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ALL THE WORLD’S A BUBBLE
How high will the Dow go? 15,000? 20,000? How about 36,000? While euphoria sweeps stock markets here and worldwide, there are at least a few voices of dissent.
One, unsurprisingly, is legendary value investor Jeremy Grantham – the man Dick Cheney, plus a lot of other rich people, trusts with his money. Grantham, chairman of Boston firm Grantham Mayo Van Otterloo, has been a voice of caution for years. But he has upped his concerns in his latest letter to shareholders. Grantham says we are now seeing the first worldwide bubble in history covering all asset classes. Everything is in bubble territory, he says. Everything.
“From Indian antiquities to modern Chinese art,” he wrote in a letter to clients this week following a 6-week world tour, “from land in Panama to Mayfair; from forestry, infrastructure and the junkiest bonds to mundane blue chips; it’s bubble time!”
“Everyone, everywhere is reinforcing one another,” he wrote. “Wherever you travel you will hear it confirmed that ‘they don’t make any more land,’ and that ‘with these growth rates and low interest rates, equity markets must keep rising,’ and ‘private equity will continue to drive the markets.’”
As Grantham points out, a bubble needs two things: excellent fundamentals and easy money. “The mechanism is surprisingly simple. Perfect conditions create very strong ‘animal spirits,’ reflected statistically in a low risk premium. Widely available cheap credit offers investors the opportunity to act on their optimism.”
And it becomes self-sustaining. “The more leverage you take, the better you do; the better you do, the more leverage you take. A critical part of a bubble is the reinforcement you get for your very optimistic view from those around you.” It is something to think about the next time you hear someone tell you that the stock market will keep rising simply because the world economy is doing so well. That would make sense only if we were paying a constant price for each unit of world GDP, instead of higher and higher prices for one slice of that GDP – equity.
Grantham concludes that every asset class is expensive today compared with historic averages and compared with the cost of replacing it. By his calculations, the only assets likely to beat inflation by any significant margin if you hold them for the next seven years are managed timber, “high-quality” U.S. stocks, and bonds. His “high-quality” U.S. stocks include Home Depot, Lowe’s, Merck, Pfizer, Johnson & Johnson, Exxon Mobil, UnitedHealth, Wal-Mart, AT&T, and Verizon.
“The bursting of [this] bubble will be across all countries and all assets, with the probable exception of high-grade bonds,” Grantham warned. “Since no similar global event has occurred before, the stresses to the system are likely to be unexpected. All of this is likely to depress confidence and lower economic activity.” Ouch.
Grantham sees two big potential catalysts that might turn this bull market into a bear: a surge in inflation, leading to higher interest rates, and a squeeze on profit margins, which are currently running way above long-term averages.
As for timing, he concedes that is impossible to predict. But here is the kicker: Even Grantham thinks you probably need to be bullish right now. The reason? Most bubbles, he notes, go through a short but dramatic “exponential phase” just before they burst. Like Japan in 1989 or the Internet in early 2000. “My colleagues suggest that this global bubble has not yet had this phase and perhaps they are right. ... In which case, pessimists or conservatives will take considerably more pain.”Link here.
PRUDENT BEAR’S DAVID TICE SAYS THE PLUNGE IS COMING
Global warming must be affecting the stock market as well. It is not just polar bears that are in trouble. Bears of any kind are being wiped out left and right, and they are nearly extinct. Someone call the World Wildlife Fund.
One of the few bears left in the wild is the so-called Prudent Bear (BEARX) – which, if my schoolboy Latin is correct, might also be known as Ursa Prudens. It has been more than 10 years since Dallas-based investment manager David Tice launched this mutual fund to hoard gold, short the market and prepare ordinary investors for the coming economic Armageddon. We spoke last week, just after the Dow topped 13,000.
“That is really irrelevant,” Tice says of the landmark. “It’s just a number.” Does the market’s seemingly inexorable rise shake his conviction that it is going to collapse? “It has been quite a rally,” he acknowledged. “But it doesn’t dissuade us in our opinion. We have never been more confident.” The Dow, he predicts, will fall “at least 50%” from these levels, and he says the market is only months away from beginning a sharp decline. “I think this is a topping pattern.” He calls the latest rally “a crack-up boom. At the tail end of credit excess it just gets crazier and crazier. It sucks people in, and it is an extremely dangerous scenario.”
In all, Tice argues that the rally of the past four years is masking a long-term bear market that began in 2000 and will not end for at least another five years. The reason? In short, Tice argues that the bull market is simply massive asset inflation caused by reckless lending and easy money. Sooner or later, he says, it will have to be worked out of the system. He argues the global money supply has grown by 18% a year for the past four years (no wonder asset prices are booming).
Crazy? Maybe. But anyone who looks at long-term charts must realize how utterly extraordinary, and unprecedented, the past dozen years have been. Stock market valuations, house prices, household debt, U.S. trade deficits – they are all tied together, and they have all gone berserk. It took the Dow Industrials nearly 100 years to put on its first 5,000 points – and just three to put on the second. Yes, there is plenty to make you nervous, and there are a lot of really good fund managers out there who are watching the latest boom with white knuckles and a large bottle of antacid. Tice is not alone.
Tice believes the canary in the coal mine will probably be the dollar. He expects the greenback to tank as international investors start to lose faith in the U.S. credit bubble. He also predicts the Federal Reserve will respond by jacking up interest rates to protect the dollar from complete collapse. That, of course, would bring the credit market to a grinding halt. We shall see.
In September 1996, when the fund was not even a year old, Alan Greenspan issued his famous warning against “irrational exuberance” on Wall Street. When Greenspan spoke, the Dow stood at around 6,400. The blue-chip index has more than doubled since then. Prudent Bear? Its N.A.V. is down from $8.40 to $5.70 over the same period. Waiting for the meltdown is an expensive business. When you factor in fund dividends,then over the past 10 years investors are only down about 5%. And that masks some pretty wild moves. Since the fund hit rock bottom in early 2000, investors have actually doubled their money. Not bad for a bear fund. And that has attracted investor interest. Prudent Bear’s fund sales hit $170 million last year, almost as high as their peak during the market collapse of 2002.
Clearly, Tice is not the only one nervous about the market. Funds under management are now $688 million, Tice says. “Since early 2003, the S&P is up 70%, but our assets are up 40%,” he says. “We have been more defensive than other bear funds because we have lost less money.” The reason? Tice is not just betting against the stock market overall. He is also short individual stocks, including selected homebuilders, financials and consumer discretionary stocks. Some bets, particularly in the homebuilding sector, have obviously done well recently.
Prudent Bear has also invested about 18% of its portfolio in companies mining precious metals, including gold, silver and uranium. And the prices for those have been skyrocketing. “Gold is the one asset that is not someone else’s liability,” Tice argues. “Gold is an asset that you can carry around in your pocket, and it is of value.”
Bears of all stripes believe gold will prove a “safe haven” if and when the economic reckoning arrives. The reality is that it has proven an exceptional investment over the past five years even while they wait. Part of Tice’s analysis, after all, has already proven correct. Easy money has driven up the price of all assets, including precious metals. Meanwhile, America’s crazy trade deficit has been slowly undermining confidence in the dollar as the world’s reserve currency. And as the greenback has slid, alternatives, including gold, have risen.
None of this has led to a dramatic market collapse yet. Tice notes that everyone in has a vested interest in keeping the game going as long as possible. “There are no enemies of asset inflation,” he says. “Washington likes it. Wall Street likes it. Consumers like it.” But as the sun shines on the markets around the world, he still believes storm clouds are on their way. “I am as confident as ever that we are going to be right,” Tice says, though he concedes, “Things are playing out more slowly than we thought.”Link here.
THEN AND NOW
Fed says hedge fund risks worst since 1998 LTCM crisis, but things are less alarming now than then. Yeah right.
Reuters went with the provocative headline “Hedge fund risks worst since ‘98 crisis, Fed says.” Over at Marketwatch, it was “Hedge fund study suggests parallels with LTCM Crisis.” But it was the Financial Times’ Richard Beales that best captured the essence of NY Fed economist Tobias Adrian’s paper “Measuring Risk in the Hedge Fund Sector”: “The risk hedge funds pose to the global financial system has reached levels by some measures comparable to those just before the Long Term Capital Management fund imploded in 1998 ... But the New York Fed said the similarities – involving close correlation among hedge fund returns seen before the LTCM crisis and again recently – had different causes, making the current environment less alarming.” From Mr. Adrian’s research:
“Hedge funds ... have grown in importance in recent years. Total assets under the management of hedge funds are currently estimated at $1.5 trillion, and the funds contribute more than half of average trading volume in equity and corporate bond markets. While the funds are major liquidity providers in normal times, their use of leveraged trading strategies has raised concerns about their liquidity effects in times of market stress.”
“Recent high correlations among hedge fund returns could suggest concentrations of risk comparable to those preceding the hedge fund crisis of 1998. A comparison of the current risk in correlations with the elevation before the 1998 event, however, reveals a key difference. The current increase stems mainly from a decline in the volatility of returns, while the earlier rise was driven by high covariances – an alternative measure of comovement in dollar terms. Because volatility and covariances are lower today, the current hedge fund environment differs from the 1998 environment.”
The current environment differs profoundly from 1998.
