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BEWARE THE GORDON GECKO FLASHBACK MARKET
Last month, The New York Times reported that a sequel to the 1987 film Wall Street entitled Money Never Sleeps is in preproduction. Michael Douglas will apparently star again in his role as Gordon Gecko. Spoke Gordon Gecko in Wall Street (1987): “The point is, ladies and gentleman, that ‘greed’ – for lack of a better word – is good. Greed is right. Greed works.”
Well, greed is back and the producers of the Wall Street remake are probably comforted that they will release the sequel during a mergers and acquisition boom akin to what was last seen in the mid-1980s. Huge private equity deals, leveraged buyouts, landmark merger battles. Barclays and Royal Bank of Scotland battle for ABN Amro. Also, accounts of vast amounts of “global liquidity” paint today’s headlines.
This October will mark the 20-year anniversary of the market crash of 1987, which occurred in the face of seemingly robust market conditions. Will the current boom be derailed by a similar sequence of events as those that preceded the 1987 crash? Of course, no two periods in history are ever exactly alike, but an examination of macroeconomic conditions in the two years leading up to “Black Monday” reveals a confluence of factors that bear an uncanny resemblance to the current period. These include:
U.S. economic growth picked up dramatically following the 1985-1986 midcycle slowdown. Stock prices accelerated to the upside, and bond yields rose significantly in response to a stronger economy, dollar weakness, an M&A-fueled increase in the supply of bonds. Protectionist policies aimed against Japan added to the combustible mix. It was the combination of sharply higher equity prices and interest rates that made a correction all but inevitable, despite the fact that – to many market observers at the time – economic strength and robust earnings growth appeared to be supportive of higher stock prices.
With many investors today wondering whether the slowdown seen in the U.S. economy in recent months might be a precursor to recession, the 1987 template is an important reminder that the biggest risk to stocks may come from the opposite direction. If the economy shows unexpected strength in the coming quarters, and if the dollar continues to break down and the supply of bonds continues to increase (as a function of surging M&A and private equity activity), if trade tensions between China and the U.S. worsen – and if the bond market responds to all of these factors by pushing yields sharply higher – then a valuation problem similar to that seen immediately preceding the 1987 crash could materialize quickly.
From the end of 1986 through August 25, 1987, the S&P 500 and the MSCI EAFE Index (tracking 21 developed markets in Europe, Australasia, and the Far East) both soared nearly 40%. This impressive performance followed four years of big gains for global equities, with the MSCI EAFE rallying nearly 300% from the fall of 1982 to the start of 1987. Then, like now, stocks seemed all but unstoppable, shaking off every piece of bad news and defying the skeptics at every turn.
The strength in equities during the past four years could hardly be more similar to what was seen in the 1980s. Both bull markets were born in the ashes of brutal, multi-year bear markets (1980-1982 and 2000-2002), and both witnessed very strong gains in the first 12 months after bottoming (1983 and 2003), followed by nearly a year of “consolidation” (1984 and 2004) before the strong bull-market trend resumed (1985-1987 and 2005-2007). The resemblance between the current period and 1982-1987 goes well beyond a comparison of stock market charts. The unrelenting strength of equities this year despite evidence of a weakening U.S. economy in the first quarter 2007, and the meltdown in the subprime lending sector, is very similar to what was seen in the mid-1980s.
Much like the period during the midcycle slowdown in 1985-1986, the market today anticipates a continued benign interest rate environment. The Fed funds futures market prices in no Fed action for the remainder of the year and the possibility of a rate cut early next year. Thanks in part to the persistence of low bond yields, the past few years have witnessed an unprecedented reduction in the overall supply of global equities. The volume of share buybacks, mergers and acquisitions, and private equity deals has swamped the amount of new stock being brought to the market via IPOs. This phenomenon has been described as “financial arbitrage”. A private equity investor can acquire a company and easily cover the cost of financing the transaction without having to do anything to improve the cash flow or profitability of the company itself. Not surprisingly, given the extent to which bond yields fell, a similar trend was seen in the mid-1980s. Between 1983 and the spring of 1987, corporate equities equivalent to more than 10% of the entire market capitalization of the New York Stock Exchange had disappeared.
Over the past year and a half, the U.S. dollar has fallen significantly (continuing a longer downtrend that began in 2002), a move that echoes the huge decline seen in the dollar from 1985 through 1987. Persistent dollar weakness can put upward pressure on interest rates. Foreign buyers of U.S. dollar-denominated bonds may demand higher yields to compensate for the risk of further currency depreciation. From 1985 to 1987, there was a series of efforts by global policy makers to stabilize the U.S. dollar, which they feared would suffer further declines due to rising rate expectations in countries outside the U.S. The U.S. was forced to increase rates in an effort to protect its currency. A similar situation appears to be developing today, as interest rates in Europe and Asia continue to move higher. Expectations for higher European rates and flat-to-lower U.S. rates have fueled a massive rally in the euro vs. the dollar over the past several months. If the dollar decline were to continue, the burden could again fall on the U.S. to boost rates in an effort to stabilize the currency.
And there is another risk to interest rates in today’s environment that was not present in the mid-1980s: rising commodity prices and elevated inflation readings. In 1985 and 1986, crude oil fell hard, but today we are seeing the opposite. Meanwhile, consumer price inflation in the U.S. and abroad has remained stubbornly high. The impact of higher oil is being seen at the gas pump, and there is certainly the potential for higher oil and gasoline prices to increase inflationary expectations, thereby pushing bond yields higher.
In the context of the huge gains being seen in global stock prices, a significant rise in bond yields could quickly create a valuation problem very similar to the one that preceded the 1987 crash.Link here.
DANGEROUS DIVERGENCES IN THE GLOBAL BOND AND STOCK MARKETS
The “bond vigilantes” are back – all over the world.
Once upon a time, many years ago, the U.S. stock market lived in fear of a violent band of traders known as the “bond market vigilantes”. Whenever the Federal Reserve’s money supply measures grew too rapidly, or the U.S. economy grew too strongly, threatening to stoke higher inflation, the bond vigilantes would take matters into their own hands, by jacking-up 30-year Treasury bond yields as much as 25 basis points or short-term T-bill rates by 50 basis points in a single day.
Former U.S. Treasury secretary Robert Rubin convinced his boss, President Bill Clinton that taming the bond vigilantes by reducing the budget deficit was the best way to reach long-term economic prosperity. But during the first Bush administration, when the Treasury’s budget was spinning out of control with a $445 billion deficit in fiscal 2004, the infamous bond vigilantes slipped into hibernation. Instead, a new band of traders with much deeper pockets, the Bank of Japan, the People’s Bank of China, and the Arab Oil kingdoms were cornering the U.S. Treasury market, and keeping yields pinned near historic lows. Tokyo and Beijing acquired a combined $2.1 trillion of foreign exchange reserves, mostly held in U.S. dollar bonds, thru massive intervention to keep the yen and yuan weak, and plowed their newly acquired dollars into U.S. bonds.
As crude oil prices more than doubled to over $65 per barrel, OPEC’s oil revenue reached $968 billion in 2006 from around $300 billion in 2002, Arab Oil kingdoms invested about $314 billion into the U.S. Treasury market thru their London brokers, representing 1/4th of the $1.3 trillion of petrodollars invested globally over the 3-years. Last week, the U.S. Treasury said holdings of U.S. securities by foreign central banks and governments rose to $2.3 trillion by the end of June 2006.
