loans funded everything from 4-wheelers to million dollar California cottages over the last few years, it was puzzling why the Fed chairman has been so confident that subprime problems would not spread across the economy like Legionaire’s disease across a cruise ship, and be “contained”. This is quite a claim for a person to swallow if that person has looked at Paul Kasriel’s chart of housing starts vs. recessions. Kasriel’'s numbers jive with those from a recent Credit Suisse report that predicts a35-45% drop-off in new starts from the peak of 2.1 million homes.
Add to this the obvious notion that the U.S. economy is not just an economy of home builders. We are an economy of mortgage bankers, title company clerks, construction crews, loan packagers and repackagers, car dealers, Best Buy employees, and guys who make plantation shutters to fit in architecturally pleasing rounded windows. Even the Home Depot employees who jump behind stacks of plywood when you need help finding Weed Eater line are at risk. As are Wal-Mart greeters and, who would have guessed it, investors in subprime car loans. So how can all the subprime unfortunates, those losing their homes, those cutting back on purchases to retain their homes, and those counting on those loans paying off to achieve their expected rate of return, how can all those people be isolated from the rest of the economy? How?
Here is how: This all became clear after watching a little known internet film making the rounds. Or maybe it was after eating late night nachos. Anyway, the plan goes something like this: Separate the subprime woes from the rest of the economy. That is, relocate the problem borrowers so the healthy borrowers will not be depressed by the subprime behavior of their neighbors. All that is needed is lots of space for the dispossessed to begin their lives anew, and a plan to deal with the vacated real estate.
Step two is even more ingenious. The government makes whole all holders of mortgage backed products, all the way from CDOs to IToldYouSos. Then, a New Deal style program is implemented to pay farmers to destroy the foreclosed properties and plant corn in their place. Why corn? To boost ethanol feedstocks! The whole plan is so clever you would have to believe the plan was in place prior to the current administration.Link here.
God must love typical investors. He created so many of them. But he cursed the poor yahoos to mediocrity. They cannot get “alpha” (above market performance), say the theorists, because they can never know as much as the market itself. For the average investor, it is true. He can do no better than average.
You can hear a lot of laughing in the City and on Wall Street lately. And this week, the cynical cackles came from the Blackstone Group, which offered to sell common investors 10% of the company for $4 billion. Here we back-track for a moment with an observation: The major decision that any stock market investor has to make is which line of guff to fall for. Any of them will ruin you – but some faster and more thoroughly than others. One of the finest pieces of guff ever – the Efficient Market Hypothesis – is probably one of the least harmful. EMH tells us that market prices incorporate all the information available at any given moment. Logically (if idiotically) any extra value an investor sees in a share is thus incorrect, compared to the price actually set by the all-seeing market.
It is impossible to beat the market, declares EMH. Of course, it is not true. But it also may not be true that you will go to jail if you kill someone. Still, it is not a bad idea to believe it. Meanwhile, for 20 years, Blackstone Group has been doing to the market approximately what Tyson did to Holyfield. Its profits in 2006 reached $2.27 billion, more than double that of the previous year. Obviously, the professors of EMH got it wrong somewhere.
While the academics say you cannot beat the market, the financial industry makes it sound as though you almost cannot help beating it. For a fee, mutual funds, account managers, stockbrokers, hedge funds and private equity groups offer to help you trounce the average investor. The hedge fund industry charges 2% of capital and 20% of performance. If the professors are right, investors who go into hedge funds are morons. If the results are purely random – as EMH insists – they are just giving away their money.
But then, the chutzpah seemed to reach a peak when hedge funds began offering shares to the public. If a hedge fund manager really could get enough “alpha” to justify the fees, why would he want to give it away to perfect strangers? Hedge fund managers would not sell shares of their own fund unless they could get a premium. Either the public was willing to pay more for alpha than alpha was worth, or, there really was not any alpha at all. It turned out that hedge fund alpha had vanished. No one seemed to know where it went, but when they toted up hedge fund performance, over the last two years, they found that they were no better than the average mutual fund ... and no better than the average, mediocrity-chasing lumpen investor.
Then, alpha was spotted hanging around with Private Equity capital, which soon became the hottest thing on Wall Street. And now comes the pitch: “Pssst,” says the Blackstone Group. “You still want alpha? Buy our shares.” Is the Blackstone Group a religious or charitable order? Not so far as we have heard. If they have any alpha, they are not going to give it away. Already, they give investors in their private funds about the same deal as the hedge funds – 2% of capital, 20% of profits. And now, like the hedge funds, they are proposing to sell their moneymaking magic to the poor fellows in the public market.
Exactly what public investors will get, we do not yet know. The prospectus for its new offer is not out yet. What we know is that private equities, like hedge funds, have taken on a speculative mentality. Deals are put together and then flipped from one PE firm to another. The objects of their attention – actual, profit-making companies – are loaded down with debt so the private equity investors can take out the profits. And then, the deals are sold back to the public at a big premium. As more and more money chases quick profit, standards slip. The deals degenerate, from super-prime to subprime. Until investors come to their senses.
In 1989, it was junk bond dealers with alpha in their pockets who were in need of wising up. Then, Ohio Mattress was being taken private by a buyout firm just at the time Drexel Burnham collapsed. Lenders got worried, and then frightened. All of a sudden, the easy credit that made the deal possible disappeared. First Boston, one of the lenders, reached into its pocket and, lo, no more alpha. The deal fell apart and the bank was so destabilized, it was later sold to Credit Suisse. Junk bond investors learned such a valuable lesson it took them almost 10 years to forget it.Link here (scroll down to piece by Bill Bonner).
MISTRUSTING MONEY WHATEVER THE PRICE
On September 16, 1992, the Bank of England in London hiked U.K. interest rates from 10% to 12% – the biggest jump in more than 8 years. The Old Lady promised a further hike to 15% for later that same day, too. The BoE was not trying to kill inflation. It was trying instead to defend the pound sterling. Somebody had to.
Speculators across the world, most famously George Soros, had got it into their heads that Europe’s exchange rate mechanism (ERM) – the precursor of today’s Eurozone currency system – was about to collapse. Britain was three years into a house-price collapse, and the ensuing recession had put more than a million people out of work. Both sterling and the Italian lira looked horribly over-valued, or so the speculators thought. The speculators were right. The BoE was wrong. By the close of trade on that autumn day in 1992, the UK had abandoned the ERM. It had also spent the equivalent of $1.6 billion, trying to prop up the pound. George Soros, on the other hand, was $1 billion richer. And sterling interest rates were cut back to 10.5% the very next day.
Two years later, higher interest rates failed to defend the Mexican peso. The government in D.F. had squandered more than 80% of its foreign reserves in 1994 trying to prop up the currency. Its devaluation in December scared foreign investors so much that they deserted Mexican bond auctions despite interest rates topping 40%. Yet again, the markets were right and the government was wrong. The Mexican peso had already lost half its value against the U.S. dollar in just 12 months. Over the next five years, it halved again.