It may have been an oversight on my part, but I saw no reference in Mr. Adrian’s work to the fact that hedge fund assets in 1998 were “only” in the neighborhood of $240 billion. Since then, the industry has ballooned more than 6-fold. Total fund assets may very well increase in excess of $240 billion just this year. But even this in no way does justice to the dramatic transformation of the global credit infrastructure – how leverage is employed, the players and instruments, the proliferation of derivatives, and the multitude of leveraged strategies. I applaud central bank efforts to better understand systemic risk, yet such an endeavor today demands a much more comprehensive and intensive approach.
Notably, “broker/dealer” assets now approach $3.0 trillion, after ending 1998 at $921 billion. Commercial banking assets have grown from $5.63 trillion to $10.20 trillion, with corporate and foreign bond holdings ballooning from $176 billion to $781 billion. Life insurance company assets have increased from $2.77 trillion to $4.71 trillion. Government Sponsored Enterprise assets have doubled to $2.84 trillion, and outstanding agency mortgage-backed securities has almost doubled to $3.97 trillion. Importantly, the asset backed securities market has more than tripled in size from $1.16 trillion to $3.60 trillion. Money market fund assets have increased from $1.33 trillion to $2.31 trillion. Over this period, the CDO market has exploded from inconsequential to untold $trillions. Total U.S. credit market borrowings inflated from $23.3 trillion to $44.6 trillion.
Even assuming that leverage these days is not commonly employed to ridiculous LTCM-style extremes, I would suggest that the scope of “leveraging” employed throughout the various risk markets is today unlike 1998 or anything previously experienced. From Bank of International Settlement data, we know that the total notional value of global derivative positions ended 1998 at $80.3 trillion. Credit derivatives did not even have their own category. By the end of 2006, total derivative positions had ballooned to $370 trillion. And while we have not had a major derivatives blow-up for some time, there have been the recurring hiccups that remind us of latent liquidity issues associated with bursting bubbles and enormous derivative hedging/speculating operations.
May 2 – The Wall Street Journal: “Placing the right bet is only half the battle. The other half is making sure one can cash out at the opportune time. Nowhere has this become more apparent than in the opaque market for derivatives based on bonds backed by subprime mortgages. Those who rushed into this market earlier this year are learning that being right isn’t good enough as they struggle to cash in on trades that are profitable only on paper. ... ‘It looks like a great trade but it isn’t a profit if you can’t get out,’ said Scott Simon, who oversees $250 billion in mortgage- and asset-backed securities at Pimco ... ‘Investors had a naive belief in liquidity thinking just because you buy it, you can sell it,’ Mr. Simon said.”
Foreign central banks today are absolutely awash in reserves and liquidity.
And when it comes to differentiating 2007 from 1998, let us not neglect that the U.S. current account deficit is up 4-fold from $214 billion to last year’s $884 billion. After ending 1998 at $5.29 trillion, Rest of World (RoW) holdings of U.S. financial assets ballooned to $12.55 trillion by the end of last year. It is not just a coincidence that derivative positions have ballooned commensurate to the U.S. current account deficit. While U.S. trade deficits were quite formidable during 1997-1999, they were easily offset by the ongoing exodus of finance out of “developing” Asia, Russia and Latin America. The “run” on these currencies severely hamstrung domestic credit systems, while depleted reserve holdings exacerbated outflows and emboldened speculative bearish bets against the “periphery”. Global financial flows were disjointed and marketplace liquidity highly erratic and susceptible.
In this vein, today’s contrast to 1998 could not be more striking. Foreign central banks – “developing” and otherwise – are absolutely awash in reserves and liquidity. Massive U.S. current account deficits coupled with a quiet “exodus” by U.S. investors/speculators – shedding dollar liquidity to participate in the global inflationary boom – has simply inundated the world in liquidity. Major asset inflations are invariably caused by some – generally unrecognized – type of monetary disorder. In this case, its origination is within the U.S. credit system.
Strangely, this international backdrop of synchronized credit booms, massive outward dollar financial flows, and unprecedented speculation has created financial flows that are these days as robust and predictable as they were vulnerable and erratic back in 1998. This has all been possible only because foreign central banks have been willing dollar liquidity “buyers of last resort”. Global derivatives have been able to expand right along with U.S. current account deficits basically because of the aura of predictability associated with foreign central bank operations to recycle U.S. deficits. Over time, the certainty of central bank behavior has emboldened risk-taking. On a global scale, the herculean flows to world securities, asset, and commodities markets have created an extraordinary impetus for speculative endeavors. At the same time, the dependable recycling of (literally) trillions of “bubble dollars” directly back into U.S. debt securities has promoted aggressive speculating in our markets. These dynamics created Wall Street a once-in-a-lifetime opportunity to amass incredible wealth and power.
The 1998 environment – post Mexican “Tequila Crisis”, “Asian Contagion”, and Russian meltdown – was one of powerful global disinflationary forces and a paucity of liquidity. The hedge funds were, on the margin, either unwinding leveraged positions or placing bearish trades. “King dollar” was like a magnet pulling precious liquidity to U.S. markets. As we witnessed recently with the subprime crisis, the exceptionally vigorous flow of (non-precious) liquidity today sooths the markets like waves smooth the beach sand. Any deleveraging that took place was easily outweighed by the unfailing expansion of speculation, credit and liquidity generally. At least for now, hedge fund deleveraging and its potential market impact are not pressing issues for the Fed or the markets.
Gross distortions emanating from (now out-of-control) global systemic liquidity excess is today’s critical issue.
From this perspective, the unparalleled $500 billion (+/-) y-t-d increase in foreign central bank reserves is indicative of the inverse of 1998’s liquidity-constricting biases and disinflationary forces. Today, powerful expansionary biases foment only greater financial excess and historic asset and commodities inflation. At this point, the risk of irreparable system damage comes not from an unwind of leveraged speculations, but rather an all-encompassing frenzied expansion of global finance. About the only “deleveraging” likely in this environment is buying associated with the covering of bearish hedges and speculations. One can think liquidity excess-induced marketplace dislocation or, perhaps, Mises’s “crackup boom” on a synchronized international scale.
Undoubtedly, such incredible excess sets the stage for an eventual devastating reversal of financial flows. While the inflated “periphery” is no doubt vulnerable, the wildly distorted “core” is at great and escalating danger. Here, also, it is helpful to compare and contrast the late-1990s to today. Back then, chairman Greenspan and his “committee to save the world” had some distinct advantages that Mr. Bernanke will not enjoy. (1) Maturing “King dollar” gave the Fed great leeway to “reliquefy” and reflate. (2) The global disinflationary backdrop allowed global central bankers to loosen policies in an unprecedented fashion without worry of negative inflationary consequences. (3) As the world’s sole financial and economic “locomotive” at the time, U.S. monetary policy had significant sway over global energy, commodities and goods prices. (4) Asian, Russian, and “developing” economy central banks were desperate to build dollar reserves to protect against future currency runs. (5) The GSEs were in aggressive balance sheet expansion mode. (6) The U.S. mortgage finance bubble had not yet financed an historic housing inflation, encouraged U.S. (7), derivative markets were not approaching $400 trillion, with incomprehensible risks and ramifications.
In short, the Fed (overseer of the world’s reserve currency) has lost both its control over the inflationary process and its consequences, as well as its flexibility to respond to events. Admittedly, these extremely important developments are lost in today’s liquidity onslaught. When the eventual reversal of flows and dislocation arrives, it should be expected to have profound effects on the maladjusted U.S. economy and fragile U.S. and global credit systems. I will venture a prediction that hedge fund deleveraging will pale in comparison to the widespread tumult that will likely engulf currency, securitization, and derivatives markets – in risk intermediation generally. The derivatives markets are poised to falter into absolute liquidity nightmares, not easily resolved with aggressive rate cuts. The longer current destabilizing flows are allowed to run roughshod – distorting prices, risk perceptions, and economic structures in the process – the more arduous the unavoidable adjustment period. That is just the way it works.Link here (scroll down).
HEDGE FUND LEVERAGE: IT IS WORSE THAN YOU THINK
In general, hedge funds are not good investments. Combine the steep fees with the fact that the overwhelming majority of fund managers underperform the market, and the odds are stacked against the investor right from the start. Unless you think you have found the next Warren Buffett, you would most likely be better off investing on your own through index or exchange traded funds.
Fund managers know they need to post superior returns in order to justify their fees. It reminds us of an environment where baseball players were encouraged to use steroids and other drugs in order to break home run records. Evidence has come out that owners, coaches, players and reporters knew what was going on, but mouths were kept shut for the good of the game in terms of television ratings. On Wall Street, the steroid known as leverage is 100% legal and its use is encouraged by investment banks and institutional investors all over the world.
Let us consider a hedge fund that is invested in a handful of widely-held large cap stocks. Many components of the S&P 500 are levered several times their annual operating earnings, so say a fund manager’s stocks have an average of 3x leverage at the corporate level. Then suppose that the manager applies 3x leverage at the portfolio level. This actually seems conservative given that we have read about several large funds using double-digit leverage ratios in recent years. Next, let us assume that a handful of large funds-of-funds (levered at 2x) comprise the investor base of the fund. Since funds-of-funds often charge their own layer of fees, they are encouraged to lever as well. Finally, the individual people that invest in funds-of-funds often lever up themselves. We will assume an individual levers at 2x.
So when you do the multiplication math above, the leverage ratio of investor capital to assets from top to bottom is an astonishing 36-to-1. This means all you need is a 3% average drop in portfolio earnings and corresponding drop in portfolio value and some select end investors could be wiped out in the daisy chain of leverage.