Perhaps, the most important single factor allowing the global economy to grow at 5% or more for each of the past four years has been historically low bond yields, courtesy of Asian central banks and Arabian petrodollars. Indirectly, abnormally low bond yields spawned $1.5 trillion of U.S. mergers and takeovers in 2006, and $1 trillion so far this year. Globally, M&A mushroomed to $3.6 trillion in 2006 and $1.9 trillion so far this year.
Also behind the boom in global stock markets, hedge-fund assets tripled in the past decade to $1.57 trillion, and private equity companies are bidding $447 billion for companies so far this year, versus $228 billion in the year-ago period. Corporate treasurers are exploiting the gap between the low yield on bonds and the earnings yield on stocks through record share buybacks, driving equity prices sharply higher. The Bernanke Fed is also operating behind the curtain, inflating the broad M3 money supply at an annualized 12.2% rate, its fastest clip in 5 years. Each morning, before the opening of the NYSE, the Bernanke Fed buys Treasuries to accommodate strong loan demand from private equity groups and leveraged takeover artists, and to prevent short term borrowing rates from rising. The global stock buying frenzy might not have been possible, if the bond vigilantes were not sedated by Arab Oil kingdoms, China, Japan, and other central bankers.
The bond vigilantes reappear in the U.S.
But when the Dow Jones Industrials climbed above 13,000 for the first time, the bond vigilantes began to crawl out of their cave. On June 1st, the Treasury’s 10-year yield rose to 4.96%, its highest level in 9 months. Treasury yields were rising despite news that the U.S. economy slowed to a scant 0.6% growth rate in Q1, its weakest in 4 1/2 years, largely due to a sharp downturn in the housing sector. On May 30, the Fed said that inflation remained a concern despite the drag of the housing slowdown. So as hopes fade for Fed rate cuts this year, traders are dumping long-term T-Notes in favor of high flying stocks.
The bond vigilantes might have greater room to maneuver in the months ahead, as Beijing observes its massive U.S. bond portfolio, estimated at over $900 billion, slide into a free-fall, when depreciating U.S. dollars are converted back into Chinese yuan. China controls $1.2 trillion in foreign exchange reserves and steady purchases of longer-dated Treasuries could evaporate, after the PBoC widened the trading band for the yuan on May 18th, allowing for a swifter devaluation of the U.S. dollar. Beijing could decide to recycle its massive trade surplus into riskier assets. But Fed chief Ben Bernanke is not worried about Beijing dumping U.S. bonds in the future, he has expressed more than once. Would Bernanke speed up the printing presses to buy bonds from Beijing?
And in Europe too.
While American bond vigilantes are just stepping into the batter’s box, the German bund vigilantes are already on first base, jacking up European benchmark yields to multi-year highs. “Euro zone inflation risks are rising and the European Central Bank is keeping its options open on how much further to raise interest rates,” said Greek central banker Nicholas Garganas on May 30th. “Inflation risks are on the upside and increasing,” he warned. “The ECB needs to exercise strong vigilance to keep price pressures in check,” warned Bundesbank chief Axel Weber on May 16th.
Since March 13th, Euro zone traders have been dumping German bunds and switching into high-flying European blue chips stocks. The ECB has spoken a million words about the risks of higher inflation, but has only lifted its repo rate a quarter-point this year. The ECB has tolerated explosive growth of the Euro M3 money supply, which hit a 24-year high of 10.9% in March, far above the central bank’s target of 4.5%, which it believes is consistent with low inflation. “Interest rates are low in the Euro area,” said Dutch central bank chief Nout Wellink on June 4th. “These low interest rates show up in asset prices, not only in the stock market, but also the housing market and other financial markets.”
While the mainstream media points to ECB rate hikes as proof of a tighter monetary policy, double-digit Euro M3 growth points to a super-easy ECB money policy. The ECB pursues a clandestine policy of pumping up European real estate and stock markets, to boost consumer confidence and spending at home by inflating M3. The ECB’s sleight of hand is part of its game of “Smoke and Mirrors” designed to lull German “bund vigilantes” to sleep, while it quietly pumps up asset markets. But the Norwegian government recognized the shell game on April 13th, and said it planned to raise the equity component of its $314 billion oil fund to as much as 60% of total assets from 40%, while reducing the portion held in bonds.
To restore its badly tarnished image of an inflation fighter, the ECB has telegraphed a quarter-point rate hike to 4.00% in June, and to 4.25% by September. The ECB was forced into the tightening mode, since gold is flirting with the psychological €500/ounce. So it was surprising that on June 1st, the ECB decided to suspend its remaining share of gold sales thru Sept 26th. That gave a small shot of adrenalin to the gold market, jumping back to €500. Stubbornly high gold prices in Europe provide more fodder for the German “bund vigilantes” in Frankfurt, whose set the benchmark yields for the rest of the Euro zone.
The Bank of England faces a backlash.
For the past three years, the ECB has operated under the same modus operandi as the Bank of England, inflating the money supply to buoy home and equity markets. But last week, the British gilt vigilantes, who have been locked in a tight box for the past eight years, came very close to breaking out. Two-year British gilt yields climbed to 5.78% on June 1st, a level not seen since in seven years.
For the past eight years, the UK’s 10-year gilt yield has been locked in a tight range between 4.00% and 5.35%, benefiting from foreign capital inflows seeking to profit from an appreciating British pound. But how much longer can the long-term gilt market ignore the monetary abuse of the BoE? On April 24th, a group of leading UK economists including former BoE member Charles Goodhart criticized the BoE for ignoring double-digit growth of the money supply since 2005. A week later, BoE chief King admitted that, “the growth of money and credit may signal in advance of other indicators that the Bank rate is set at a level inconsistent with bringing inflation back to the target in the medium term.” On May 10th, the BoE lifted its base lending rate by a quarter-point to a 6-year high of 5.50%. But UK house prices jumped 0.9% in April and 0.5% in May, and stand 10.3% higher from a year ago. Not surprising, with the UK’s M4 money supply standing 13.3% higher from a year ago.
Asian bond vigilantes lift yields.
South Korea’s economy, Asia’s 3rd-largest after Japan and China, has expanded for 16-quarters in a row, marking the longest winning streak since the 1990s. Behind the scenes, the Bank of Korea (BoK) is inflating its M3 money supply, buoying stock prices but rattling the bond market. The BoK lifted its overnight loan rate by 125 basis points to 4.50% last year, and raised bank reserve ratios by 2% to 7%, but in defiance of its baby-step tightening maneuvers, Korea’s M3 money supply exploded from a 7% growth rate to an annualized 12.3% in April 2007. Korean housing prices are growing four times as fast as consumer prices.
Korean bond vigilantes are alarmed by the BoK’s super-easy money policy, and have jacked up the government’s borrowing costs by 50 basis points over the past three months. “Abundant global liquidity is one of the risky factors that all countries need to monitor,” South Korea’s finance minister Kwon O-kyu told reporters on May 17th.
Australian bonds have lost considerable ground in recent weeks as Aussie traders dumped safe-haven government debt, in favor of riskier stocks. Australian bond futures fell to their lowest in three years on June 5th, with Aussie bond vigilantes taking their cue from bears in Asia, Europe, and North America. Australia’s jobless rate fell to 4.4% in April, to a 32-year trough and stoking concerns that a super-tight labor market would eventually threaten higher inflation and interest rates.