This same mistrust of money at any price also whacked the U.S. dollar in the early 1930s, even as deflation hit and the value of money seemed to be rising. The Great Depression led American citizens to hoard gold before cash. During 1932 the U.S. Federal Reserve raised its discount rate to defend the dollar. But fearing an imminent devaluation of the dollar, the American public continued to hoard non-interest bearing gold. The American public was right to fear devaluation. In the end, it took the Presidential executive order of April 5, 1933 to force U.S. citizens back into the dollar. President Roosevelt made gold ownership illegal, punishable by $10,000 fines and/or imprisonment. He also devalued the dollar by 40% at a stroke.
Fast forward to March 2007. Investors, householders, businesses and governments right across the developed world now refuse to hold cash. They would rather spend it, gear it up for investment, lend it out or swap it for financial assets – any financial assets – rather than hoard it. But no one is refusing to accept money in payment. Not yet. So the issue of what it would take to restore confidence in official currency – including the dollar, sterling, euros, pesos and all the rest – looks purely academic. Today’s disdain for paper currency remains a long way from loathing. Right?
David Ranson, in a research paper for a World Gold Council research paper in 2005, found that changes in the price of gold bear a 0.50 correlation with consumer price inflation 12 months down the road. So rather than gold acting as “an inflation hedge”, as many pundits would have us believe, the metal in fact gives us a lead indicator of inflation in the cost of living. Put it another way, gold signals the forthcoming devaluation of paper money.
The U.S. Fed once knew this, too. And it might still today, according to the debate that rages over illegal manipulation of the gold price in the open market. But under Paul Volcker, the famously tall chairman from 1979-87, the Fed clearly saw gold as a barometer of inflationary expectations. At one policy meeting in late 1979, the Fed committee noted that “speculative activity” in the gold market was spilling over into other commodity markets. An official at the U.S. Treasury called the gold rush “a symptom of growing concern about world-wide inflation.”
Paul Volcker hit on one way of stopping inflationary expectations, however. He took U.S. interest rates to 19% and stopped the great gold speculation dead in its tracks. Real U.S. interest rates – nominal rates less inflation – rose to more than 9%. That destroyed long-dated bond prices, but no one wanted them anymore anyway. Treasury bonds had become known as “certificates of confiscation”. Only high real returns, guaranteed by the U.S. government, could entice fresh finance via the bond market once again.
So far, no one is prescribing the same kind of strong medicine for paper money today. But how might this slow-motion destruction of confidence in government-issued currency be resolved in the long run? It might take more than a few 0.25% hikes in interest rates. But if Washington were to make owning gold illegal once again – as in 1933 – at least U.S. investors now have the option of hoarding physical gold offshore ... beyond the reach of their government’s caprice and diktat.Link here.
BONDS: WHO IS MANIPULATING THE FED?
According to entrenched lore, the Federal Reserve System is the primary arbiter of the direction of U.S. interest rates. The Fed’s every prelude and move is eagerly awaited, packaged and sold by the media to a currently adoring public. And, for investors who do not look too closely at what is actually happening, it does seem the Fed drives the bus. But a closer look dispels a large chunk of this myth.
Three of the tasks of the Federal Reserve System are to seek maximum employment, stable prices and moderate long-term interest rates. It is beyond the scope of this article to investigate the Fed’s success at stabilizing the economy, but you will probably agree that price stability over the last 50 years has been debatable. And as for the Fed’s efforts to moderate interest rates – well, a cursory glance at a Federal Funds rate chart will tell you how “well” they have done.
The Fed tries to set the effective federal funds rate by targeting (relatively matching) the rate that banks charge each other for overnight loans. Wikipedia says that, “This rate is actually determined by the market and is not explicitly mandated by the Fed.” But the Fed itself, like most confident bureaucracies, has little doubt that they are in control of interest rates: “The interest rate on federal funds, the federal funds rate, is highly sensitive to Federal Reserve open market operations. For example, if the Federal Reserve wishes to decrease the federal funds rate, it may purchase U.S. Treasury securities in the open market, thereby increasing the availability of bank reserves and putting downward pressure on the federal funds rate.” (newyorkfed.org)
This chart is simple, accurate and speaks for itself. It clearly shows who follows whom. Why does the myth of the Fed’s control over interest rates persist, then? The only reason I can imagine is that most people have never plotted the actual data on a chart. Such a lack of curiosity is definitely not the typical personality trait of successful traders, who must think for themselves.
A number of financial writers are beginning to suggest defensive investors move into treasuries. Well, now that you know who follows whom, to set up your position in the bond market do you want to rely on what the Fed might do – or would you rather look at what the market itself is telling you?Link here.
LOWER-RISK PINK SHEETS STOCKS
A major concern with investing in stocks listed on the Pink Sheets is accidentally stumbling onto an illegitimate company that could instantaneously drop 50%, 75% or even 100%. It happens all the time on this thinly regulated exchange. The Pinks are crawling with pump-and-dump penny stocks and even sub-penny shell companies that do nothing more than issue periodic press releases and more shares of worthless stock. There are always new investors to scam, and new press releases with new business plans to push. Crooked companies flock to this exchange, all too eager to fleece unsuspecting investors of their money.
And then there is the scarcity of information available to investors on many of these companies. The Pink Sheets is not an exchange like the NASDAQ or AMEX – it is only a quotation service. The only requirement a company faces on the Pinks is that it must have at least one market maker quoting its stock. Financials do not need to be disclosed. Even on the OTCBB, companies are required to keep current filings with the S.E.C.
These hurdles can make the information gathering process for Pink Sheet investors very frustrating. But there is a very small group of stocks on the Pink Sheets that every small-cap investor should know about. If you are looking to invest in Pink Sheet securities instead of making quick trades on momentum, this is the place you should look. It is a new premium listing service on the Pinks called OTCQX. The new listing service includes three different levels, each with specific requirements for the companies.
The top tier is called PremierQX. These are securities that trade for a minimum of $1 and meet all of the requirements to be listed on a national stock exchange. The companies are required to post quarterly and annual reports, and also interim information that could affect share prices. The second tier is called PrimeQX. Stocks here must also meet the requirements to be listed on a major exchange, but do not have to trade for the $1 minimum. International OTCQX stocks must meet requirements of their foreign exchange and make their reports available in English. All three groups require the companies to maintain ongoing operations (this helps keep those pesky shell companies out of the picture). Together, these three lists make up the safest investments on the Pinks. It is a great place to start looking if you have never invested in these types of companies before.
As of today, there are only seven companies listed on the OTCQX: Computer Services (CSVI), Meritage Hospitality Group (MHGU), Moro Corporation (MRCR), Day Software Holding A.G. (DYIHY), Globex Mining Enterprises (GLBXF), Wal-Mart de Mexico S.A.B. (WMMVY) and Starpharma Holdings Ltd. (OTCQX: SPHRY). The list is practically brand new, having commenced trading on March 5. More stocks should be added to these groups in the very near future. The people at Pink Sheets are currently processing applications filed by 20 more companies. The quotation service will probably announce additions to the OTCQX lists soon. This could be great exposure for some small, legitimate firms. And it could also be a great opportunity for savvy penny investors to score shares.Link here.
TWO AGENTS THAT WERE SUPPOSED TO HAVE MADE A GREAT BULL MARKET RISK-FREE
A great bull market involving stocks, commodities, and low grade bonds ran for a number of years and completed in 1873. During the latter part of it, Europe suffered a war and, with the usual strains found in credit markets, the establishment found two features that would eliminate risk. One was that Treasury Secretary Richardson had immense abilities and powers that would prevent anything going wrong. Then, backing this up, was that the undersea telegraph cables could render the immediate transfer of the precise amount of liquidity to extinguish a problem.