To be fair, most hedge funds short a significant amount of stock, and these positions would benefit from a market-wide decline in earnings. However, given the strong stock market of recent years and days, we think the temptation has clearly been to lessen money-losing shorts to chase after ever-increasing longs. When the tide goes out, we may find out that a lot of fund managers were swimming naked. In such a scenario, it would not take a tremendous downdraft to wreak a lot of havoc given the record breaking amounts of leverage in the system.
Why did we not see stories in the newspaper of funds or notable individuals having problems when the Dow got hit for just under 4% in a single day in February? Because in the short term drops of several percent can largely be papered over in the short run by extensions of further credit at brokerage houses and banks. Heck, we would argue that many brokers and banks that have lent money have no clue as to the true value of the collateral that is posted throughout the chain. Given that a wide range of synthetic instruments, derivatives, and less liquid asset classes are often “marked to model”, it may take a number of months for the head-in-the-sand lenders to realize their collateral is worth a lot less than a hedge fund’s model. We venture to guess that a sustained 10-15% drop in corporate profits along with a corresponding drop in most stocks could set off a leverage liquidation chain.
It is one thing to be willing to pay hefty hedge fund fees for outstanding stock/asset picking performance. It is another thing to pay hedge fund fees for mediocre performance juiced by leverage. We think a perfect storm is brewing that may put a downward pressure on the vast majority of asset classes simultaneously. Just as all asset classes have been going up together, they seem destined to go down together as hefty valuations and disappearing liquidity prove a toxic mix.Link here.
HOUSE HUNTERS WITH WEAK CREDIT GET SHUT OUT OF MARKET
With a second child on the way, Chris Shields and his wife, Michelle, wanted to move from their 2-bedroom apartment in Southern California to a house with more space. But because their timing coincided with a shakeout in the mortgage market earlier this year, their credit now is not good enough to get a loan to purchase the house they wanted with no money down.
Rising interest rates and dropping home prices have squeezed a market that had been propped up by risky loans and easy credit during the housing boom. As mortgage bills came due, foreclosures rose, and the easy credit dried up for families like the Shieldses. “Now we are stuck in the apartment,” said Shields, 31, a firefighter who lives in Manifee, Calif. His wife gave birth to baby Gabriella at the end of March, and they are running out of space without options for a house.
In the past, lenders did not want to give mortgages to people with below-average credit because it was risky, said Kathe Newman, a professor at Rutgers University in New Jersey who has studied the subprime market and foreclosures. But the explosion of a secondary market for repurchasing mortgages provided more cash to lenders, and investors were willing to take bigger risks. Technology, such as automated credit scoring, also allowed lenders to quickly assess risk, she said.
This year, the volume of subprime mortgages is expected to drop by about 30%, said Jay Brinkmann, V.P. of research and an economist for the Mortgage Bankers Association in Washington, D.C. Over the last few months, Louis Allee, a mortgage broker based in Whittier, California, said he has seen fewer clients qualify for 100% home financing. More potential home buyers also are having to prove their incomes, and they must show they have the equivalent of several months’ mortgage payments in their savings account.
LaVerne Jackson, who sells homes south of Newark, N.J., said the mortgage situation is slowing her business. In early March, one of her clients was set to close one afternoon on a $320,000, 4-bedroom home. But the deal was canceled abruptly just hours before closing when the buyer’s mortgage company shut its doors, she said. Jackson said the housing market will suffer as buyers work to establish better credit. “They will have to do a lot of credit repairs before they can qualify,” Jackson said. “It also means the houses will sit a little longer.”
The shakeout of the market could have positive benefits, some housing advocates say. Ira Rheingold, executive director of the National Association of Consumer Advocates, said people will not qualify for loans they cannot afford. “People will have the opportunity to buy homes they can sustain, not the absurdities we’ve been seeing,” he said. “What is going to happen is only good for homeowners and consumers.”Link here.
REAL WORLD VS. FINANCIAL WORLD
More and more indicators are highly suggestive of an upcoming recession. I recently talked about capital spending, home sales, GDP, auto sales, and manufacturing in “Capital Spending Suggests Hard Landing”. This month’s free issue of Contrary Investor, called “Deficit Attention Syndrome”, contains some interesting charts and commentary on still more indicators that are signaling recession.
Trade numbers, auto sales, retail trends, housing conditions, and slowing in corporate capital spending all point directly toward a recession as a very strong possibility, based on historical precedent. But this real world of the U.S. economy is colliding with the global financial markets of the moment – financial markets that are clearly being supported and elevated by acceleration in monetary accommodation as of late. Across the globe, the year-over-year rate of change in monetary aggregates in the major economies is running in the double digits.
Here in the U.S., we know that M3 was bound, tied, and thrown off the side of the ship into the deep blue abyss a year ago. But as a quasi-substitute, MZM (money of zero maturity) is relatively broad in and of itself as a measure of monetary levels and acceleration. As an example of what is really happening in the land of stateside money/credit creation, this table lists the annualized growth rates of MZM over the last one, two, three, six, and 12 months. Get the picture?
There is no need for a quasi-M3 substitute. Bart at NowAndFutures.com has reconstructed M3. The only component that is not available is eurodollars, and Bart estimates that based on historical correlations. Still, eurodollars are only about 3% of M3, so unless eurodollars have skyrocketed unbeknownst to anyone, whatever he is off on eurodollar estimates is not likely to be statistically significant. Bart calls his reconstructed numbers M3b. Here is the weekly chart as of April 28. Is this a start of a pullback in M3? It will be interesting to watch going forward.
Excluding Everything, Things Are Fine
Caroline Baum is writing, “Housing? What Housing? I Don’t See Any Housing”:
Excluding housing, the U.S. economy is doing just fine.
“That’s the latest rationalization of a select group of operators who think that the Bush administration’s 4.6 percentage point cut in the top marginal tax rate and 5 point reduction in the top capital gains rate can protect the economy from any and all ills.
“To say that ex-housing the economy is doing just fine is tantamount to claiming that ex-Iraq, Bush’s Middle East policy is a rousing success.
“How valid is the claim that outside of housing everything is hunky-dory? Let’s go to the videotape to see how housing-centric the U.S. economy’s weakness really is.
“The Commerce Department reported Friday that real gross domestic product rose 1.3% in the first quarter, the slowest pace in four years. The year-over-year growth rate slipped to 2.1%, also a four-year low. ...
“Companies that haul the stuff consumers buy – United Parcel Service, for example – are reporting weakness in their domestic operations. UPS, the world’s largest package-delivery company, said U.S. volume showed no change in the first quarter from a year ago.
“‘I don’t think much of UPS’s business is housing related,’ [Northern Trust’s Paul] Kasriel says. ‘They don’t ship lumber, wallboard, and toilets’ ...
“Another quarter of growth with a 1% handle is apt to make Fed officials nervous for the simple reason that there is no mandate for a recession with inflation running at 2-something percent. When growth is that slow, all it takes is a big quarterly inventory decline to thrust a negative sign in front of GDP, which in turn leads to a diminution in confidence. ...
“Imagine how it would look if Congress were to ask [Fed Chairman Ben Bernanke] to explain why the Fed let the economy slip into recession with inflation so low. Would Bernanke be able to keep a straight face when he told them that GDP ex-housing was solid?
“Heck, GDP excluding consumer spending, business investment, housing, and exports was robust in the Great Depression, too.”
Things are not fine when you have to exclude everything to prove it. Then again, that is the difference between the real world and a financial world gone crazy with leveraged buyouts, derivatives, and carry trades.Link here.
“GROWTH” IS IN THE EYE OF THE BEHOLDER
It may come as a shock to many of you, but I too believe that we are experiencing a “Goldilocks” economy. However, unlike most on Wall Street I do not define this as economic growth that is neither too hot nor too cold. I believe the analogy is apt simply because U.S. economic growth is a fairy tale! When such gains are measured against the gains in the price of just about anything people buy, or in just about any foreign currency, it is a whole different story. Measured in euros, U.S. GDP has declined from €11.5 trillion in January of 2000 to €10 trillion today. From a European perspective, the U.S. economy has been in a 7-year recession, with GDP declining by close to 2% per annum.
Also ignored in the rhapsodizing over U.S. GDP growth is the extent to which consumption has been paid for with borrowed money. Since these debts must be repaid with interest, GDP will likely decline even more significantly in the future. Had we borrowed primarily to finance capital investment this would not be the case, as the loans could have been repaid out of increased income. However, as the vast majority of borrowing is simply used to purchase consumer goods, the income needed to repay the debts will have to come at the expense of reduced future consumption.
This week we received new data that illustrates how big of a financial hole U.S. consumers are digging. Despite disappointing sales from major retailers such as Target and Circuit City, first-quarter profits at MasterCard surged 70% to a record $214.9 million following a 19% jump in transactions. I see two possible explanations for this apparent paradox. The first is that despite buying fewer items, consumers were forced to borrow to pay for things that until recently they could afford to pay for in cash. A second possibility is that due to disappearing home equity and tighter lending standards, fewer home owners were able to tap into home equity and were thus forced to use credit cards instead. Since credit card debt carries higher interest rates and is non-tax deductible, it is far more expensive to finance then mortgage debt. Under either possibility, future consumption will suffer as an even greater share of personal income is devoted to making interest and principal payments on items consumed in the past.