While the mainstream media puts its faith in doctored-up government statistics on inflation as gospel, Aussie bond vigilantes are following the money. The Australian bank’s cash rate of 6.25% might sound high compared to other countries, but in reality, the RBA is pursuing a super-easy money policy, allowing its M3 money supply to expand at an explosive 13.7% annualized rate.
The Australian government barely issues enough new paper to cover maturities. Flush with cash after a string of budget surpluses, Aussie bonds outstanding are around A$60 billion, down from around A$94 billion when Prime Minister John Howard came to power in 1996. That is in sharp contrast to the U.S. where total public debt has ballooned by 50% since the turn of the century to reach $8.8 trillion. The task of the Aussie bond vigilantes in jacking-up Treasury bond yields is daunting, given the small supply of T-bonds outstanding, and the insatiable appetite of Asian central bankers. But a super tight jobs market, a booming economy, explosive growth of the M3 money supply, and a new round of $A67 billion in income tax cuts, gives the Aussie bond vigilantes plenty of ammunition to work with.
Canadian bond vigilantes flex some muscle.
Canadian bond vigilantes have chipped away at government bond prices for the past three months, following a slew of economic data that paints a picture of a red-hot economy and higher inflation. Canadian bond vigilantes are grinding government paper lower, even as Ottawa pays off some of its national debt. The budget for 2007 reduces the debt balance down to C$472.3 billion, or 35% of GDP, a 25-year low. Canada’s federal debt has fallen by C$81.4 billion over the past decade.
The inflation alarm bells went off in the Canadian bond market, because the central bank miscalculated the underlying strength of the economy and permitted its M3 money supply to expand at double-digit rates in April, after the central bank made a premature decision to pause its rate hike campaign at 4.25%. In order to rein in the M3 growth rate, the BoC must narrow the interest rate gap with the U.S. fed funds rate of 5.25%. That has lifted the Canadian dollar to 30-year highs against the U.S. dollar, which can help shield Canada from higher import prices.
Natural resources have outperformed the weakening manufacturing sector in Ontario and Quebec, which has been hard hit by a high Canadian dollar and troubles in the lumber and paper industry. Overall, Canada’s unemployment rate has not budged from 6.1%, a 33-year low, for three straight months, so with the BoC set to rekindle its tightening campaign in the weeks ahead, the Canadian bond vigilantes have plenty of ammunition to work with in the months ahead.
Dangerous divergences and the Chinese bond vigilantes.
It is easy to say that what goes up, must come down. But stock markets do not necessarily follow the laws of Newtonian Physics. The Russian Trading System Index stays perched in the stratosphere, with the Russian central bank inflating its money supply at a 57% annualized rate. Central banks have to make a determined effort to deflate stock market bubbles, even at the cost of a slower economy.
Explosive money supply growth, stock buybacks, and mergers and takeovers, are all linked to the super easy money policies, within the context of a larger game of competitive currency devaluations. However, the most powerful force moving global stock markets today was not even mentioned in this article, but is highlighted in each weekly edition of the Global Money Trends newsletter. So far, this powerful force moving stock markets shows no signs of abating, but what are the early warning signals of a possible reversal of the market’s good fortune?
In Shanghai, the Chinese bond vigilantes have jacked-up yields on the benchmark 5-year Treasury bond by 105 basis points over the past two months, to 3.82%, including a 50 basis point surge over the past 2-days. While the mainstream media points to Beijing’s tiny 0.2% tax increase on stock transactions to explain the wicked 21% correction in Shanghai red-chips, quietly, little is spoken of the Chinese bond vigilantes emerging from hibernation.
On May 23rd, Guru Al Greenspan said the recent boom in Chinese stocks could not last. “It is clearly unsustainable. There’s going to be a dramatic contraction at some point,” he correctly predicted, but did not say why. At its peak, the combined market value of the two bourses in Shanghai and Shenzhen hit a record $2.5 trillion, exceeding the country’s savings deposits for the first time in history. The value of shares in China surged more than 6-fold in the past two years, to become the world’s 5th-biggest equity market.
Policy makers were not sympathetic to the plight of over zealous red-chip bulls on June 4th. “China’s increase in stamp duty is a proper forward-looking adjustment to avoid greater systemic risks in the market and to ensure its healthy development,” the state-owned China Securities Journal wrote. The Shanghai Stock Index tumbled 7.25% in the morning of June 5th after PBoC chief Zhou Xiaochuan left open the possibility of further monetary tightening. Yet Shanghai red-chips finished the day with a furious 10% rally off the intra-day low to close 2.6% higher. Bargain hunters swooped into the marketplace, after Shanghai red-chips had tumbled as much as 21% in four trading days, wiping out $450 billion of market value. Buyers spread rumors that Beijing would not introduce a capital gains tax for 3-years to stabilize the market.
There is an unshakeable belief that Beijing can move the red-chip market to its desires by remote control, thru jawboning and adjustments in the money supply. The rise in China’s 5-year bond yield to 3.82% is not as threatening as it appears, when one considers that China’s official inflation rate is expected to accelerate to 3.5% to 4% in the months ahead, reflecting sharply higher food prices. However, there is a much bigger storm looming on the horizon that could overwhelm Beijing, and wreak further havoc on Chinese red-chips, its economy, and the Asian region.Link here.
WHEN WILL ALL THIS BAD NEWS SINK IN?
As a steady stream of bad U.S. economic news accumulates, one wonders when the stock market will finally take notice. After years of highly effective spin coming from Washington and Wall Street, stock investors must re-learn how to recognize bad news, and to stop making lemonade out of every economic lemon that comes their way.
Little noticed amidst the dizzying stock rally in May was the steep increase in bond yields. Costlier credit has ominous implications for highly indebted American families (particularly homeowners with ARMs), over-leveraged corporations, hedge funds and private equity players, and the biggest debtor of them all, the Federal government, which must constantly refinance trillions of dollars of maturing debt.
In addition to rising interest rates, more sobering housing market news arrived, including record declines in new home prices and existing home sales. Combine this with steeper losses and more warnings from prominent home builders, and the housing picture gets a lot bleaker. Not only does Wall Street fail to grasp how the chill in real estate will dampen consumer spending, but it is also in denial about how much further home prices and consumer spending will fall as interest rates continue to rise.
We learned that Q1 GDP “grew” at an annualized rate of only 0.6% (of course if the government used honest inflation numbers, real GDP is already contracting). Slower growth means fewer jobs and declining incomes, which will further pressure the housing market as homeowners have less income to confront rising adjustable rate mortgages. For potential home buyers the situation is even worse. Not only do they face higher mortgage payments but they must now come up with actual down-payments – which they do not have – and meet far stricter lending standards, including documenting their inadequate incomes.
Further evidence that our imbalanced economy is moving further off kilter came in as another 19,000 manufacturing jobs were lost and the personal savings rate fell to minus 1.3%. Fewer goods being produced means even larger future trade deficits, which will be made more difficult to finance as a result of rising interest rates. Tighter credit and inadequate income growth will also make record personal indebtedness that much more costly to service.
My guess is that Wall Street’s blissful slumber may be ended by the shrilling wake-up call of the collapsing dollar. In the last 10 weeks the Canadian dollar has risen by over 10% against the greenback. With the weakness in the U.S. economy becoming increasingly apparent overseas, and global interest rates continuing their ascent, it will not be much longer before foreigners pull the plug on the dollar. When they do, it is the American economy, and Wall Street’s phony rally, that will go down the drain.