A recent article by a well known historian observed that today’s instantaneous news transmission will be less forgiving than in the past. Also noted was that long-distance communications “were a bit patchy” as far back as 1914. This seems to be a limited step towards fully appreciating the role of “instantaneous communications” and phases of great excitements in the financial markets. Indeed, long distance communication was virtually made instantaneous in the late 1860s with wire services provided by cross-channel and transatlantic cable systems. This, as well as the speed of the “new” ticker tape machines were important parts of the bubble in stocks, corporate bonds, and commodities that blew out in September, 1873. Western Union Telegraph was the popular big-cap high-tech stock.
On the way up the boom, the enthusiasm went beyond individual high-tech favorites and formed a consensus that instantaneous communication would provide ready assistance in staving off a liquidity problem. The leading New York newspaper, the Herald, had editorialized that the power of central government could also be used to avert panics. Secretary of the Treasury Richardson’s esteem was considerable and, most believed, proof against liquidity problems. At the time, the U.S. was between experiments in central banking and absent such an agency with the hindrance of a gold-convertible currency, it was argued that the Treasury could issue any amount of liquidity to stave off any problem.
The ironies with and subsequent to the appearance of financial stringency in that fateful September of 1873 are worth reviewing. The stock market crashed through October such that Western Union plunged from $90 in mid-September to $46 at the end of October. The instruction is that even with instantaneous “cable transfers” a highly speculative financial market recorded yet another typical September to November catastrophe. Then, despite more time for more assistance, the global bear market endured until 1878. As with the previous great bubble that climaxed in 1825, the post-1873 contraction was lengthy. The U.K. was the senior economy and leading economists called the period from 1873 to 1895 as “The Great Depression”. The ultimate irony was that economists were still analyzing “The Great Depression” as to how it happened, or been ameliorated, or even avoided, well into the 1930s.
The financial mania that climaxed in 1873 was fourth in a series of new financial eras that began in the early 1700s. From the peak of the last business cycle with the “old” and disturbing era of inflation, all six such eras ran for 9 years. Then the data are available to the month, which is the case for the 1929 and 2000 examples, the duration was 116 months. Also, in 1873 the U.S. dollar was fiat and Europe suffered the Franco-Prussian War of 1870-71. Paris suffered bombardment and siege that threatened starvation. So there are some similarities to the recent financial mania as it is being played out in the U.S.
One reason the crowd partied too late in 1873 was that the Secretary of the Treasury had immense powers to prevent contraction. At the height of the boom, the Herald editorialized: “Power had been centralized in him to an extent not enjoyed by the Governor of the Bank of England. He can issue the paper representatives of a score or more of millions ... it is difficult to conceive of any condition or circumstances which he cannot control.” In so many words, risk had been eliminated. This was reinforced by the new instantaneous communications that would render immediate assistance, should any be needed.
Essentially, there are two ways of reviewing financial history. One, the more popular, is to rewrite with little use of quotation. The other, for full effect, directly employs rich and vivid quotation. This brief review will close with another from the always positive Herald. This irony was in claiming that a panic was not possible. After the initial phase of the crash (on October 1) the cheerleading continued with: “A crisis in our financial dealings has been met and passed without loss of confidence, without fear, largely without distrust. Here are growth, understanding, increased knowledge, firmer reliance. [We have] safe engineers in time of peril.”
According to mainline economists, The Great Depression ran from 1873 to 1895. At the height of the 1929 mania, the popular consensus was that the old, destabilized, and discredited Treasury System had been replaced by the vastly superior Federal Reserve System – whereby nothing could go wrong.Link here.
CAPITAL SPENDING: MYTH AND REALITY
In what should be no surprise to readers of this column, BusinessWeek is talking about “The Real Economic Threat: Weak Capital Spending”. There is no paradox about falling capital spending, nor is there a disconnect, except in the minds of proponents of the Goldilocks theory. It remains complete silliness to expect businesses to expand in the face of rising defaults, rising bankruptcies, and decreased needs for all kinds of durable goods associated with home purchases. Nonetheless, that is what nearly everyone seemed to believe. MarketWatch is reporting that, “Lower earnings could cut into capital spending, hiring.”
The grim reality is that, excluding transportation, durable goods orders fell 0.1% in February. “Awful data,” concluded Ian Shepherdson, chief U.S. economist for High Frequency Economics, in an email. In Ben Bernanke’s economic outlook before the U.S. Congress Joint Economic Committee on March 28, he said, “Although core inflation seems likely to moderate gradually over time, the risks to this forecast are to the upside.” If inflation risks are to the upside, then why did he remove the statement about additional monetary firming being required from the latest FOMC statement? Answer: He is spooked more than he is letting on about the risks of a continued housing implosion.
Bernanke also claimed that, “Anecdotal reports suggest that businesses are having difficulty recruiting well-qualified workers in a range of occupations.” What about anecdotal reports about “The Disposable Workforce”? That last jobs report was anemic, with fewer than 100,000 jobs created, and 39% of those were government jobs. And with so many homeowners missing payments, exactly why should “growth in consumer spending ... continue to support the economic expansion in coming quarters”, as Bernanke claimed? What about “Hot Lines for Hard Times” and 2.1 million homeowners who are struggling so much that they missed a home payment in the fourth quarter?
It is pretty tough to swallow the idea of strong consumer spending in the face of 2.1 million homeowner delinquencies. And what about those rising inventories in both housing and durable goods? What about the effect of interest rate resets, the bulk of which have not yet hit? If someone is looking for a major disconnect, here it is: Bernanke is expecting growth in consumer spending in the face of a housing bust, a slowdown in capital spending, rising defaults, and massive interest rate resets that will culminate later this year.
Unlike Greenspan’s typical congressional testimony, one can actually understand every single word Bernanke said. Unfortunately, we have traded Greenspan’s incomprehensible gibberish for Bernanke’s comprehensible doublespeak. That doublespeak allows Bernanke to sit in his ever-tightening box pretending that these economic problems will go away, there will not be a housing spillover, capital spending will rise, and consumers will not throw in the towel. He is wrong on all counts.Link here.
IT’S DELIGHTFUL, IT’S DELOVELY, IT’S DELEVERAGE!
The broad U.S. economy itself can appropriately be called the Asset Inflation Nation! Just have a little glimpse at this chart. We are looking at the annual increase in household real estate and equity holdings as a percentage of the annual change in household net worth. Real estate and equity price inflation has driven two thirds of the increase in household net worth in the current decade – the largest number we have seen in six decades at least.
Without belaboring the point, this change in character of household net worth creation over the last three decades has indeed influenced household consumer behavior as is clearly depicted in this chart. Quite simplistically, have the drivers of household asset inflation beginning in the early 1980’s influenced consumption patterns and the character of the U.S. economy since that time? If this graphical view of life does not answer that question, then we just do not know what does.