Compounding the problem is the fact that job growth is stalling. As falling real estate prices, rising mortgage payments, and tighter lending standards knock the legs out from under American consumers, look for even worse jobs reports in the months ahead. If Americans are struggling to make ends meet now, imagine how much harder it will be without paychecks.
While Americans continue to sacrifice their futures to indulge their present, the rest of the world sacrifices today to build a brighter tomorrow. As a result, the American economy will become increasingly less significant in global affairs. In January of 2000, the U.S. accounted for a staggering 31% of global GDP. While that percentage is still an impressive 28% today, it will likely fall to 20% over the next several years. Once the bottom really drops out of the dollar, I expect U.S. GDP to fall below 10% of global GDP. By then the world will surely have realized that the U.S. economy has not been the locomotive of global growth, but rather the caboose. If the actual productive economies decide to decouple the deadweight, the train would actually move much faster.Link here.
Retail sales bomb.
April retail sales were expected to be weak, and excuses like an early Easter and bad weather were lined up in advance. The big surprise, however, was to the downside. April was a disaster for most retailers. It is interesting to note that these retail reports are on the heels of a brisk rise in revolving credit. This huge increase in revolving debt right in the face of a slowing economy smacks of inability to service current debt. And ability to service debt depends on jobs and rising wages.
Every time there is a dip in consumer spending, consumers come roaring back the next month. It remains to be seen if this is an outlier or not, but consumers are clearly stressed. There is one additional factor in this mess that scarcely anyone has talked about, and that is an overexpansion of stores. We have overcapacity in everything. We do not need more Home Depots, Lowe’s, Wal-Marts, Pizza Huts, or anything. But as long as stores were expanding, jobs were added to the economy, and that kept consumers spending.
With any sustained pullback in consumer spending, the massive overcapacity in retail stores will become rudely apparent. Perhaps this is finally it or perhaps not, but eventually, those stores that were busy hiring because of expansion are going to have to start laying people off. All the pieces are in place for one heck of a nasty consumer-led recession. Unfortunately, few are prepared for it.Link here.
IN THE BUY-OUT GOLD RUSH INVESTORS THROW CAUTION AWAY
Last week brought the unedifying spectacle of one family-controlled company bidding for another, both families deriving their control from super-voting stock. Since News Corp. and Dow Jones are old-established media companies, this voting structure might be thought a hangover from the past and specific to one sector. Sadly, it is neither.
Consider the impending flotation of Blackstone, the private equity firm. The company will be controlled by a board made up of its senior executives. That board will be hired or fired by the two founders, without any reference to the shareholders (technically, unitholders). Should any outsider build up more than 20% of the votes, the votes of those shares will be cancelled. And the opportunity to exercise votes will be somewhat limited. To quote the prospectus, Blackstone “does not anticipate that any meeting of the common unitholders will be called in the foreseeable future.” As a limited partnership, Blackstone does not have to meet the governance requirements of the New York Stock Exchange, where the units will be quoted.
All this matters, since a chorus of voices from both sides of the Atlantic assures us flotation is the way forward for private equity firms. It gives them currency to attract and retain staff, and it cushions them against downswings. Above all, it gives them permanent capital. Restricted voting rights, it seems, will be the norm. Fortress, another U.S. firm which floated in February, has a similar set-up to Blackstone.
It might be objected that institutions investing in those firms’ buy-out funds today are similarly powerless. On the contrary – they can refuse to invest in the next fund. This puts the institutions in a curious position. They make plenty of noise about the need to improve governance rights in public companies. But they are selling those companies to private equity, then buying private equity shares with no governance rights at all.
Why? Simply because in the private equity gold rush, investors have thrown caution to the winds. If they subscribe to leveraged loans, they require weak covenants or none. If they buy equity, they ask no voting rights. Like the dot-com boom, these will be strange times to look back on.
Has the quality of Wall Street analysis declined?
I have recently heard several chief executives complain of the poor quality of analysis on both the sell side and the buy side. If true, this would be worrying. It is the job of markets to set prices and they cannot do so efficiently without good information. No doubt, conventional analysis is less useful than it was. But the market has responded by shifting the burden of fact-finding elsewhere.
In the golden days of a decade ago, the best brokers’ analysts had privileged access to companies. They were also allowed in on corporate work, which did wonders for their bonuses. No longer. Run-of-the-mill analysts are reduced to churning out spreadsheets and the old-style model of brokers’ notes. The notes are ignored in consequence. Chief executives only see the brokers’ notes and are misled accordingly.
On the buy side, consolidation among conventional long-only funds has meant more money in fewer hands and less time to devote to individual companies. But hedge funds and private equity firms study companies in depth and some of the best brokers’ analysts have shifted over to help them do it. Chief executives should rest assured that their efforts are being scrutinized by capable people. It rather depends on their share price, of course, whether they find that soothing or not.
Sir Nigel Rudd, chairman of the pharmacy chain Alliance Boots, is evidently peeved that the merger of Boots and Alliance Unichem a year ago was badly received. Now KKR proposes a handsome premium to the market price. Analysts were allegedly stupid for not seeing the value Sir Nigel had helped create.
There are several fallacies here. KKR may have overpaid. Only time will tell, if at all. More important, analysts are abused for cooking up bids that never happen. Valuing a stock comes in three parts. First, establish its fundamental value. Then estimate the premium private equity might pay. Then guess the odds of that happening. Thus, if you calculate a stock is worth 100p and there is a 10% chance of private equity bidding 150p, the price ought to be 105p. Sir Nigel’s logic would suggest going straight to 150p. That would be, to coin a phrase, stupid.Link here.
FALLEN TECH ANGELS
Ace fund manager Walter Price finds some good technology stocks are on Wall Street’s losers list for the wrong reasons.
One reason Walter C. Price Jr. runs a star tech fund is that he is devilishly good at spotting beaten-down stocks that do not deserve their ignominy. In 2006 and thus far in 2007 Price’s Allianz RCM Technology has consistently turned in the best-ranked 10-year performance for a tech fund, says fund tracker Morningstar. Its recent 10-year annual return is an exceptional 16.1%. The MIT-educated Price, 58, has been with San Francisco’s RCM Capital Management since 1974
Tech stocks have staged a comeback of sorts after their dark night of the soul earlier in the decade, although they lag behind many other sectors. In 2006 the tech-laden Nasdaq Composite posted a 9.5% return, versus the broad-market S&P 500’s 13.6%. In this year’s rockier market, the two indexes are doing similarly, each up some 5%. Price looks for fallen angels – companies that used to sport robust, double-digit earnings growth, only to stumble for a quarter or acquire some black mark, like an options scandal. Some of these will resume their growth records. Which ones? “It is a little bit of a venture capital mentality,” says Price.
His fund has a large swatch of mainstream tech names like Nintendo, Cisco and Google. But it is in midcaps (generally defined by RCM as $1 billion to $15 billion in market value) that Price trolls for the surprise winners. Midcaps make up half of the portfolio. Helping in the search is RCM’s Grassroots Research division, which specializes in ground-level examinations of company operations. This is vital because it requires clearing the fog of bogus enthusiasm that surrounded too many tech issues. “There are a lot of companies that overstate their case and overstate their product,” Price says.
RCM launched the research unit in 1984 after taking a shellacking on the old Warner Communications, maker of Atari videogames. When the games did not sell one Christmas, Warner stock plunged. Founder Claude Rosenberg blamed himself for letting his people talk only to rah-rah analysts, not retailers. Store managers “would have told us that these games were piling up on the shelves,” Price quotes Rosenberg as saying. Rosenberg, now 79, left RCM in 2001 to focus on philanthropy.
So in the spirit of Price’s contrarian perspective and an intent to get early-mover advantage, here are some of his best picks (see table) from the $1.2 billion fund. These are not cheap, and one is not profitable. But he is convinced they have great futures.
Chartered Semiconductor (Nasdaq: CHRT) is partly owned by Singapore’s government. This company makes chips for tech outfits without manufacturing operations. But in late April the company reported the second straight quarter of earnings declines. Chartered produces chips used in Advanced Micro Devices’ computer processors and Apple’s video iPods. An excess of chip inventory and a price war between AMD and Intel makes things look iffy for the short term. And the monster of Chartered’s field, Taiwan Semiconductor, is the odds-on favorite to come out ahead during any industry turmoil. For the long pull, however, prospects look good for Chartered. It has forged an alliance with IBM and Samsung to create the next generation of semiconductors, at 45 nanometers or below. Chartered is down from its $12 high a year ago, although at $9 it has clawed back from the $7 nadir it hit in August.
Research In Motion (Nasdaq: RIMM) makes the ubiquitous and indispensable BlackBerry for executives on the go. Its stock doubled in 2006 but tumbled 8% last month after robust quarterly results failed to meet analysts’ expectations. Also hurting the stock: The company announced that stock options grants in the 1990s had been improperly accounted for. With a $24 billion market cap RIM these days is a bit beyond Price's midcap range, but he thinks its growth prospects remain remarkable. Price is especially impressed by the Canadian company’s moves to take it beyond its customary business clientele into the wider consumer market. The elegantly styled Pearl smart phone features a camera and a multimedia player that appeals to consumers. “Our Grassroots survey says that this product is really hot,” says Price. “So I think this adds a whole new growth layer.”