For a more in depth analysis of the tenuous position of the American economy and U.S. dollar denominated investments, read my new book Crash Proof: How to Profit from the Coming Economic Collapse.Link here.
Over the past 6 months the foundation of fundamentals under our McMansion of equity market hope has started to buckle. One by one the supports show signs of aging. The golden opportunities of the last few years have started to lose some of their shine. The solutions have been to either ignore unpleasant facts or assume they are short lived and of moderate import. All bad news is exciting as it suggests that the Federal Reserve will cut interest rates. All good news is proof of our resilient economy in which stocks, growth, opportunity and optimism spring eternal. Needless to say, risk premiums are small, speculative play massive and triumphalism is the air we breathe. We offer a structural health report, the sort of undertaking that no one has much had time for lately. None of which is to say that much is not well, much is very well. We just happen to believe that admitting all is not perfect provides insight and value.
In the one year period between Q1 2006 and Q1 2007 we managed a fall in the U.S. rate of home ownership! While you are to be immediately comforted that the decline was not statistically significant, we humbly imagine this to be a dramatic indicator of trouble. Housing and associated industries have played the roles of employer, lender and wealth effect sentiment booster to American consumers. It is unclear if, when, what and from where a replacement sector will emerge. The U.S. Census Bureau April New Housing Report showed a 10.6% year-over-year sales decline and a 6.5 month inventory backlog. Using their data we find a 4% y-o-y average house price decline and an 11% decline in median home price. A vital sector that loaned citizens hundreds of billions of dollars per year and accounted for 20-35% of employment growth since 2001, is entering a secular bear market. I would tell you not to worry about it, but I know you have already heard that many, many times.
I should have titled this section, “Growth? We don’t need no sticking growth.” Our Q1 2007 real annualized GDP growth rate is firmly in growth recession territory. “Expansion” in the 0.6% range is sub-par and begs serious question. Please gaze at this GDP growth chart and try to spot a pattern. It would seem that we are heading back toward recession territory. A large drag from negative net exports (exports minus imports), inventory declines and housing downturn have created significant headwind.
Consumer spending is 70% of the economy and the most recent numbers are not the stuff of frothy good times. The June 1, 2007 Bureau of Economic Analysis Personal Income and Outlays Report starts out with a bang. Income – real and disposable – actually fell. You will be comforted – but you should be terrified – to learn that spending rose nonetheless. This is a running on empty story, and looks to become a running into the wall story. Why so little concern? Golden expectations seem to produce a kind of alchemy of understanding. These leaden numbers suggest a weighted down public. Through the magical sophistry of expert opinion the lead becomes golden opportunity and impending rebound. When all else fails, we have come to know that credit always saves the day!
The areas of massive and growing strength are those tied to, and dependent upon, credit growth, financial engineering, speculation and expectation. Thus, wave after wave of buy-out and buy-back buoy equity prices. With each repurchase announcement and buy-out deal comes renewed speculation and buying pressure. Easy abundant credit is required. No matter how low you get your wage bill, no matter how inexpensively and innovatively you get your financing, ultimately you still need buyers. Sure, stagnant wages, declining tax bills and regulatory relief seem grand now, but risk greater savings and reduced consumption. For now, debt has filled the gap, and in doing so, opened another grand avenue to profit. So long as this lasts it supports asset prices and economic activity.
Already the nimble have begun to realize that the future of lending at high rates with good repayment levels may well be outside the U.S. Over the past few years we have been consuming 60-70% of the world’s excess savings. We have 4.5% of the world’s population, 20% of global GDP, and are now growing more slowly than the EU, India, China much of Latin America. We are also far more indebted. Thus, the growing excitement about micro-credit and booming consumer debt markets in Eastern Europe, Asia and beyond.
We suggest that a rethinking of the news flow and less euphoric perspective may now be in order. There is little doubt that such a perspective will cost you some of the remaining upside and dampen spirits. After all, who wants to see lead when where they expect to find gold?Link here.
NOW DON’T YOU WORRY YOUR PRETTY LITTLE HEAD. THIS WON’T HURT A BIT
Recently CNBC hosts displayed such comforting bedside manners that guest appearances on House are inevitable. The crew took a break from their minute-by-minute infatuation with U.S. stocks to explain why a crash in the Chinese market – should one occur – would be a non-event for market players. Their tone was particularly soothing compared to that of Alan Greenspan who just the day before explained to a captive audience in Spain that the Chinese market was in for a “dramatic correction”. And this was the same week that Chinese officials warned about stocks in their own market, yet again, hoping that anyone listening would realize that buying Chinese stocks was riskier than breathing the air in Shanxi Province.
But CNBC hosts and more than a few guests waved off such concerns, assuring U.S. investors that a Chinese “correction” would not be fatal or even painful. After all, they whispered, China is a long term growth story and long term growth does wonders for even the sharpest bouts of account atrophy. And besides, this is America, and what does a deflating Chinese market have to do with inflating domestic indices? “Nothing” was their diagnosis. Besides, it is no secret that Chinese stocks and those who are buying them have been acting a little nutty lately. All to be expected from an upstart capitalist in communist clothing. (Or is it the other way around?)
Still, a provincial Westerner cannot help but wonder if a Chinese market crash will draw only yawns, like news of another Paris Hilton arrest. After all, the same day CNBC was passing out placebos, the Wall Street Journal was describing how Chinese investors use lucky numbers to pick stocks. While that may be a more rigorous approach than counting eyeballs when selecting internet stocks, betting on an attractive ticker symbol is a symptom of severe bubble-itus, nonetheless. Just the day before, Reuters explained how China’s central bank is working overtime to plug the flood of money leaving boring bank deposits in search of stock market riches.
According to the Asia Pulse, almost as many brokerage accounts opened in April (4.5 million) as in the entire first quarter. All that account opening has earned China the title of the market with the largest share of retail investors, which Asia Pulse estimates at 60-70%. And if you have an account, you might as well use it. Many Chinese companies allow a one hour break each day so workers have time to buy and sell some stocks.
China’s market is valued at more than 70% of its GDP vs. a mere 15% in 2001. Maybe that is one reason former Chinese central banker Yu Yongding is not buying the idea that a stock market plunge will not do some real damage. He told AsiaOne News that once the bubble bursts, “... it will have an immeasurable impact on the economy and social stability.” Not only that, with all the borrowing to buy stock, a crash would precipitate a slew of new banking problems.
Besides, bursting bubbles hardly burst in isolation these days. As MarketWatch’s Jonathan Burton, a man who has done real live research on this topic, points out, Chinese stocks make up 10% of the MSCI Emerging Markets Index, perhaps the most popular benchmark for emerging markets. And if you think that international fund managers do not have at least that 10% exposure, you probably think that a contrite Ms. Hilton has a newfound zeal for philanthropy. Burton also cleverly reminds us that mutual funds dedicated to China attracted about half of the $24 billion that went into emerging-market equity funds last year. Also many A share stocks trading in China also trade H shares in Hong Kong. CNBC’s assurances notwithstanding, it is difficult to believe that dip in Chinese stocks will not take markets around the world lower.
Just as it did in February.Link here.