Asset inflation has been a huge macro force for some time. So just why is this all of a sudden important now? Because in very large part the character of continued household asset inflation over the last three decades has been accomplished by the macro theme of accelerated leveraging of household assets. This chart really says it all and ties directly back into the breakout periods of the prior two charts. In large measure, all of these charts reflect baby boomer demographics. The baby boom generation has been more than willing to lever up their personal balance sheets over the last quarter century without so much as batting an eye. Since 1980, household leverage as a percentage of GDP has doubled, after remaining relatively constant in the prior quarter century. As this baby boom generation pushes ever closer to retirement years where income and liquidity will most certainly be two primary concerns, just how much more leverage requiring long term cash flow servicing will they be willing to accept? How many more assets do they have left at the household level that are both appreciating in price and can be further levered? At this point, for all intents and purposes, it is clear that the process of leveraging has had a profound influence on both household net worth growth as well as the character of the real consumer driven U.S. economy.
We are an asset inflation dependent nation that has been brought here on the horse called leverage. Over the recent past, leveraging household real estate assets has been the ticket to continued net worth acceleration and GDP growth dependent household consumption patterns. So far, its been delightful. So far, its been delovely. But up to now, let’s face it, it has really been driven primarily by deleverage. So as we look ahead, it is the character of the macro credit cycle that we believe is THE most important area to monitor. If households balk at further levering their own balance sheets ahead, what happens to real estate prices? What happens to consumption? Although these sound cliché at this point, with the change now occurring in the U.S. mortgage credit markets, we believe it is of central focus.
The important corollary to the willingness to leverage has been the availability of credit at ever lower prices for really over two decades now. We humbly suggest that anything acting to upset this symbiotic willingness and availability relationship changes the game. And although it is more than obvious at the moment, a credit contraction in the land of widespread mortgage credit availability would do the trick in about five seconds in terms of being a marker of important change.
Overextension of credit in the mortgage markets has now come home to roost. Deterioration in subprime is self obvious. The spillover is already being seen on the edges of the Alt-A paper world. And although so many talking heads have put forth the premise recently that the “worst is already behind us” or that “subprime credit deterioration is contained,” events in the mortgage credit markets as of late are EXACTLY how broad credit contractions begin. They always begin at the margin. Initial problems are always contained. Until they spill into other areas. To suggest that the worst is already behind us in subprime and other questionable mortgage credits is lunacy.
And during the current cycle, we believe the thought that the Fed will ride to the rescue is a good bit misplaced (although they will surely try). Why? Because in the current cycle, so much credit creation has taken place outside of the banking system. The Fed is no longer large and in charge when it comes to the total credit cycle, and especially mortgage credit in our current circumstances. Private credit markets have absolutely no incentive whatsoever to “accommodate” or “provide liquidity” to ease the pain once a credit cycle turns dark. And it is private credit markets that have largely funded mortgage credit creation for years now, not the Fed or the U.S. banking system. Just think back to how quickly funding was pulled from New Century Financial. Does blink of an eye sum it up? Asset Inflation Nation, you are on notice sir!
We want to switch gears a bit. As explained above in very simplified form, there is no question in our minds that leverage is the horse that brought us to the U.S. household asset inflation party of the last quarter century. But we also need to importantly keep in mind that leverage has increasingly been a keynote of the acceleration in financial asset prices, especially during the current decade. One of the important premises of hedge investing is the ability to use leverage. The carry trade is about nothing but leverage. The derivatives markets do nothing but support leverage. And new age wrinkles such as CDO vehicles center directly on insuring against leverage gone bad. Of course, many of these are themselves leveraged in the almighty attempt to generate ever greater rates of investment return. You get the picture. Much like the household sector dependent on leverage for household asset inflation, the financial asset markets have likewise become quite the animals dependent on the ever-greater use of leverage in the investment process.
One of the clear results of all this leverage is that so many markets and asset classes really trade as one, directionally. The swoon in February and March certainly proves that out. Where the U.S. financial markets travel ahead is as much a function of the character of the global financial market as it is specific to the current attributes of the U.S. markets. The credit/liquidity cycle is really global in nature. Again, to simplify and characterize the most important events of the last few months, it is the relatively abrupt and coincidental breaks in the global equity markets in addition to the simultaneous rapid deterioration in the subprime corner of the U.S. credit markets. Both go directly back to the central issue of leverage. Without sounding too philosophical or conceptual, as we move forward we believe we need to watch for evidence of change in the character of leverage. As we see it, directional change in leverage has been responsible for real world economic outcomes for years now. Same really goes for financial market outcomes. So as we move forward, we need to ask, is macro leverage accelerating or decelerating in both the real economy and the financial markets? At any point in time, are we releveraging or deleveraging? Simple enough? Recent events simply force us to at least think about the process of deleveraging. And that has implications for both the real economy and financial markets. So here comes the big question, what do we watch if deleveraging is to take hold at some point?
First, the real world. We all know at this point that the blowups in the world of subprime mortgage credit will act to close off what has been an important avenue of credit creation in the U.S. economy, clearly influencing real world outcomes for the economy as translated through the housing cycle. As the credit environment has turned so abruptly in sub prime, former subprime lender after lender has been cut off from further “funding” in recent weeks. This is credit contraction in action – something that has been quite absent from the markets and real economy in recent years.
But maybe more importantly, many in the fast money community are finding, and some to their surprise, believe it or not, that they are exposed to subprime problems via investments in CDO’s, other structured products, etc. As leveraged investors begin to feel pain in their portfolios, not only do they begin to question broader risk exposure in a much more meaningful manner, but many are both forced to and many choose to deleverage, at least for a period, to stop the shortterm hemorrhaging. Macro growth of credit has been a one way street for many a moon. We have now hit our first important credit market speed bump. If the problems in subprime spread (which we believe they will), and/or investors begin to reprice risk vis-à-vis credit spreads in alternative credit market asset classes, will investors as a whole relever anew? Or will they begin a process of deleveraging (that we believe has just begun)? In a world and global financial marketplace grown accustomed to ongoing acceleration in leverage that has been supporting asset prices, any change in the process of what has been ongoing acceleration in leverage is wildly important. We are referring to deleveraging in the investment process, not homeowners paying down debt. This is all about the dynamics of structured/leveraged finance that has come to characterize the U.S., and in good part global, financial markets. That is the issue.
Leverage that has already turned against its practitioners and former benefactors in the land of U.S. subprime mortgage paper. From a macro overview standpoint, we cannot overemphasize how important it will be to keep an eye on fixed income credit spreads as well as emerging market debt and equities. These have been the primary areas most heavily influenced by macro leveraged investment/speculation over the last three to four years. So too should they be the areas to “tell”" us change, in terms of potential deleveraging, has arrived.Link here (April 2007 issue).
LEVERAGE BLACKENS A BLUE CHIP
New Century Financial has gained notoriety as the biggest blowup in the unfolding subprime mortgage debacle. With hubris reminiscent of Enron, New Century came up with the corporate motto, “A New Shade of Blue Chip”. But this business was not your parents’ idea of “blue chip”. Blue chip normally refers to companies with priceless brands, dominant market positions, and/or rock-solid balance sheets.
New Century’s management and board must have viewed their business model as revolutionary and deserving of the “new shade” motto. Unfortunately for their shareholders, it more closely parallels Enron’s revolutionary “asset-lite” business model than that of a real blue chip. New Century was involved in a market with few barriers to entry (writing loans – anybody with capital and experience can do this). And it was managed in a slipshod manner with the added pressure of a grossly overleveraged balance sheet. To complicate things even further, a few years ago, New Century opted to transform itself into a tax-advantaged real estate investment trust (REIT), thereby committing most future earnings to dividend payouts. This took away management’s ability to conserve cash when business would inevitably worsen.