Price’s Allianz RCM Technology Fund is offered in multiple share classes. The no-load D shares, while not available for direct purchase, can be acquired through brokerage platforms at outfits like Fidelity, Schwab and Vanguard. The D shares cost $1.64 per $100 of assets annually, which is on the high side. You will not have to pay a purchase or transaction fee when buying the D shares through one of the fund supermarkets. The fund’s high turnover (272%) says this investment belongs in a tax-deferred account.Link here.
INDIA’S ROADS TO RICHES
Private financing is fueling an infrastructure boom in India. Invest in the builders.
The cow problem should delight investors. Between Ahmedabad and Vadodara in India’s heavily industrialized Gujarat Province, cattle – sacred to Hindus – tend to wander onto the highway, disrupting traffic and hence commerce. So, at great expense, the government is planning to widen the road and include cow underpasses, one of many such projects under way in India. Varun Bajpai, head of Macquarie Bank’s 76-person investment banking operation in Mumbai, is a fan of Indian construction outfits that will benefit from the massive building job now getting started on the economically booming subcontinent.
With its well-educated, English-speaking, low-wage workforce, India’s stunning growth (8.5% last year, with an even faster tempo expected ahead) faces bottlenecks. Some 80% of traffic is crammed onto just 3% of available roadway. The country’s antiquated power network is so overburdened that demand exceeds supply by 8% on a good day, causing frequent outages. The country needs dozens more airports. The volume of flights is expanding 10% yearly. Fast-growing China also has infrastructure problems, but investing in that country is dicier. In any event, India is hungrier for asphalt. It has just 3,700 miles of expressways vs. China’s 25,000.
The Indian government cannot afford to fund needed upgrades alone, so it recently opened infrastructure projects to private capital. Sleepy Indian construction companies that a few years ago existed on occasional handouts of government contracts now have fat order books. To sweeten the enticements the government is cutting the companies in on future revenues from the public projects.
Indian Prime Minister Manmohan Singh has promised $300 billion in new roads, subways, power plants, ports and irrigation canals by 2012. One-quarter of the projects will operate within the framework of private-public partnerships. That places financial risk squarely on the builders, says Sayali Mahashur of Riedel Research in Mumbai. In return, builders collect user tolls on projects for up to 30 years before handing them over to the government. India’s legal system is creaky and quirky, but there is some notion in that country that property rights should be respected and contracts enforced. The construction firms there are well capitalized and well run.
While international giants like France’s Saint-Gobain and the U.S.’s Halliburton may well get involved later – plenty of work is around for everybody – the early action is with the homegrown builders. After the global downdraft last winter Indian stocks are almost back to their February highs. Indian builders (see table) are expensive: Most have trailing P/Es near or above 25. Many can be bought as Global Depositary Receipts. The others can be had via your broker, although you will pay a premium for the trip.Link here.
INVESTING IN BANKING
I am starting to really give Southeast Asian banks a serious look.
No one ever feels comfortable walking into a bank. There is no denying it. A bank’s atmosphere immediately places you on the defensive. Banks project power and greed. It is their fundamental nature. One goes to a bank to beg, to ask for a loan. In return, a bank tells you what you are worth, down to the very last penny. A bank infringes on a man’s pride. It inherently conveys some type of God complex in the financial world. It is because all finance begins and ends with banking. This sensitivity issue means one thing: People do not like to bank with something they fear.
And what does just about every person living outside of the continental U.S. fear most? It is not Al Qaeda, Iran, Vladimir Putin or Israel. It is not Hugo Chavez or another international currency crisis. They fear the bully. They fear American imperialism, in whatever form that force may come. They know we own the IMF, the World Bank and the bombs to obliterate anyone who stands in our way.
They see our attitude. They know we do not know what it is like to have a war on our very own soil. To us, war is CNN. War takes place over a cup of coffee on the 60-minute Long Island commute into New York City. People fear what they do not understand. Most people living in foreign lands fear what we bring to the table. So do you think one person in Asia feels comfortable placing their money in an institution called “Bank of America”? The same logic can be used for most Americans. Do you think Johnny Smith from Topeka, Kansas would ever place the proceeds of his latest corn crop in the Bank of China?
Asia is creating personal wealth on a level that the world has never seen. And that money has to go somewhere. It will go into the banks of which 99% of Americans have never heard – names like HSBC, Standard Chartered and DBS. I think the big American names like Citigroup, JP Morgan and Wachovia know this. Their strategy will be to take large equity stakes in their Southeast Asian counterparts. And over the long-term, you will probably see the Asian banking community consolidate in a similar manner that the U.S. commercial banks did.
I think there are a slew of Southeast Asian banks poised for real long-term growth. As Christopher Browne points out: “The average person views banks as stodgy, old economy relics ... but what would we do without ATMs, debit cards or credit cards?” I agree. Banks are one of the few growth stocks I love to own. It is the world’s other “oldest profession”.Link here.
CARBON NANOTUBE MANUFACTURERS
Generally speaking, nanotechnology refers to objects and devices the size of a few molecules. However, researchers are busily developing applications that link enormous numbers of nanotechnology drive particles into larger structures. This has important business implications. The University of Texas reports that a team at UT Dallas has recently been able to “grow” sheets of carbon nanotubes at high speeds using a revolutionary process.
These sheets have many remarkable properties. They are transparent. They are also stronger than steel on a pound-for-pound basis. The new process “spins out” these sheets at the rate of about 20 feet per minute. By comparison, wool is spun out commercially at the rate of roughly 60 feet per minute. Unlike previous approaches that relied upon the dispersion of carbon nanotubes in liquids, this new approach is dry. Trillions of carbon nanotubes constantly rotate in a coordinated manner, with new ones attaching to the previous part of the sheet in a self-assembling fashion.
Carbon nanotubes are theoretically one of the strongest materials known to man, and may just be the strongest possible in terms of weight-to-strength ratio. They are considered ideal for applications where weight must be minimized, yet intense stresses will be applied to the finished product. Not only are the sheets both light and strong, they are very flexible. This is particularly important in space and aircraft applications, where minimizing weight is crucial to fuel economy. In years to come, we can expect to begin seeing these sheets molded into coverings and eventually structural components of aircraft and spacecraft.
In addition, these sheets have high electrical conductivity. They could be cut and formed into different shapes and serve as bright light emitting diodes (LEDs). LEDs are already increasingly being deployed as replacements to traditional filament-based bulbs, and this will hasten the transition. Another exciting potential use is as solar cells. Although the efficiency has apparently yet to be determined, this should offer advantages in the simplicity of the manufacturing process and eventually a very low cost per square foot. A more exotic use is in making artificial muscles.
It is funny how sometimes technologies from diverse areas converge. I recently had dinner in Baltimore with the CEO and lead scientific researcher of Hepalife Technologies (HPLF.OB: OTC BB), a Transformational Technologies Portfolio holding. The scientist is quite confident that his research will lead to the world’s first functioning artificial liver. They have the perfect liver cell line. It is basically immortal, does the same job of purifying blood as human liver cells and is “well-behaved”, meaning that it will grow to cover a scaffold and then stop growing.
So far, so good. The problem, Menzler candidly admitted, was that they have not yet found the ideal scaffolding material. I am guessing that these carbon nanotubes sheets with their flexibility, biocompatibility and durability may be just the ticket. You can be sure I will let the folks at Hepalife know about this breakthrough.
Multiple other possible applications have been identified, including batteries, fuel cells and even multifunctional applications in which the sheets can both store energy and provide structural reinforcement. Imagine, for example, a car battery that also serves as a roll bar. “Rarely is a processing advance so elegantly simple that rapid commercialization seems possible, and rarely does such an advance so quickly enable diverse application demonstrations,” said the Science article’s corresponding author, Dr. Ray Baughman, director of the UTD NanoTech Institute. The institute is reportedly working with some major corporations and government agencies to bring the technology forward to commercialization. I will be watching for small, promising companies to pick up some of these applications and run with them.Link here.
RHYMES WITH “SPANKRATE”
Bankrate’s (Nasdaq: RATE) business model is easy to understand, but its richly valued share price is not. The company operates a Web site that publishes mortgage interest rates. By so doing, it directs prospective borrowers toward prospective lenders ... for a fee.
Business was good during the housing market’s boom years. But the housing boom has busted, and yet, Bankrate’s high-flying stock seems not to have heard the news. Since Bankrate does little more than publish interest rate data, why should its stock sell for 50 times earnings? Could such a website have a lasting competitive advantage? Why could sites with far larger audiences – like MSN Money, Yahoo Finance, or Google Finance – not eat Bankrate’s lunch in the Internet advertising game? Perhaps more importantly, since Bankrate's core customer base is in the midst of a nasty downturn, why should Wall Street expect 118% earnings growth in 2007?
These are the questions that spring to mind when I think about Bankrate’s business ... and its lofty share price. Simply stated, I think RATE is a stock to sell. One caveat: 5.4 million shares, or 42% of RATE’s public float is already sold short, so the potential for a further “short squeeze” is high. At the same time, many of these shares have been sold short by very accomplished, patient institutional short sellers that are usually proven right over the long run. Since many brokers have restricted short sales of RATE, I recommend put options as a more attractive way to play the downside in Bankrate.Link here.
THE END OF OIL SECURITY
By seizing control of the Orinoco tar sands Tuesday, Venezuelan President Hugo Chavez delivered a stunning blow to U.S. oil security. If the world economy worked in the way postulated by the globalizers his action would hardly have mattered, except to the unfortunate shareholders of the affected oil companies. However, the world economy does not work that way, and Chavez’s seizure is thus of major long term importance.