THE OTHER SIDE TO THE STORY
Last week’s headline read “U.S. Economic Growth Weakest in Over 4 Years.” At 0.6%, revised first quarter annualized Real GDP was certainly nothing to write home about. Gross Private Investment contracted at a 9.3% annualized rate, led by a 15.4% annualized drop in Residential Investment. And the ongoing weakness in housing was confirmed by Pending Homes Sales data – weakest in four years. Certainly, there is some support for the bearish view that ongoing housing weakness is in the process of dragging down the U.S. consumer and our consumption-based economy. But why then is the Morgan Stanley Cyclical index sporting a 22% y-t-d gain, the Dow Transports a 17% rise, and U.S. and global stock markets all posting robust advances on top of last year’s gains? Why are 10-year Treasury yields almost back to 5%?
There is another side to the story. First quarter Nominal GDP actually expanded at a 4.7% rate, an increase from Q4 2006’s 4.1% and Q3’s 3.9%. At 4.0%, the strongest GDP Price Index gain in years weighed heavily on Real GDP. Interestingly, personal consumption was actually revised up to a respectable 4.4% rate (from 3.8%), accelerating from Q4’s 4.2% and Q3’s 2.8%. In annualized nominal dollars, personal consumption jumped 5.8% from Q1 2006 to Q1 2007.
How is it possible that consumer spending holds up so well in the face of faltering housing markets and reduced mortgage borrowings? There is no mystery Q1 personal income expanded at a blistering 9.4% pace. In nominal annualized dollars, Q1 personal income increased 5.8%. Disposable income grew an annualized 8.2%. The huge income gains were not a one quarter anomaly. We already knew that, through the first seven months of fiscal year 2007, federal personal income tax receipts were running 17.3% ahead of the year ago level. Clearly, enormous capital gains and investment income growth coupled with strong compensation trends are having a significant impact.
Financial sector debt should not be disregarded any more.
I read interesting research the other day taking exception to the bullish view that the economy will soon emerge from a “mid-cycle slowdown”. The basic premise was that only accelerated debt growth would empower an economic bounce-back. And it was their view that with household mortgage debt growth slowing sharply and government deficits shrinking, even a meaningful jump in corporate borrowings would likely prove insufficient to support the necessary expansion in total system credit. This analysis follows the conventional method of examining household, corporate and government debt growth – analyzing only “non-financial” credit. It is traditional thinking that financial sector debt must be disregarded, as including it with non-financial would be counting the same loan twice (e.g., a home mortgage loan held on a bank’s balance sheet). While there is definitely a “double counting” issue at play, financial sector borrowing dynamics should be anything but ignored – especially these days. They are the key to liquidity abundance and hold the key to sound analysis.
Aggressive financial sector expansion in the face of slowing non-financial debt was the notable 2006 development. The slowdown in non-financial debt growth has been consistent with moderating nominal GDP. What has caught many analysts by surprise is the acceleration of income growth and overly abundant marketplace liquidity (with booming global stock markets). In both cases, the rapid expansion of financial sector debt has played the prevailing role.
Examining the “Big 5” Wall Street broker/dealers, one can see that combined 2006 net revenues were up 33% y-o-y to $133 billion. These firms paid out 44% of net revenues in compensation last year. Compensation actually increased 31% from 2005. Combined Q1 2007 compensation increased to $19.7 billion, providing the most direct flow of financial sector leveraging to augmented income. Obviously, “Big 5” paychecks are only part of today’s Financial Sphere compensation bonanza. Employee pay was up 17-21% y-o-y at a few of the largest “banks”. And let us not forget the hedge fund industry. Whether it is a Wall Street firm, “money center bank”, hedge fund, or local bank branch, the expansion of financial credit provides growing revenues and rising income that bubble outside the traditional confines of non-financial debt statistics.
Direct compensation is only one aspect of today’s credit bubble-induced surge in financial sector debt growth. Offsetting slowing mortgage debt growth, the rapidly expanding financial sector – aggressively using leverage to balloon securities holdings – set in motion unprecedented marketplace liquidity creation. This liquidity has fueled myriad self-reinforcing asset price and credit booms. Importantly, overly abundant liquidity has spurred a historic global M&A and debt issuance boom. And it is worth noting that, according to Bloomberg, “banks, brokerages, insurers and other financial companies” accounted for 65% of May’s record bond sales. It has become rather obvious that financial sector credit expansion is financing much of the acquisitions boom.
Deals are driving record debt issuance, and each acquisition completed with debt adds additional “liquidity” into the system. Some of this new liquidity flows to the sellers, where it will be used to purchase other assets or financial instruments. Some of this newly created liquidity is enjoyed by the acquirer through the currently popular private-equity “special dividend.” Some of the new financial credit becomes revenues and income for the various financial intermediaries and their accountant and attorneys.
Meanwhile, the M&A boom is definitely a major factor stoking stock prices generally, in the process providing additional collateral for leveraging (i.e., margin debt, derivatives, borrowing against capital gains). The backdrop certainly provides ample incentive to start a new business or aggressively grow an existing one in hope of a deal. And, importantly, strong earnings growth coupled with abundant liquidity spur the ongoing stock repurchase boom, reinforcing asset inflation and a recursive cycle of credit and liquidity excess. Financial sector debt growth permitted last year’s record S&P companies’ stock repurchases – which enriched many and supported general stock market inflation. Today’s powerful interplay between financial sector and corporate Credit growth should not be downplayed.
Importantly, the massive expansion of financial sector credit has become the key marginal source of liquidity for the real economy. Undoubtedly, it is the prevailing underlying source – The Other Side to the Story – for booming government tax receipts and shrinking deficits. I would also argue that the ballooning financial sector goes far in explaining how the (negative savings rate) household sector retains sufficient liquidity to send $100s of billions to speculate on foreign financial markets.
Financial sector expansion is distorting the true scope of the current credit expansion.
While it is impossible to quantify, I am convinced that the rampant financial sector expansion is distorting the true scope of the current credit expansion. Clearly, the massive expansion of financial credit is boosting income, gains on assets sales, foreign flows recycled back into the U.S. economy and confidence generally. As such, it today requires less – perhaps significantly less – household, corporate and government debt growth to sustain the U.S. bubble than would normally be the case.
I believe that the U.S. bond market is coming to recognize this dynamic. For some time, players have been monitoring housing market dynamics with the expectation that an abrupt slowdown in mortgage credit growth would have dire consequences for the vulnerable U.S. economy and credit system generally. Not only has unparalleled financial sector expansion created more than ample liquidity to sustain the boom, resulting income and securities markets gains have supported home prices and held a full-scale housing bust at bay.
Some see rising global bond yields as evidence of waning liquidity. I believe that bond markets are instead finally wising up to the implications of chronic global liquidity excess. Considering the amount of leveraging in the system – especially in the U.S. where markets have been too well-positioned for the next easing cycle – it is now conceivable that a spike in rates could lead to some problematic de-leveraging and liquidity issues.
I do not buy into the bulls’ fanciful imminent recovery from a “mid-cycle slowdown” thesis. Nor am I much of a fan of the bearish view that housing is well into the process of dragging the economy into recession. Rather, I see the economy in the process of bouncing back at the hands of precarious credit bubble excess – especially throughout the financial sector. Housing has been a meaningful setback, but the enterprising U.S. credit system has found a way to sustain more than ample credit and liquidity creation – not to mention speculation.