As I wrote on February 15, New Century “has been caught with its pants down and now faces financial restatements, shareholder lawsuits, and an uncertain future.” On the day this article was published, New Century stock closed at $18.78 per share. It has since been delisted from the NYSE. Several million shares per day now trade in the $1 per share range on the Pink Sheets.
In the 2/15 article, I wrote, “New Century is facing a liquidity crisis by violating several covenants on its own lines of credit. Creditworthiness is a rather important characteristic for lenders to maintain. The laundry list of Wall Street firms providing these lines probably agrees ... and are likely to balk at extending credit at the time New Century needs it the most.” Within a few weeks, New Century needed credit to continue operations. But pleas for a financial lifeline were met with silence. Most recall what unfolded as soon as the Wall Street-sourced “liquidity” was shut off in early March.
The knockout blow arrived early this week as New Century filed Chapter 11 bankruptcy. The Wall Street Journal reported that, “Most of New Century’s borrowings are short-term credits from such institutions as Morgan Stanley, Goldman Sachs Group Inc., and Barclays. Those credits are backed by mortgage loans, and the lenders have begun seizing that collateral and in some cases putting it up for sale. ... In a bankruptcy filing, such lenders are ‘in a very protected position’ and their losses ‘will be quite minor ... assuming the collateral has decent value,’ said Ronald Greenspan,” a senior managing director with FTI Consulting, which is acting as financial adviser to unsecured creditors in three subprime bankruptcies.
Describing the value of New Century’s collateral – a portfolio of subprime mortgages – as “decent” is quite a euphemism. “Decent” is in the eye of the beholder. While the collateral is very difficult to value, it certainly has some value – perhaps a bit more than creditors’ claims. That is why a few bold speculators are still trading New Century stock. They believe the collateral’s value exceeds the claims of creditors by more than $1 per share. But if they really appreciate New Century’s reckless lending practices, these speculators should not be surprised if the stock goes to $0.
Let’s skim New Century’s latest available financial statements for hints of a potential corporate blowup. Corporate autopsies can help investors avoid situations like this in the future. The first clue lies at the heart of New Century’s business: a snazzy automated credit-grading model hyped as a competitive advantage. Unfortunately, these types of mathematical models are used widely on Wall Street and are only as good as the assumptions that go into them. A model built upon the history of the last 20 years of U.S. housing and employment markets will not function smoothly through the uncertainty of the next 20. For example, what if a borrower’s income looks good because he is a realtor whose income was inflated by a few years of red-hot home sales? How can a model capture the effect of a housing market downturn on this borrower’s personal balance sheet and income statement? Yet this type of model prompted New Century to write toxic loans.
The returns from successfully navigating the high-risk mortgage market are high as long as the positive of receiving high interest rates in an inflating housing environment more than offsets the negative of high default rates. But these returns apparently were not high enough. Management clearly wanted to “juice” shareholder returns by employing tons of leverage. New Century management was in a position of controlling $25 billion worth of assets with a $2 billion sliver of equity. There is very little margin for error when using this degree of financial leverage. If business is humming along nicely, the returns for shareholders can be huge. But if New Century’s assets were to fall just 8% in value, bankruptcy would become likely unless a new investor provided “loan shark” financing or offers to refinance its entire balance sheet (the market has already anticipated such a hit by severely punishing its stock).
Leverage was the key ingredient that set New Century up to fail. The growing number and size of “early payment defaults” – described in my 2/15 article – merely pushed the company over the edge of insolvency. Early payment defaults triggered an off-balance sheet liability that hardly anyone was thinking about as recently as January. The real tragedy lies in the fact that a syndicate of banks was foolish enough to lend New Century $13.8 billion to speculate on high-risk mortgages in the first place. It is yet another credit bubble symptom.
The balance sheet also shows that banks and Wall Street brokerages provided an extra $8.5 billion worth of short-term financing to New Century in order to facilitate the “origination” business. Firms like Bear Stearns did this so they could be first in line to slice and dice toxic waste subprime mortgages into collateralized debt obligations (CDOs). Institutions were hungry for CDOs up until about a month ago, so Wall Street made a killing as a middleman. For a thorough yet entertaining primer on CDOs, I direct you to Bill Bonner’s piece “Loans From Hell”.
New Century was an incredibly complex business that set itself up to be one hiccup away from bankruptcy. In most cases, avoiding stock in leveraged, complex business will serve you well.Link here.
SAM ZELL FALLS FOR THE PRIVATE EQUITY SWINDLE
And is willing to risk everyone else’s capital to pull it off.
Sam Zell’s purchase of the Tribune Company, owner of the LA Times, the Chicago Cubs, and 25 TV stations, has piqued our interest. Zell made his money in real estate – by buying and selling wisely. When he unloaded his Equity Office Partners to Blackstone a few months ago, we figured the man knew what he was doing. It looked like a top in the property market. And it looked like the old pro had found it.
But now Zell proposes to do something even more remarkable. He is entering a business that appears to be a long-term, structural downturn – like the U.S. auto business. The Tribune Co. stock sells for only half what it did in 2000, and only 60% of what it did a few months ago. The Tribune Co. publishes old-fashioned newspapers, while readers are migrating to the Internet, with advertisers following them.
“Whatever your weakness, the market will find it,” says Richard Russell. And one weakness to which we are all prone is vanity. We say this from recent personal experience. “Did you hear ... [a prominent, prestigious publication in London] is for sale?” asked a friend who came in the office just yesterday. For about two seconds, we were tempted. But, no, we prefer to write to our small group of dear readers – and enjoy the meager fruits of our labors in well-deserved obscurity. Whatever other merits it may have, there is less temptation to take ourselves seriously.
There is nothing particularly glamorous or prestigious about being a real estate mogul. Traditionally, it is gritty work, better than running a string of dry cleaning shops, but not much. So it would not be surprising to find that a man like Zell wanted to spend some of his loot to acquire a little better place in society. At 65, he is still a young man. He can still enjoy it. And we hear that his wife has gotten very interested in contemporary art. That is always a danger signal. Like a man who buys a convertible and has hair transplants, she must be looking for something more than money. The next thing you hear, she will be buying tracts of land the size of Delaware in Patagonia in order to protect nature from her fellow humans. So what is the deal?
In the old days, private equity purchases really could increase shareholder value. Old companies often needed a shake-up. A corporate raider could buy a public company, fire the fossils in the executive suites, sell off non-performing units, pay down debt ... and then, for his reward, he would have a better, more profitable company.
But the present fad for private equity is largely a swindle, and Sam Zell seems to have fallen for it. Management will stay where it is, he says. And instead of selling off the non-performing units, he is selling off the best ones – the Chicago Cubs and the TV stations. Plus, he is not paying down debt. He is adding to it. $7 billion of new debt are to be added, while the old debt stays where it is. Since the market value of the entire company is only $8 billion, that leaves the company with very little actual equity. And like Robert Maxwell, before he drowned, Zell is drawing on the employees’ pension funds to help finance the deal ... and putting the remaining equity into an Employee Stock Ownership Plan for the tax breaks. At least, that is how we see it – after the 10 minutes we gave to trying to understand it.