Orinoco is important, not because of current production from the region, a modest 600,000 barrels per day at a cost of $20 per barrel – economic but well in excess of the cost of Saudi or even Mexican offshore oil – but because of the size of the tar sands deposit. This has been variously estimated at between 1.2 trillion and 1.8 trillion barrels of oil, with higher estimates more recently. At the latter figure Orinoco represents 34% of all known world oil reserves, and 58 years of world oil consumption at current levels.
Since Orinoco’s oil comes in the form of tar sands, extracting petroleum is expensive, and not all the theoretically available petroleum can be extracted. However, current estimates that only around one fifth of these sands can be economically used are probably over-pessimistic. Extraction technology can be expected to improve. Over the next couple of decades, production from Orinoco could be ramped up and extraction technology improved, so that the sands could take their rightful place among the world’s truly important sources of energy supply.
Thus if Orinoco and Athabasca tar sands in Canada were freely available to the world market the extreme “peak oil” theorizers would be wrong. There is enough oil supply for the world’s needs for at least 100 years at current prices. Only a sharp ramp-up in world oil usage or a disruption in the free trade patterns of world oil could prevent the U.S. and other major world oil users from having enough supply well past 2100.
Before Chavez’s action, a free world oil market seemed a reasonable assumption. There were certain rigidities, such as the U.S. refusal to deal with Iran, but Iran is a second tier supplier and there are plenty of other countries willing to deal with it. The main problem has been the extraordinarily rapid surge in Chinese and to a lesser extent Indian oil demand, which disrupted established market relationships and was bound to strain the system as well as raising oil prices.
In a well ordered market, other participants would have met with China and held open discussions of China’s future needs and the potential sources to satisfy Chinese demand. This would have ensured that China was reassured about the openness of world oil markets to Chinese participation, and might well have led China itself to play by the rules in a value-maximizing way. One way of convincing China that the world market was truly open to it, for example, would have been to allow the Chinese National Oil Company to buy Union Oil of California in 2005, a substantial but strictly second-tier transaction that threatened nobody. This did not happen. Instead the Chinese leadership, having been brought up outside the free market system, naturally do not expect to play by its rules. Having seen political pressure brought to bear in the U.S. Congress to prevent them buying an oil source on the free market, China has determined to deal primarily with the “bad guys” who violate human rights or are otherwise motivated by hatred of the US and the existing world order. Since in turn Chinese checkbooks have removed any incentive to good behavior for human rights violators with natural resource deposits, human rights abuses have increased, as has anti-Americanism.
However, until now China’s actions were not particularly important. The combination of Chavez’s visceral anti-Americanism with Chinese paranoia, when applied to the Orinoco oil sands is uniquely damaging to the stability of the world’s oil market. It is a marriage truly made in the nether regions as far as the U.S. is concerned. If Chavez did not have access to non-U.S. technology, even the simplest of embargoes would prevent him from exploiting Orinoco beyond its current state of development. With Chinese help, however, Chavez is in a very different position. Chinese technology is probably not currently state-of-the-art in its ability to extract oil from sands. However China’s ability to backward-engineer technology and the resources it has available to devote to the problem would, with the U.S. facilities already in place, quickly bring a Chinese “technical assistance” crew up to speed. At that point, there would be no further need for Chavez ever to sell another barrel of oil to the U.S.
Again, if the world oil market were truly free in the Adam Smith sense, this would not matter. If China bought its oil from Venezuela, and used its technological abilities to ramp up Venezuelan output, the U.S. could simply divert its purchases to other sellers. However, in a tight oil market this runs into a problem. In the long term, the major oil suppliers outside Orinoco, Athabasca and Russia are all in the Middle East. As it has shown in the gas market and again with its attempted suspension of deliveries to Estonia, the Russia of Vladimir Putin is a fairly unreliable supplier. In any case Russian oil production is beginning to decline, and is unlikely to be increased sharply while the country is mired in its current corruption.
Thus instead of China being forced to rely on unpleasant and unreliable Sudanese and Iranians for the additional oil it needs, the U.S. consumer will now be subject to the tender mercies of the three major Middle Eastern oil producers, Saudi Arabia, Iraq and Iran. While the U.S. has troops in Iraq, there probably is not a problem. Iraq is now believed to have oil reserves of 200 billion barrels, little more than a tenth of Orinoco but still enough to be ramped up to supplement other sources. If and when the U.S. withdraws from Iraq, and that country either collapses into civil war or aligns itself with U.S.-hostile Iran, the U.S. suddenly has a frighteningly large number of economic chips placed on the fragile political stability of Saudi Arabia.
Absent a major world recession, this is a problem that is only going to get worse. The U.S. currently imports 58% of its oil needs. That percentage is forecast to rise to 68% by 2020. Athabasca will supply some of the excess, but environmental considerations and the difficulty and cost of extraction mean that Athabasca may not be able to be ramped up as quickly as the U.S. would wish. China’s consumption is expected to have quadrupled by 2030.
If Venezuela were democratic, the U.S. would not need to worry – Chavez would be out of office at the latest by 2015 or so, as even the impoverished Venezuelan masses would not elect him indefinitely. If he did not have China to help him, an undemocratic but economically incompetent Chavez would also undoubtedly fall from power well before then. However, as Chavez moves towards dictatorship his potential longevity increases. In 2030 Chavez will still be only 76, five years younger than Castro is today and with Chinese-derived oil revenues he is very likely to be still in power. The U.S., desperate for oil imports, may well by that year be begging Vladimir Putin’s thuggish successors and the revolutionary regime that replaced Saudi Arabia’s monarchy for oil market mercy.
The Iraq war was not about oil. It did not need to be. The world oil market under the control of the U.S., Japan and the EU was more or less free, so that a hostile Iraqi regime could easily be countered by a partial oil embargo and purchases elsewhere. The next war in which the U.S. is involved may well be about oil, however, and if the U.S. seeks to preserve its essential interests by assaulting the largest source of supply, with the most irredeemably hostile regime, Islam will have nothing whatever to do with it.Link here.
“I Won’t Rob You”
“We are going to pass a law, Rocca,” said Venezuelan President Hugo Chavez last week. Ordinarily, it is no big deal when a nation passes a law or two. The world is full of legislatures that pass laws. And the world is also full of lawyers, who figure out how people can do what they want to do without breaking those laws. But if a law has somebody’s name on it, particularly as a target of that edict, then it makes you sit up and take closer notice. ...Link here.
LIQUIDITY BOOM DECOUPLES U.S. EQUITY MARKETS FROM THE U.S. ECONOMY
Economic growth in the U.S. slowed to 1.3% in Q1 of this year, the worst performance in four years of an overextended debt bubble. Yet the Dow Jones Industrials rose to an intraday all-time high of 13,285 May 4, rising over 1,000 points or 9% in the same period. The DJIA is now 82% higher than its low of 7,286 on October 9, 2002 during which the GDP (GDP) grew only 38%.
The Business cycle appears to have been replaced by the finance cycle. The historical pattern of a 10-year rhythm of cyclical financial crises looms as a menacing storm cloud over the financial markets. The 30% market crash of 1987, in which investors lost 10% of 1987 GDP, was set off by the 1985 Plaza Accord to push down the Japanese yen with an aim of reducing the growing U.S. trade deficit with Japan.
The 1987 crash was followed 10 years later by the Asian Financial Crisis of July 2, 1997, with all Asian economies going broke, with some stock markets such as Thailand’s losing 75% of their value, and Hong Kong having to raise its overnight deposit rate to 500% which promptly crashed its real property market, trying to defend the fixed exchange rates of their currencies. In Korea, Daewoo Motors, facing bankruptcy, was forced to be taken over on the cheap by General Motors. In Indonesia, the Suharto government fell from social instability arising from the financial crisis. A wave of deflation spread over all of Asia from which Japan, already in recession since 1987, has yet to fully recover two decades later. In the US, the DJIA dropped 7.2% on October 27, 1997 and the NYSE had to suspend trading briefly to break the free fall.
Now in 2007, a looming debt-driven financial crisis threatens to put an end to the decade-long liquidity boom that has been generated by the circular flow of trade deficits back into capital account surpluses through the conduit of dollar hegemony. While the specific details of these recurring financial crises are not congruent, the fundamental causality is similar. Highly-leveraged short-term borrowing of low-interest currencies was used to finance high-return long-term investments in high-interest currencies through “carry trade” and currency arbitrage ... with projected future cash flows booked as current profit to push up share prices.
In all these cases, a point would be reached where the scale would tip to reverse the irrational rise in asset prices beyond market fundamentals. Market analysts call such as reversals “paradigm shifts”. One such shift was a steady fall in the exchange value of the dollar, the main reserve currency in international trade and finance, to cause a sudden market meltdown that quickly spread across national borders through contagion with selling in strong markets to try to save hopeless positions in distressed markets. There are ominous signs that such a point is now again imminent, in fact overdue, in globalized markets around the world.