I have argued for too long that the U.S. credit bubble is acutely vulnerable to a spike in interest rates. With the booming U.S. financial sector and global financial and economic bubbles as a backdrop, we might now be only a growth spurt and a negative inflation surprise from testing this thesis. Deleveraging and the unwinding of speculative positions would be especially debilitating for our unstable financial sector and economy. And that is, as they say, The Other Side to the Story.Link here (scroll down).
MERGE, PILE ON DEBT, THEN WE WILL COME TO THE RESCUE
Don’t you just love investment banking?
Investment banking is a wonderful business. First, persuasive bankers in New York and London promote takeovers, earning millions of dollars for their advice. To complete the deals, investment firms load the companies with debt, taking more fees for selling the junk bonds or making the interim loans necessary. Finally, when companies collapse under the debt burden, the bankers advise corporations on how to avoid or get out of bankruptcy and they trade the companies’ distressed bonds and loans.
Today, even as they continue to bask in the latest takeover boom investment firms are cynically preparing for the bust they know must come. Goldman Sachs and Morgan Stanley have beefed up their distressed-debt groups recently. So has Amsterdam’s ABN Amro Holding NV, which is the target of two takeover bids. Blackstone Group LP, which manages $33 billion in funds that buy companies largely with borrowed money, is starting a corporate salvaging group in London. Does Blackstone have any of the companies it bought in mind?
While hard evidence of corporate distress is scarce at the moment, the rapid pace of debt accumulation can only mean trouble. Leveraged buyouts totaling $446 billion have been proposed so far this year following a record $702 billion for all of 2006.
Investors have a great appetite for high-yield, high-risk U.S. corporate bonds, many of which are sold to finance takeovers. The yield on junk bonds is just 2.42 percentage points higher on average than the yield on U.S. Treasury bonds. The average difference over the past five years has been about 5 percentage points. Junk bonds do well because stocks are doing well, analysts say. A strong economy that buoys share prices also helps companies pay their debts.
There may be a self-perpetuating cycle here. Takeovers boost stock prices. Higher stock prices then boost demand for junk bonds used to pay the premiums that boost stock prices. Something may give soon. Warren Buffett, whose Berkshire Hathaway investments regularly beat the market, says there are few bargain stocks today.
The merger pace will not abate as long as money can be borrowed at relatively low interest rates and on easy terms. Though no one knows exactly when the credit bubble will burst, investment firms on Wall Street and in the City of London will be ready. They are paying as much as $3 million a year for bankruptcy specialists and distressed-debt traders, according to a recruiting company. That gives you an idea of how much the investment bankers figure they will make by rescuing the companies they once advised to go astray.Link here.
LOOKING FOR COMPANIES WHOSE CROWN JEWELS ARE ENCRUSTED WITH MEDIOCRE BUSINESSES
Get in before the buyout artists discover the value.
Sometimes it makes sense for a company to shed its most lucrative business. Two years ago First Data (FDC) was a $10.5 billion in sales company with three divisions. The gem was its $4 billion Western Union (WU) money-transfer operation. Western Union, which built the first transcontinental telegraph line in 1861, is a powerful brand with a leading 17% market share. This business had a fat 33% operating margin. Its top line, goosed by immigrants sending money back home to their families, was increasing at a 14% annual clip. Sales at First Data’s other two businesses – payment processing for merchants and credit card services – which had a combined 21% operating margin, were flat.
First Data’s stock was stuck in neutral from 2002 through 2005. Then early last year the company announced it would would spin off Western Union. First Data’s shares popped 5% on the day of the announcement. If you bought then and held both the Western Union shares distributed and the First Data remnants, you would have a 32% gain. Interestingly, it is the payment processing and credit card businesses that have attracted a buyout offer, from Kohlberg Kravis Roberts.
The buyout frenzy has led to a feverish level of spinning off. Presumably, managers are figuring that it is better to produce shareholder value themselves than to wait for a raider to reap the gain. The freed-up assets do well. A Lehman Brothers study found that since 1990 shares of the average spinoff division returned 18.2% above the S&P 500 during its first two years as a stand-alone company. But you can make even more money by buying shares of the parent company before it announces its plans for a spinoff. Lehman looked at total returns over a three-year period (the year before a spinoff was completed and the two years that followed) and found that the parents beat the S&P by 25 percentage points. “Businesses are run better once they are out in the sunshine by themselves,” says Joseph Cornell of Spin-Off Advisors. And a spinoff is four times as likely to be bought out as a typical S&P company, according to Spin-Off Advisors.
Most spinoffs are tax free at the corporate level. In contrast, if a parent chooses to sell a business rather than distribute it to its shareholders, it will typically incur a capital gains tax of 35%. For the investor, the tax cost for the investment is apportioned between the parent and the subsidiary, and you have no profit to report until you sell.
We looked for companies where shareholders could gain from a spinoff. These five stocks have either underperformed the S&P 500 in the past two years or trade at a below-market enterprise multiple (stock market value plus net debt, divided by operating income). Also, each company has a business segment that could be spun off because it has an operating margin superior to its parent and would also command an above-market enterprise multiple as a stand-alone business. Our estimates of breakup values come from conversations with analysts and comparisons with similar businesses.
One company meeting the criteria included Fortune Brands (FOPRA), which has three businesses: home and hardware products (57% of sales), spirits and wine (27%) and golf products (16%). The stock is down 8% this year due to softness in the housing market and has an enterprise value (market value of common plus net debt) of $18.1 billion. But in pieces this company would be worth, we estimate, $21.3 billion. E.W. Scripps (SPP) owns newspapers in 17 markets, 10 television stations and 5 cable television networks that cater to cooks, home gardeners and do-it-yourselfers, among others. The newspapers are treading water, but the networks’ revenues have doubled in three years. So why not spin off the cable channels as an independent company and unlock some value for shareholders? One problem: The Edward Scripps Trust, established in 1922, controls 88% of the vote.Link here.
RAILROAD TO RICHES
A top transportation analyst talks trains, trucks and shipping stocks, and tells why investors are flocking to the industry.
Last year Edward Wolfe outscored his security analyst peers with his buy-and-sell recommendations on transportation stocks, but that is only part of the story. StarMine, a San Francisco company that tracks analysts’ forecasts and stock picks, tells us that Wolfe is the most consistent winner among 3,400 analysts following U.S. stocks since it started its awards in 2001. Wolfe, 40, has been at Bear Stearns for eight years.
In 2006 Wolfe generated a 9.6% excess return, that being how much his stock picking in one of his sectors, airfreight and logistics, beat the sector return. Among his good calls: a yearlong buy on Hub Group (HUBG), an asset-light domestic logistics provider. That stock returned 56%. His best bearish call in 2006 was one he made on Old Dominion Freight Line (ODFL) in the second half of the year, during which time the stock fell 21%. Wolfe also leads the dozen airfreight and logistics analysts in StarMine’s database in 3-year performance, with an excess return averaging 11.5%.
Used to be that an analyst could make a good living by putting out plausible earnings forecasts and taking care not to offend any of his employer’s investment banking clients. No more. Now scorekeepers like StarMine are quick to punish an analyst for failing to change a hold to a sell.