Zell was not born yesterday. He has got plenty of money from the Blackstone deal. And he is not fool enough to use his own money in this deal. Instead, he is putting up just a bit over $300 million. If the deal goes bad, he loses the money. But it represents only a small part of his fortune. If it goes well, on the other hand, he can make 10 times his money. But here is the part that we find interesting ... and telling. Thanks to the wonders of modern finance, a rich, experienced investor can now make 10 times his money while enjoying the prestige of newspaper publishing. Whether it works out or not, he will be able to enjoy his modernist art and his lifestyle of the rich and famous.
Meanwhile, the pensioners, the lumpen investors, the employees ... what will they get? Not much, according to Andy Martin. At a press conference where the Internet publisher, broadcaster and media critic made very clear that he will continue to oppose the Zell’s takeover, and will shortly file a competing proposal with the S.E.C. “I think it is ironic that on the day when New Century Financial filed for bankruptcy, the Tribune Company agreed to a takeover with a 2% down payment. That sure looks like a risky deal to the stock market, which has posted a tepid response in early trading,” Martin said. “Talk about a subprime corporate deal. Mr. Zell knows nothing about newspapers, but he is expected to now ‘know more’ than the entire industry. It makes no sense. And who gets left holding the bag when Zell parachutes out? Why the employees, of course.”
Andy Martin continued: “Once again, the investment bankers and brokers will profit by all of the transaction fees, and the public will be the loser. The Tribune will be left weaker, and under the direction of a man with no commitment to journalism and very little financial commitment to the enterprise. Mr. Zell has little risk and some upside; the employees have virtually all the risk and all the down downside.”Link here.
THE NEXT GOLD STANDARD
It appears that we are slowly drifting into a period of monetary turmoil. Turmoil leads to change, and ideally the result of a widespread desire for change will be the establishment of a new gold standard. Indeed, there are some indications that this may be achieved by the end of this year, although it may seem unlikely at this moment.
A necessary condition of a new gold standard is that at least a small group of people must understand what a gold standard is. So let us start with that. Humans have used gold (and its adjunct silver) as money since prehistory because it is the one item best suited for this role. The primary reason being that gold’s monetary value is stable, or at least more stable, than the alternatives. It follows that anything whose value is linked to that of gold must, by definition, be as stable in value as gold. It is not particularly a stretch to link the value of a paper currency to gold. In fact, the world’s first gold-linked “paper money” was made of clay, during Sumerian times, around 3500 BC. Clay tablets were used as warehouse receipts for gold, and traded among third parties.
It is not difficult to link the value of a paper currency to gold, even if the issuers of currency own no gold whatsoever. This is accomplished via the adjustment of the supply of currency, much like a currency board operates. Currency boards, such as those in use in Hong Kong or Estonia today, can just as easily and reliably link to gold instead of another currency.
One of the most straightforward ways to link the value of a currency to gold is to, quite simply, make the currency out of gold. In the past, when economies and currencies collapsed, people sometimes just started doing their business in gold and silver coins. Most of the dollar bills in the world today are actually being used outside the U.S., and it appears that most of them are being used in under-the-table or even illegal activities of one sort or another. The popularity of the dollar outside the U.S. has been in steep decline in recent years, and many people that had used the dollar for their business have been transitioning to euros or other currencies. Apparently, some of these underworld elements have even begun to do their business in gold coins.
However, there really is not enough gold in the world today to run today’s economy with gold coins. And since all of the existing gold is already owned, the question is, what is everyone else going to use? Unless we are going to have a worldwide collapse of the most dramatic proportions, which would make the Great Depression look like a hiccup, it will be necessary to establish a paper currency linked to gold. A few governments have indicated a willingness to step up to the plate, including a number from the Islamic world who share the tradition of the gold dinar. Russia has also shown some interest. These incipient attempts have generally foundered on a lack of confidence in the technical ability to actually get the job done right – a conclusion which appears to be correct. It is better to have no gold standard than one that soon collapses due to incompetence.
That said it is also necessary to know how to create and maintain a viable gold standard. That is a subject rather more complicated than we can deal with in these pages, but at least we can now identify the steps along path from the present state of worsening chaos to the land of monetary milk and honey. If the man-in-the-street has the knowledge of why and how to operate a gold standard, governments will likely follow along.
Another crucial stage will be to sweep away the encrustations of generations of misunderstanding of what a gold standard is supposed to accomplish. Many of today’s gold standard advocates cling to the most implausible notions decade after decade, just as today’s lovers of floating fiat currencies spout their own brand of ridiculous nonsense. A gold standard does not prevent a government from running a budget deficit. A gold standard does not prevent a current account deficit, which is another term for the importation of capital. In fact, a gold standard makes both government deficit financing and capital importation easier, because it tends to lead to lower interest rates and currency stability. As governments and other economic actors are forever engaged in all sorts of reprehensible behavior, and it is foolish to expect a gold standard to solve all those problems – just as it is foolish for the floating-currency advocates to think that the Fed can make any economic difficulty disappear by waving its magic wand over interest rates.
What can you do today? Imagine that a world of gold-linked money already exists. Things are considered politically impossible, but when they happen, and the historians call them inevitable. In this hypothetical world, the euro may be replaced by the gold dinar, which got its start in Dubai in the autumn of 2007. The gold dinar was equivalent to one gram of gold. The Dubai Commerce Bank – it was supported by the government, which provided deposit insurance on amounts less than 5 kilograms – offered CDs in gold dinars, which proved popular as they paid 1% interest and were redeemable in gold bullion. (ETFs based on these CDs almost immediately appeared worldwide. After deducting management fees, they paid a 0.80% dividend.) The bank then lent at 4.5%, in gold dinars.
The gold dinar was quickly adopted as payment for oil exports throughout the Middle East, especially since the oil futures exchange in Dubai priced its crude oil contract in gold dinars. Soon the Middle Easterners were anxious to reinvest their oil revenues, leading them to make loans to governments and corporations around the world – loans (and bonds) denominated in gold dinars, of course.
Consequentially, governments and corporations were eager to borrow in gold dinars because they bore interest rates of only 3.5% for a 10-year bond for governments, and 4.5% for corporates, rates that were common in the 19th century. This was far better than borrowing in dollars or other local fiat currencies, which bore rates in excess of 15% due to worsening inflation. The trade-dependent countries such as Korea or Malaysia, which had always linked their currencies to those used in international trade, soon gravitated towards the gold dinar, and eventually finalized their links via currency boards. China’s sheer size and international ambitions were too great for that country to become a monetary vassal of Dubai, so China established an independent gold-linked currency. The gold yuan soon became popular in Africa, where it was received in payment for commodities exports. Because both the gold dinar and the gold yuan were linked to gold, their exchange rates were effectively fixed. Russia followed soon thereafter, with an independent gold ruble. Japan and Switzerland were next.
The Federal Reserve eventually raised its interest rate target to 85% in an attempt to support the dollar, but that policy was not able to counteract the dollar’s worldwide rejection. Cindy Sheehan camped out in front of the Federal Reserve building, asking for a meeting with Chairman Bernanke. “I just want him to explain what ‘In God We Trust’ is supposed to mean,” she told the media. She was soon joined by over 200 others.