While Federal Reserve policymakers traditionally view inflation as the main danger to the economy, they optimistically predict that inflation will moderate going forward as the central bank stays with a tight monetary policy. The Fed’s stated goal is to cool an overheated economy sufficiently to keep inflation in check by raising short-term interest rates, but not so much as to provoke a recession. Yet, in this age of finance and credit derivatives, the Fed’s interest rate policy no longer holds dictatorial command over the supply of liquidity in the economy. Virtual money created by structured finance has reduced all central banks to the status of mere players rather than key conductors of financial markets. The Fed now finds itself in a difficult position of being between a rock and a hard place, facing a liquidity boom that decouples rising equity markets from a slowing underlying economy that can easily turn towards stagflation, with slow growth accompanied by high inflation.
The wealth effect from rising equity prices has been caused directly by a debt bubble fed by overflowing liquidity created beyond the Fed’s control, by the U.S. trade deficit denominated in dollars returning to the U.S. as capital account surpluses. This debt-driven liquidity boom is exacerbated by a falling dollar which artificially inflates offshore earnings of transnational corporation to support rising share prices pushed up by too many dollars chasing after a dwindling supply of shares caused by corporate share-buyback programs paid for with low-interest loans.
Further, the wealth effect from the equity bubble has not been broadly distributed, resulting in a boom in the luxury consumer market catering to the beneficiaries of capital gain while the broad consumer market catering to wage earners stalls. The newly rich in the financial sectors are buying multi-million-dollar first and second and even third homes, while average workers are buying cheap t-shirts and sneakers made in China. If the minimum wage had risen at the same rate as CEO pay, it would have been $22.61 per hour in 2006.
The adverse effect of dollar hegemony on the Chinese economy is becoming clearly visible. As the dollar-denominated trade surplus mounts, the PBoC is forced to tighten domestic macro monetary measures in order to neutralize the increased RMB money supply resulting from buying up the surplus dollars in the Chinese economy with yuan. The Chinese trade surplus is causing a monetary bubble in the Chinese economy while real wealth is leaving China in the form of exported goods, causing a rising money supply chasing after a shrinking asset base.
The dollars that the PBoC buys with Chinese yuan go to finance the U.S. debt bubble. The new yuan money, instead of going to finance development of the interior region in China, is attracted by speculative real estate and equities, pushing prices up beyond fundamentals. The Shanghai real estate bubble keeps growing in a speculative frenzy while rural villages are starving for capital.
Led by China and Japan, all the exporting economies, saddled with dollars that cannot be used in their domestic economies without creating a monetary crisis, are fuelling a global liquidity boom focused on the importing economies led by the U.S., where the dollar is a legal tender that involves no conversion cost. This global liquidity boom denominated in dollars will cause inflation in the dollar economy that will spill over to all other economies. The U.S. real property boom has created huge service demands that lead to tight labor markets. The global commodity bubble of the past three years has increased costs of living and production, adding over 5% to global GDP growth. Although commodity inflation has been absorbed through low-interest consumer borrowings and lower-wage labor in the past, it is now finally showing up as higher-cost factor inputs. China has kept the global cost of manufacturing artificially low by not paying adequately for pollution control and worker wages and benefits, including inadequate retirement provisions. Domestic political pressure within China is forcing the government to normalizing full production cost, which will boost global inflation.
Finance globalization is causing a delayed effect in inflation, but it has not banished inflation all together. Nor has it eliminated the business cycle. It has merely extended the historical cycle from 7 years to beyond 10 years. Global inflation has picked up by 60 basis points in the past four quarters. If the trend continues, major central banks will have to focus on fighting inflation by cooling the liquidity boom. To avoid a drastic market collapse, anti-inflation measures would need to be implemented at a “measured pace” which means it may take as long as two years to take effect. The problem is that the system which operates on ever rising asset values cannot weather a 2-year-long anemic growth. Thus even a soft landing will quickly turn into a crash.
Bonds will be the first asset class to decline in market value in this anti-inflation cycle which will eventually also affect other asset classes. As the flat or inverted yield curve spikes upward back to normal, making the spread between long-term and short-term rates wider, the commodity bubble will burst, followed by the stock market in a general deflation. Such a deflation cannot be cured by the Fed adopting inflation targeting through printing more dollars.
Globalization has stunted wage inflation as the main transmission between monetary growth and inflation. Hedging only reassigns unit risk to systemic risk. It does not eliminate risk. Instead, excessive liquidity fuels asset appreciation beyond economic fundamentals. To generate demand from the wealth effect, appreciated value must be monetized through debt. As debt rises, systemic risk rises with it. As globalization spreads demand growth around the world, inflation has taken longer than normal to show up in outdated data interpretation.
The burst of the tech bubble, the 9/11 shock, the manufacturing and IT outsourcing caused sharp disinflation in 2002 to neutralize debt-driven dollar inflation. The threat of dollar deflation caused the Fed to cut the Fed funds rate to 1% on July 9, 2003 and kept it there for 12 months while the Bank of Japan maintained a zero interest rate. This in turn led to a massive liquidity boom that fed an escalating U.S. trade deficit. Before the emergence of dollar hegemony, Fed chairman Paul Volcker had to raise the Fed funds rate to 19.75% in December 1980 to curb U.S. stagflation caused by a rising trade deficit. In 1985, Volcker engineered the Plaza Accord to force the Japanese yen up against the dollar to curb U.S. trade deficit with Japan, promptly pushed the Japanese economy into sharp deflationary depression from which Japan has not yet fully recovered. Volcker’s victory over U.S. inflation was won with forcing deflation on Japan.
The fountainhead of the global liquidity boom is located in the vast increase of the supply of dollars, both as a result of Fed monetary policy and of dollar-denominated structured finance under dollar hegemony. This liquidity boom has helped create demand through inflating asset markets. The wealth effect of property inflation produced both producer and consumer spending power released by debt. Commodity inflation has given producer economies, such as oil states, windfall income to invest in the advanced economies. Declining cost of capital fueled a new wave of financial expansion through private equity and hedge fund acquisitions finance with high leverage.
A liquidity boom requires the continuing confluence of many factors, an even slight change in any of which can have an unraveling effect that puts a sudden end to it. A precipitous fall in the dollar could trigger market sell-offs as it did after the Plaza/Louvre Accords of 1985 and 1987 to first push down and later push up the dollar, which contributed to the 1987 crash. Another cause of the 1987 crash was a threat by the House Ways and Means Committee to eliminate the tax deduction for interest expenses incurred in leverage buyouts. Still another cause was the 1986 Tax Act, while sharply lowering marginal tax rates, nevertheless raised the capital gains tax to 28% from 20% and left capital gains without the protection against inflated gains that indexing would have provided. This caused investors to sell equities to avoid negative net after-tax returns and contributed significantly to the 1987 crash.
Today, any one factor out of a host of interconnected factors, such as new regulation on hedge funds, or sharp changes in the yuan exchange rate against the dollar, or an imbalance between tradable assets and available credit, etc, could bring the current liquidity boom to a screeching halt and turn it into a liquidity bust. With finance globalization and the dominance of derivative plays by hedge funds and private equity firms, any minor disruption can turn into a financial perfect storm that makes the collapse of Long Term Capital Management look like a tempest in a tea cup.
The 5-year global growth boom and 4-year secular bull market may simple run out of steam, or become oversaturated by too many late-coming imitators entering a very specialized and exotic market of high-risk, high leverage arbitrage. The liquidity boom has been delivering strong growth through asset inflation (property, credit spreads, commodities, and emerging market stocks) without adding commensurate substantive expansion of the real economy. Unlike real physical assets, virtual financial mirages that arise out of thin air can evaporate again into thin air without warning. As inflation picks up, the liquidity boom and asset inflation will draw to a close, leaving a hollowed economy devoid of substance.
Massive fund flows from the less experienced non-institutional, retail investors into hot-concept funds such as those focusing on opportunities in BRIC (Brazil, Russia, India and China) or in commodities, or in financial firms involved in currency arbitrage and carry trades, have caused a global financial mania in the past five quarters which has defied gravity which will all melt away in a catastrophic unwinding some morning.
Inflationary pressure in the US and other OECD economies makes a cyclical bear market inevitable and an orderly unwinding unlikely. Central banks cannot ease because of a liquidity trap that prevents banks from being able to find credit worthy borrowers at any interest rate. Banks would be pushing on a credit string and global liquidity could decline, causing risk asset valuations to contact suddenly and sharply. A liquidity trap can also occur when the economy is stagnant and the nominal interest rate is close or equal to zero, and the central bank is unable to stimulate the economy with traditional monetary tools because people do not expect positive returns on investments, so they hoard cash to preserve capital. Capital then becomes idle assets.
A global financial crisis is inevitable. So much investment has been sunk into increasing commodity production that a commodity market bust, while having the effect of a sudden tax cut for the consuming economies, will cause bankruptcies that will wipe out massive amounts of global capital. A financial crisis could trigger a global economic hard landing. Global financial markets look suspiciously like a pyramid game in this over-extended secular bull market.
When markets are hot, fund manager companies tend to market funds aggressively, especially ones with hot concepts. Commodity, BRIC, etc., have been the hot concepts in this cycle. Tens of billions of dollars have been raised by such funds from the less experienced retail investors over the past three quarters in Japan, Korea, Taiwan, Hong Kong, etc. This source of money has fueled rapid price appreciation in the recipient markets. Starved of good returns in the US, long-term investors have been allocating funds to emerging market and commodity specialists to chase the good performance. Such funds have flowed disproportionately into small and illiquid stocks, causing them to rise in rapid multiples. Their good performance attracts more funds and reinforces the virtuous cycle.