Wolfe’s résumé does not fit the mold. After earning a law degree at Fordham University, he headed for a Wall Street law firm but ditched it for the Legal Aid Society in the Bronx, representing tenants threatened with eviction. All his Legal Aid cases were “emergencies”, with no discovery period to interview witnesses before their hearings. “I didn’t always know the answers to my questions beforehand, so I had to listen very carefully and follow up quickly,” he says. Wolfe has adapted those skills to cross-examining executives during analyst conference calls. “I pick up on other analysts’ questions where they leave off.” Wolfe keeps up with the customers of the companies he covers. Why would shippers help a Wall Street analyst? Wolfe makes it worth their while by sharing his anonymous customer surveys with them.
Transportation stocks are doing well at the moment. Railroads Burlington Northern Santa Fe, Union Pacific and CSX realized hefty increases when it came out that Warren Buffett and Carl Icahn were buying. But Wolfe is not blindly in love with his sectors. He advises his clients to buy rails at 13 to 14 times forward earnings and sell them at above 16 times. Burlington Northern, an industry darling and Buffett’s favorite, is at the upper end of the safe range at 16 times its consensus forecast. Wolfe favors Canadian National Railway, which enjoys the industry’s best operating margin – 40% versus 25% for U.S. rails – and Norfolk Southern (NSC), which trades at 14 times estimated earnings over the next 12 months. Wolfe is bullish on Expeditors International, a global logistics provider, for the fact that only 2% of its revenues come from freight movements entirely within the U.S. And he is sticking with Hub Group. Its earnings growth has topped 50% annually for the last three years.Link here.
THE RENTING EFFECT
Companies will have to start counting operating leases as long-term liabilities. This is going to be very bad news for some.
Call it “The Case of the Hidden Obligation.” Since the Enron unpleasantness, better disclosure in corporate financial statements has been a trend. Important liabilities that were tucked away in footnotes or not reported at all, like pension obligations, off-balance-sheet entities and derivative exposures, have been dragged into the sunlight.
Next on the hit list for a public outing is leases. The results will not be pretty. The accounting changes, likely to go into effect several years from now, could boost debt levels and shrink earnings.
Leases allow companies to avoid buying a hard asset. Instead executives opt for the flexibility of renting. Drugstore chain CVS owns only 6% of its 6,202 stores. Leasing gives CVS some operating flexibility if the chain wants to reconfigure geographic strategy. It also lightens CVS’s balance sheet.
Everything from computers to airplanes, retail outlets to office buildings are leased. The Equipment Leasing & Finance Association trade group estimates that 80% of U.S. companies rent some or all of their equipment. Half of mainframe computer systems are leased. Real estate leases account for 70% of operating lease payments.
In an earlier round of accounting reform (going back decades) lessees had to make a distinction between “capital” and “operating” leases. The former are very long-term leases that closely resemble a mortgaged purchase of a building (or equipment) by the company using it. The latter are more like the temporary equipment rentals common in construction firms. The dividing point is whether the sum of all lease payments, discounted to present value, represents 90% or more of the value of the property. If it does, the lessee must account for the arrangement as a capitalized lease, i.e., as a property acquisition. The building or equipment goes on the balance sheet as an asset and a corresponding debt gets recorded as a liability. Under present rules operating leases do not go on the balance sheet but often must be summarized in the footnotes.
Off-balance-sheet operating lease commitments, as revealed in footnotes, totaled $1.04 trillion at 4,718 public U.S. companies in 2005, the latest data available, according to research done by Matthew Magilke, an assistant professor of accounting at the University of Utah. The $1.04 trillion is the raw sum, not the discounted present value of the lease payments. The companies’ average lease amount came to 35% of reported liabilities.
Some off-balance-sheet lease obligations are many times higher than reported debt. Total long-term liabilities at the grocer Whole Foods (WFMI) came to $639 million in late 2006, up 22% in a year. But unrecorded minimum lease payments for its 182 stores were seven and a half times that sum, $4.8 billion, up 41%. “That’s a rather large commitment not being recognized on the balance sheet,” says professor Magilke.
The Financial Accounting Standards Board, which sets the accounting rules for U.S. corporations, aims to move operating leases out of the shadows and onto the balance sheet. The International Accounting Standards Board, which sets international rules, intends to do the same. Where the old rule made 90% of property value a turning point, the new one will treat leases just like any other loan. (Short-term leases for things like cars might not be affected.) FASB Chairman Robert Herz expects the harsher treatment to begin in 2008 or 2009. Pre-Enron, companies did a good job squelching FASB plans for better disclosure. Now the pleas for easier rules are not well received.
The effect of capitalizing a lease is usually unfavorable. Assets and debt go up. Leasing costs are eliminated but replaced by depreciation and imputed interest. Usually the sum of interest and depreciation exceeds the lease payment. Taxes are, generally speaking, unaffected. The IRS generally expects the lessee to deduct the lease payments, not the depreciation and interest. Under the FASB plan many companies will see their earnings drop. The ratio of debt to equity will go up. The return on assets will go down. This is not likely to trigger a raft of credit downgrades from rating agencies like Standard & Poor’s, who already examine footnotes and taking hidden obligations into account when assigning scores.
Some might shrug all this talk off as a mere paper exercise. The disagreeable reality is that companies have been working the system to lower the amount of debt they show investors, even though lease debt is just as real as any bank loan. At Bed Bath & Beyond (BBBY) a total of $1.3 billion in liabilities can be found on the balance sheet for the fiscal year ended March 3. But off-balance-sheet lease commitments for stores, equipment, warehouses and offices amount to $3.2 billion. Delta Air Lines showed $19.8 billion in long-term liabilities on its balance sheet for December 2006. That did not include the $10 billion in operating lease commitments it had on 166 aircraft.
Professor Magilke estimates that Whole Foods would see its return on assets fall from 7.2% to 3.7%, while its debt/equity ratio would climb from 38% to 169%. Walgreens (drugstores), Panera Bread (bakery/cafes) and AirTran Holdings (airlines) would also see some damage. Charles Mulford, an accounting expert at the Georgia Institute of Technology, reworked the numbers for 19 of the largest department store companies, which obviously love to rent out stores in malls and elsewhere. If the proposed FASB rule had been in force for 2006, earnings from continuing operations would have been cut by a median 5.3%. Assets would have risen a median 14.6%, liabilities a median 26.4%. Return on assets would have gone down by a sixth.
Using Mulford’s study, we have focused on the eight companies that take the biggest drubbing. In the table below we zero in on the two items that concern investors the most: EPS and debt-to-equity ratio.
The FASB scheme does have an upside for companies, which investors should watch with a wary eye. The one metric that the new method benefits is earnings before interest, depreciation and amortization. EBITDA will be boosted by the amount now shelled out in lease payments. Mulford calculates that if the new rules were in effect for 2006, EBITDA at the companies in his study would have increased a median 22.5%. EBITDA inflation might help companies whose bank loans become immediately callable if their EBITDA falls too low. It would also help if executives’ salaries are linked to EBITDA, which is the situation at Sears Holdings (SHLD) and Saks (SKS).Link here.
BUILD YOUR OWN HEDGE FUND ON THE CHEAP, AND AVOID OBSCENE FEES
Instead of “2 and 20”, incur fees of “1 and none”.
How do hedge funds justify their sky-high fees? One reason individual investors might be persuaded to part with 2% of assets annually, plus 20% of profits, is that it is hard for them to hedge on their own. Shorting shares of stock is a risky business – the potential loss is unlimited – and terms are not too good (see “Shortchanged”). But salvation is at hand. New tools are cropping up to make bearish stock positions much more accessible to the retail customer. You can create your own hedge fund, at low cost.