Despite becoming the first Chairman of the Federal Reserve to win a Nobel Prize in economics only six months earlier, Chairman Bernanke stepped down in disgrace, in the middle of his term. He then became president of the World Bank, replacing Paul Wolfowitz. Hyperinflation in the U.S.s eventually led to a new political party, formed by dissatisfied Congresspeople from both the Republican and Democratic parties, which took a strictly Constitutionalist approach to monetary affairs. The unused Federal Reserve building in Washington, D.C. was eventually converted into a museum of Native American art.Link here (scroll down to piece by Nate Lewis).
THE ENRONIZATION OF AMERICA
The Cato Institute ran a seminar on “The Culture of Enterprise in an Age of Globalization” which brought up the question: to what extent is the U.S. still a free market economy? It certainly was a free market economy in 1925, or even in 1995, but in the last decade the balance of economic power has shifted substantially from profit-seeking free businesses to rent-seeking operations dependent on subsidy and regulation. What is more, the balance appears to be shifting further in that direction. In honor of the late unlamented energy company that to a large extent epitomized the new tendency, one can typify the new outfits as Enrons and the economy as having been Enronized.
Enron itself was never a truly free market operation. It began by a merger of two pipeline companies, back in the days when pipeline revenues were regulated and hence profits predictable. It expanded internationally into various public utility operations that were wholly dependent on permits from foreign governments, some of which were then countermanded by different foreign governments, as in its Indian Dabhol power plant which became a gigantic loss-maker. Its energy trading operation, which eventually forced it into bankruptcy, depended largely on the regulations imposed by various U.S. jurisdictions as they haphazardly deregulated the energy market. It was never a free market operation, it was not run like a free market operation and its death was caused, not by extraordinarily criminality in its top management, but by the collapse of a rent-seeking scam in energy trading that was never likely to last forever.
Derivatives themselves are one area where rent-seeking is essential to success. If the market is perfectly competitive, the returns available from derivatives transactions quickly arbitrage themselves away, making it a business of high risk and very little profit. Only where there are quirks in the playing field, tax advantages, regulatory requirements, etc. can a superior return be made, either by leveraging a small cost advantage many times or through utilizing less capital in trading than competitors. Similar considerations apply to Third World debt trading and to the “carry” trade in which low cost yen are borrowed to invest in higher-yielding currencies. Both depend for their returns on the continuation of deal-friendly policies by the IMF and the Bank of Japan respectively.
As Thomas Woods, author of The Church and the Market said at the Cato conference, it is a universal economic law that people will seek to enrich themselves by the easiest means available. In a sternly enforced free market, with small government and puritanical ethical standards in public service, it will be very difficult to achieve riches other than through productive market activity between willing buyers and willing sellers. In a big-government culture with questionable ethical standards, huge government programs, opaque capital markets with separation of ownership and control and distant, globalized business relationships, there is no question that rent-seeking becomes easier than profit-seeking. Probably the greatest indictment of the easy-money years since 1995 is that the U.S. has moved a great deal further down this road.
Farm subsidies, for example, are a rent seeking way of life, although to be fair this problem originated during the Great Depression, not recently. In the U.S., the EU and Japan farmers have contrived to protect themselves from the vagaries of nature and the market by extracting subsidies from the taxpayer. The worst extension of agricultural rent seeking has been the U.S. ethanol program. Instead of allowing the free market to ramp up supplies from sugar cane in Brazil, the Caribbean and southern Mexico, the Bush administration has chosen to subsidize domestic producers of ethanol from corn who are not only far less efficient than sugarcane-based ethanol producers but may even produce more greenhouse gases than they consume. The free market has played almost no role in combating global warming so far, nor is it likely to. However great the dangers of global warming, it must surely be clear that to allow environmental lobbyists to control our lives in this way is a recipe for economic disaster far greater than any that could be caused by a global warming of at the most 3-4 degrees Celsius by 2100.
Lobbyists themselves are a sure indicator of the prevalence of “rent-seeking”, as is the level of “earmarks” – private spending proposals – in the federal budget. The number of Washington lobbyists has more than doubled since 2000, to around 35,000, a disgraceful statistic under a Republican administration, whereas the number of earmarks has increased by a factor of 10 between 1994 and 2005, again with Republicans in control. Needless to say, the $20 billion of earmarks in this year’s supposedly emergency $100 billion Iraq funding bill is sufficient indication that neither tendency will slow now the Democrats are back in control of Congress, nor would it slow with a Democratic Presidency in 2009. The explosion of lobbyists is fantastic news for Washington-area developers and realtors, who have been able to build and sell innumerable new homes of unsurpassable size and vulgarity, but very bad news for the U.S. economy as a whole.
Bilateral trade agreements are a further area where rent seeking has exploded. Under a multilateral agreement, since there are several countries participating in negotiations there are relatively few opportunities for private interests to structure a rent-seeking side deal, because there are too many parties involved. Under a bilateral agreement, particularly a bilateral agreement where one party such as the U.S., or indeed China, is much stronger than its trading partner, all sorts of side deals can be done that benefit particular businesses. Either imports such as sugar that would normally enter the U.S. can be blocked, providing protection for domestic producers with strong lobbies, or trade provisions can be structured so as to block third parties from a market. Bilateral agreements offer little or nothing to the world in terms of freeing up trade and huge amounts to well connected companies in terms of redirecting trade.
Further rent seeking takes place in the area of “anti-dumping” tariffs. Last week’s unilateral imposition of an anti-dumping tariff on Chinese coated paper was nothing more than a successful search for rent by the U.S. producer NewPage Corporation. Other examples abound. The increase in tort law suits in the 1990s, benefiting tort lawyers at the expense of the general public was another diversion of resources from profits to rents, as was the Kelo. v. New London Supreme Court decision in 2005, allowing condemnation of private property for politically connected redevelopment. Consider one final example that has been in the news recently and is explosively increasing its control over the U.S. economy: private equity firms.
Private equity was a relatively benign operation under which pools of capital would buy a company, strip out dead wood, restructure its operations and sell it, all within a couple of years. If the management of the private equity company was good, or the management in the company purchased egregiously bad, this added modest value to the economy – it was certainly very profitable indeed for the private equity firms’ partners, if less so for their investors.
However in recent years the expansion of private equity has led it to do deals in which the companies acquired are well run, the management is kept on and rewarded with a piece of the deal, and the turnaround to public shareholders is accomplished remarkably quickly, without any great corporate restructuring beyond a new logo. The value added of the private equity firm in these cases is its political contacts, which enable it to smooth the way for the acquisition, bring the acquired company some juicy licenses, pieces of government business or regulatory changes, and prime the market for a successful sale. This private equity investment by influence peddling, as practiced by the largest firms such as Carlyle and Blackstone, is crony capitalism in its purest form. It would fit well in the new Russia of Vladimir Putin. Needless to say, it is utterly detrimental to the rights of outsiders, and to the long-term performance of the U.S. and world economies as a whole.
The U.S. economy has been held up for the last half decade only by the housing and consumption bubbles caused by cheap money. Much of its healthy capitalist tissue has rotted internally, and been replaced by corrupt politically-determined rent-seeking. Only when the cheap money finally disappears, and recession occurs, will we be able to tell the full damage caused by the Enronization of America.Link here.