The financial markets experienced minor shocks recently when the Bank of Japan soaked-up a lot of liquidity and hinted on the need to commence a rate-hike program. The minor shocks forced the BoJ to back away from its planned monetary tightening to keep the speculative frenzy going. This is the reason why the inversion of theU.S. yield curve which normally mean liquidity was about to contract, has not yet triggered a liquidity recession. A liquidity boom will continue as long as a major central bank with large foreign reserves, such as the BoJ, continues to price short-term credit at bargain-basement levels and leaves its borrowing window open to all comers. The People’ Bank of China also contributes to the global liquidity boom by its willingness to continue to buy long-term U.S. T-bonds even if rates falls. The U.S. current account deficit is the key driver of the liquidity boom. Those who clamor for a reduction of the U.S. trade deficit are unwitting calling for a U.S. recession.
When the ongoing meltdown in the sub-prime mortgage spreads to other parts of the credit markets, the Fed will be forced to implement a monetary ease. But a liquidity trap will activate the dynamics of an inverted yield curve, with long term rate falling faster than the Fed funds rate. When demand for bank reserves decreases due to a general slump in loan demand, then the Fed has to destroy bank reserves in order to prevent a collapse of Fed funds rate to zero.
A liquidity trap can be a serious problem because the world is still blighted with excess liquidity potential – massive foreign reserves held by central banks, bulging petro-dollars, hedge funds and private equity funds, massive increases in global monetary base, $4 trillion in low-yielding Chinese bank deposits ready for release for higher yields, $5 trillion in low-yielding U.S. time deposits maturing, $10 trillion in low-yielding Japanese financial net worth plus $27 trillion in medium-yielding U.S. household financial net worth waiting to be monetized for aggressive yields. A global liquidity trap of with $50 trillion of idle assets will implode like a doomsday machine.
The exchange rate is a measure of the relative value of these currencies, not the intrinsic value of the dollar. When the euro rises against the dollar, it is possible that both currencies have fallen in purchasing power, but the euro has merely fallen less than the dollar. This is what drives the liquidity boom that has decoupled the equity markets from the real economy.Link here.
TELL US SWEET LITTLE LIES
Tell me lies
Tell me sweet little lies
(tell me, tell me, tell me lies) ~~ Christine McVie, Fleetwood Mac
Whenever somebody complains about “the lies that George Bush & Co. told to get us into the Iraq war”, I wonder how those lies compare to the lies that the American public tells itself every day – for example, that we could run America without oil from the Middle East, or that hybrid cars will save Happy Motoring, or that we can have an economy without producing anything of value.
Meanwhile, the Dow Jones index went up over a hundred points the same day that 32 people were massacred on a university campus. And bear in mind that the massacre did not occur late in the day but literally around the same time that the New York Stock Exchange rang its opening bell – so that as the body counts mounted through mid-day, the stock markets only went higher! Then, the rest of the week, while the cable news Mommy-Daddies went through the familiar rituals of bewildered hand-wringing, and NBC released the trove of farewell videos sent in by the shooter between killings, the Dow piled on another 250 points to close at an all-time record high just under 13,000. Could the financial markets be more detached from reality, from life on the ground (or in a free-fire-zone classroom) in this nation?
Doug Noland over at Prudent Bear.com is right. We have entered a euphoric phase of financial arbitrage capitalism with extreme Ponzi overtones, a pyramid scheme of revolving credit rackets and percentage spread plays completely abstracted from any reality of fruitful activity. The reason we do not even call “money” by its former name anymore is precisely because we realize at some semi-conscious level that “liquidity” is not really money. Liquidity is a flow of hallucinated surplus wealth. As long as it flows in one direction, into financial markets, valve-keepers along the pipeline, like Goldman Sachs, Citibank, or the hedge funds, can siphon off billions of buckets of liquidity. The trouble will come when the flow stops – or reverses. That will be the point where we will rediscover that liquidity really is different from money, and if we are really unlucky we will discover that our money (the U.S. dollar) is actually different from real wealth.
Noland and others recognize the severe distortions in the finance sector, and they are surely correct to flag the implied dangers. But even these clear-eyed observers survey the disturbing finance scene without factoring the global energy situation. In a nutshell, world oil production seems to have peaked about 10 months ago. Being just past peak, there is still a huge amount of oil going into world economies. But being just past peak we are now seeing how complex systems proceed toward instability and breakdown when the underlying energy flow turns toward contraction.
The situation in finance is particularly sensitive and acute because an overall contraction in available energy means the end of industrial expansion (“growth”) at “normal” rates of three to seven percent annually. More to the point, it means that certificates, contracts, deals, plays, and rackets pegged to the expectation of growth will lose their legitimacy. Meaning, stocks, bonds, collateralized debt obligations, hedges – anything that represents the hope and expectation for more-of-anything – will no longer be understood to represent real value.
The current euphoric hysteria should therefore be viewed as a form of disorder in its own right. The players in the markets are making their moves based on misunderstood signals. They think the world is awash in energy and prosperity. They believe that the mortgage fiasco and the associated imploding housing bubble are just a couple of temporary zits on the handsome face that Wall Street presents to the world. In the background, though, feedback loops are aligning to rock the systems we depend on for daily life in the real world. Capital will become unavailable. Food will grow scarce. Trade will be interrupted. Mobility will be constrained. And an awful lot of pissed-off people will be poised to fight over the table scraps of industrial civilization.
The markets have been on an extraordinary spring run. The Dow finished 23 out of the last 26 days on the upside. This is the biggest U.S. stock market up-streak since a 19 for 21 streak in July of 1929, prior to the October crash. A similar run happened on the Tokyo exchange – 32 upside trading days out of 38 – just prior to its 1989 tanking. While this kind of behavior seems ominous, I am not claiming it necessarily has predictive value. One can say that the financial markets per se are running in an impressive state of structural distortion and imbalance and that systems way out of balance do not stay that way forever. But I risk more opprobrium by stating the obvious.
I think the persistence of this gross imbalance can be accounted for in large part by the current global energy situation. The world is at peak energy, peak oil especially, and the world runs on oil. I happen to think that oil production probably peaked about a year ago, but we are still so close to it that the net available energy remains immense. Markets may be dumber than we think. All they see is a vast amount of cheap energy for manufacturing plastic salad shooters, for powering tourist jet charters to Cancun, for running Wal-Mart, Walt Disney World, and Taco Bell. All that energy is here right now.
Among the many tragic elements in the human condition is this tendency toward short-term thinking, the inability to imagine how our arrangements will work in a time that is not right now. Interestingly, the main effect of post-peak oil on markets and economies is that it will produce shocking instabilities in complex systems dependent not just on the energy itself, but on the expectation for continuity of the energy. Financial markets are especially sensitive because they operate on sheer expectations. The Dow Jones does not manufacture salad shooters, or haul tourists to the Mexican beaches, or build suburban houses. It just relays a dumb signal that says “we expect more” and investors respond. The trouble will start when the signal changes to “we do not expect more.” That moment will be when the recognition of peak oil galvanizes the public’s attention. When that happens, the markets will exhibit the dumb herd behavior that they are famous for.
I have argued previously that the stupendous run-ups of market indexes themselves represent a kind of instability (those distortions and imbalances), as do also the supernatural flows of “liquidity” and I would stick to that observation. If the world is “high” on oil – I would argue that it is zonked out of its mind – then it would naturally spring way up off the diving board before swan-diving into the empty pool below.
Me, I am keeping my eye on things like the production figures coming out of Mexico, the North Sea, and the Kingdom of Saudi Arabia. They are all sliding down. Mexico is especially interesting because it is our #3 source of oil imports and its production is crashing so hard that a couple of years from now it may not be able to send us a single drop of oil. What do you think of that? Maybe the Walton family will buy Iowa so they can keep Wal-Mart running on ethanol.
Meanwhile, U.S. oil refineries are running above 90% production capacity to keep up with the gasoline demand for Happy Motoring. The stress on these complex operations is unprecedented. It gives them no slack time for routine repairs. The results are liable to be interesting, too, between the 4th of July and Labor Day.Link here (scroll down to piece by James Howard Kunstler).
SIX SECRETS OF A MASTER TRADER
Speculators get a bad rap. The very word conjures up pictures of some carefree playboy throwing money into any crazy investment – not really caring if they win or lose. Well, I am here to tell you “speculating” is not a dirty word. You can be a conservative investor and still enjoy that chance at phenomenal profits that speculating can bring.
I learned that lesson from my father, Paul Sarnoff. He was one of the first people to offer an options course – introducing novice investors to the concept of Superleverage. But he also had a strong conservative streak. In fact, he was an avid fan of precious metals, advocating that they should be at the core of every solid investment portfolio. He even wrote books on gold and silver investing.
My father proved that even cautious investors can benefit from speculating. But as he always stressed – and as I still stress today – the key to being successful was to have a complete plan of action. You never, ever throw your money around casually ... even if it is money you can afford to lose. And you must take steps to make sure you never get in over your head.
Of course, that is easier said than done. That is why my father developed six simple strategies for keeping a level head when speculating. They may sound common sense, but I have spent enough time in the markets to know that common sense is not that common when money is involved. So, if you are thinking of dipping your toe into the speculative markets, here are a few proven ideas to keep in mind:
Options trading is more accessible than ever before. And the profit potential has not diminished a single cent. Going out of your way to learn the myriad of ways they can boost your bottom line is the easiest way to discover what works for you.Link here (scroll down to piece by Steve Sarnoff).
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