Mind over matter ... and money.
A few weeks ago, as I was rolling up the tracks from Baltimore to New York, my gaze landed on an oil refinery. A little while later, I spotted a casino. Then I started to think about these two very different forms of capitalism – one that relies on an intensive investment of physical capital and one that relies almost entirely on paper money.
Is one these forms of capitalism inherently better than the other? Does one of them produce a more enduring prosperity?
Yes, to both questions. ...Link here.
WHAT MAKES THE “SMART MONEY” SMART?
I lived in New York for several years and moved back to Laguna Beach, California recently. This adjustment is going pretty well so far. But you know, the two places are really not that different. Laguna Beach is really just like Manhattan without bagels or Central Park ... or cold weather, or crime, or filth, or air pollution. But I kind of miss the place. I spent the four of the best years of my life in New York. Of course I lived there for 8 years. Anyway, let’s get started ...
What makes the Smart Money so smart?
Well, first of all, who is the Smart Money? Who are those guys? I am not really sure who they are, except that I know they are often on the other side of my trades! So one way to begin becoming smart yourself is to analyze your bad trades. Somebody did something smart on the opposite of your losing trade. So one of the ways to begin to learn how to be a smarter investor is to ask yourself, “Okay, what did this guy do on the other side of my losing trade? What did he do that made him so smart?” Sometimes it is just pure luck. Sometimes there is something more to it. But this kind of self-examination is a great way to begin becoming smart yourself. Let’s go into more detail.
(1) The Smart Money is focused. It invests only in what it knows, and knows exactly why it invests. Whenever anyone asks me, “What is the main thing I should be doing as an individual investor?” I always answer, “Know your investments. And if you do not really know what they are, then do not do anything.” Warren Buffett probably put it best when he said, “Risk comes from not knowing what you are doing.” Many of you here operate in industries that you understand well. Or your education enables you to invest in various top-down ideas that you understand well. Invest in those kinds of ideas. In general, I would guess, if you looked at your own investment successes and failures, you would discover that the majority of your success occurred in the areas that you understood pretty well. And the reverse.
(2) Smart Money is contrarian. It avoids extreme situations. Or seeks them out. At the New Orleans Gold Show in October of 2003, I made the recommendation to avoid certain interest rate sensitive stocks: Fannie Mae, H&R Block and General Motors. Back then, a 3-month T-bill was paying less than 1%. A 10-year Treasury was paying less than 4%. In other words, these securities offered what Jim Grant referred to as “return-free risk”. You incur all the risk of a long-term bond, but receive very little return. This was an extreme market. And in the middle of extreme markets, you have to ask yourself, “How much more do I have to gain here?” In October 2003, you did not seem to have much more to gain by owning bonds, nor even from owning T-bills.
Many factors suggested that we were near a low in interest rates at that point, thus that interest-rate sensitive stocks would begin doing less well going forward. The total return for those three securities from October 2003 to the present was -16% for Fannie Mae,–14% for GM and -3% for H&R Block. What do these results tell us? They may simply tell us that I made a lucky guess. Or maybe these results tell us that in the midst of the extremely low interest rates of 2003, the risk/reward of holding interest-rate sensitive stocks was extremely poor.
So the Smart Money avoids extreme situations. Or seeks them out. In other words, it seeks out extreme values. Obviously, opportunity resides among the dispossessed, among the overlooked, the forgotten, the places where CNBC commentators and Wall Street Journal writers do not look.
(3) The Smart Money is selective. It focuses on superior opportunities and rejects the rest. The Smart Money focuses on the areas where it enjoys the optimal risk-reward proposition. No one goes into a restaurant and asks, “Hey, could you get me some reasonably fresh fish?” But in the investment sphere, we often do exactly that. We invest in things that look reasonably good, but not great. But I would bet that if you looked across the investment returns of your entire portfolio, the investments that have dragged that return down have been the marginal ideas. And if you had just stuck with the names that you really understood to be superior long-term opportunities, your total return would have been better.
It is important, therefore, to reject the ideas that do not measure up. There is a guy ho used to have an office right next to me, back in 1992 when I was managing money in San Francisco. He had $10 million under management. I had $10 million under management. Today he has about $2 billion under management and I have got – ohhh – maybe $200 in my savings account. He does all of the things I have just been mentioning. He is the Smart Money incarnate. He insists on having everything lined up perfectly before investing.
On the short side, he focuses on industries that are chronic capital consumers, rather than capital producers. You would never catch him on the long side of an airline stock. You would never catch him on the long side of a computer hardware stock, or the long side of a semiconductor stock. Those are industries that for more than two decades have consumed capital, in aggregate. And they have not produced wealth, in aggregate, for shareholders. They have produced some individual success stories. But, in aggregate, they have produced losses.
Over the last 20 years, airline stocks have produced a compound annual growth rate of -6%. The computer hardware industry produced a compound annual growth rate of -13%. So, why invest in these industries? Why buy the best house in the worst neighborhood? The Smart Money tries to find the worst house in the best neighborhood. The Smart Money tries to find the best value in a robust industry. I love this quote: “If a capitalist had been present at Kittyhawk during the 1890s, he should have shot Orville Wright. He would have saved his progeny some money.” This is a direct quote from Warren Buffett, who has gone on record to say that the worst investment he ever made was in USAir.
Airlines, overall, between 1947 and 2003 accumulated a net loss of $5 billion. Biotechnology between 1992 and 2003 consumed $41 billion. Obviously, there are some success stories in biotech. And there will be trading opportunities in the airlines. But again, in general, the long-term investor, the Smart Money, avoids industries that consume capital, rather than produce capital for investors.
(4) The Smart Money is patient. It cares less about lost opportunity than lost capital, but gives its investments time to work. It is slow to act, then slow to react. It does not mind missing out on ambiguous risk-reward propositions. It does not chase stocks when they are popular. It waits for moments of weakness. If you know your investments, and you have been selective, then you can invest with confidence. You know you have a solid long-term idea, so you have to give it time to work.
All of the great investors – the Warren Buffett’s of the world – have made their money by buying opportunistically, then holding on for the long-term. So if we look around in the stock market today, what are the “Smart Money” sells? What are the sectors to avoid? I am not the Smart Money, but I will just take some guesses about what they might be. Homebuilders would be one of them. A lot of folks think the housing stocks might be bottoming out, even though the housing market is not. They think we should be rushing in to pick up some homebuilding stocks off the bottom.
Maybe. But the housing market has become a capital destroyer. For my own money, I do not want to be the first guy back in there. I do not care if the stocks are bottoming, or that they are bouncing. I want evidence that this market has turned around before I am going to invest in a long-term trend.
Is there any evidence of a recovery in the housing market? Not if you ask insiders. If you are sensitive to crude vernacular, then you will not want to the next quote, from the CEO of D.R. Horton, a homebuilder: “I don’t want to be too sophisticated here, but 2007 is going to suck. All 12 months of the calendar year.” Nearly every homebuilding CEO has uttered a similar remark. You will not find an optimist. These folks probably know a little something about the homebuilding industry. Mortgage lenders. Same story.
To be continued ... [In next week’s WIL Finacial Digest too.]Link here.
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