The mechanism is exchange-traded funds. In the last 12 months ProShares has launched 29 ETFs that short the broad market (like the S&P 500 and Russell 2000 indexes) and its subsectors (like technology and health care). To pair against these bearish vehicles you can own either stocks and mutual funds of a conventional sort or else one of the 23 bullish ETFs offered by ProShares.
Say you are agnostic on which way the overall market will go but are convinced that the technology-heavy Nasdaq will do worse. A neutral strategy is to go long a broad-market ETF from ProShares or another vendor, then also buy the bearish Short QQQ ProShares, which shorts 100 of the largest Nasdaq stocks. Annual expenses on the ProShares bearish instruments are not so bad at less than 1%. The hedge fund industry’s fee structure goes by the name “2 and 20”. This one you could call “1 and none”.
The bearish ETFs are the brainchild of Michael Sapir, 49, a securities lawyer. It took him seven arduous years to gain SEC approval to issue them. Sapir helped launch the Rydex fund family in 1993. Rydex sells bullish and bearish funds and long ETFs to individual investors. In 1997 Sapir cofounded ProFunds, an index-fund provider whose products were initially pitched to professional investors (money managers and financial planners). In 2006 he created ProShares, a sister corporation devoted to operating ETFs. Between the two there is $13.7 billion under management – $7.8 billion at ProFunds in 60 long and short index funds, and $5.9 billion at ProShares in 52 short and long index ETFs.
ProShares’ bullish ETFs are for the most part nothing special. Its broad-market fund is outsold by cheaper offerings from Vanguard and Barclays. But the bearish ETFs, accounting for 80% of ProShares’ assets, have no competition yet. ProShares offers standard ETFs with no leverage and, for investors interested in faster action, ultras with 2-to-1 leverage. Say you put $5,000 into the UltraShort Dow30. You would control $10,000 worth of the Dow Jones 30 index. If that index does go down, your gains are doubled. But if it goes up, your losses are doubled. The standard Short Dow30 makes (before expenses) the same daily percentage moves as the Dow. With an ETF your risk is limited to your initial investment, and you have no margin calls. When shorting a stock the risk can be infinite.
ProShares funds are convenient for various market-neutral bets. Perhaps you think a particular large-cap stock or fund will outperform the large-cap market but fear a general market downdraft will drag down its performance. Purchase that stock or fund, but also buy ProShares Short S&P 500. You could use ProShares to go short a basket of stocks in real estate and go long in oil and gas. You can find a pair to play growth stocks against value stocks. Or you could make an indirect bet on a fundamental economic indicator like interest rates. Do you think a rate rise is inevitable and it will hurt banks more than utilities? Buy equal amounts of ProShares Ultra Utility and UltraShort Financials.
What if you believe small caps are headed for a decline and want to protect gains in your small-cap holdings without selling them? Perhaps you want to avoid capital gains taxes or your long position consists of restricted stock. You can partially hedge by buying the Short Russell 2000. To save a bit on expenses, buy half the quantity of the double-action ProShares fund.
Tax rules favor ProShares, at least if you make money on them. Hold an ETF for more than a year and your gain is long term, taxed federally at a maximum 15%. So if your bearish ETF is a winner, hang on to it for at least a year and a day. If it stinks, sell sooner to claim a short-term capital loss. In contrast, short-sale bets (generally speaking) give rise to short-term gains and losses, even if you hold a position open for a long time.
Sapir says there is a patent pending on part of his process. That may or may not inhibit a competitor like Barclays or Rydex from moving into this business. ProShares offers no bearish ETFs covering bonds or international stocks yet, but it is looking to add them. For some of ProShares’ most popular short ETFs, see this table. Needless to say, hedging does not mean eliminating risk. With any paired bet, you could conceivably lose on both sides.Link here.
COMPARING TOYS TO HEDGE FUNDS
My grandfather walked me through the doors of Pittsburgh’s newest Toys ‘R’ Us. Without a second thought, he instructed me to pick out any one single toy my heart desired. I knew he was serious. He never joked on monetary issues. Without hesitation, I took off for the Hot Wheels aisle. I needed to replace the Exxon 18-wheel tanker truck my cousin launched from the 4th-story window of my parent’s attic. My search took no less than three minutes. He waited by the cashier as I placed the 50-cent piece of rolling plastic on the black conveyer belt.
“Is that all?” he insisted. “You are certain that’s what you want?” I was no fool. My grandpa had a soft heart and cash to burn. So I snagged two packs of Rollos and some peanut M&Ms. These assets were strict contraband at home. But for two weeks a year, my mother was not in charge. And I diplomatically manipulated this power like the Chinese and their undervalued Yuan.
Sometimes I simply like to relive those brief moments in life when world was truly my oyster. It is a feeling the managers of the top 12 sovereign-wealth funds must be experiencing these days. This select group The Economist calls a secretive society each control anywhere from $20 billion to hundreds of billions of dollars to invest. According to The Economist, some estimate these funds combined will control $2.5 trillion by the end of this year alone (in contrast, hedge funds are thought to have a mere $1.6 trillion). If FOREX coffers keep growing at this remarkable pace, the amount could balloon to $12 trillion by 2015. I am not sure that even the Fed’s printing press running at full capacity could match that mark so quickly.
So what does this mean? For one, the global liquidity lush fest does not seem to be ending anytime soon. Governments around the globe effectively possess a weapon more powerful than even the greatest industrial military complex could ever produce. It makes more sense to own the building itself than waste the time, money, and energy blowing it to pieces. That is the real way to apply diplomatic pressure. I believe China certainly knows this. And that is why I believe we should find China’s symbolic stake in Blackstone so compelling. The Blackstone deal may effectively pave the way for Beijing to circumvent government protectionism in their quest to purchase sensitive assets on foreign soil.
To take this step further, why would other, less influential nations (say Russia, South Korea or Singapore) not follow suit? But let us not lose focus. Not only have most governments, both East and West, assumed the enlightened function of providing a pampers-to-pampers welfare state, but federal entities have also cleverly assumed the role as private money managers as well. They read the papers. They see the money private equity firms and hedge funds are making. They want in. They want a piece of the action. Consequently, they have anointed themselves as the new mega-hedge funds. And we know when governments have money to spend, they undoubtedly possess the insatiable propensity to spend it.
But the real question remains: What will they buy? That is the $trillion question. If you were head of a multi-$billion sovereign-wealth fund, and you were given the task of securing a premium well above a benchmark government bond, which markets would instantly grab your attention? Take a quick look at the various stock market moves since December 29, 2006. One thing is for sure. If I were a sovereign-wealth manager, assets denominated in the U.S. dollar would probably be the last place I would sink the majority of my country’s cash right now.
And if the dollar’s slide continues, it may be a long time before we can make the case that the dollar is poised for a fundamental climb. In the mean time, we will keep focusing where we think a majority of this wealth will eventually end up – on markets outside the U.S. We will follow the growth. We will follow the true wealth.
Right now, for the select few controlling this multi-trillion dollar hedge fund, the world is literally their oyster. The best we can hope to do may be tag along for the ride.Link here.
NEW FUND AIMS TO TAP INVESTORS’ TASTE FOR ART
One of the world’s first hedge funds focused on the buying and selling of fine art has been launched by the Guernsey-registered fund Artistic Investment Advisers Ltd. The Art Trading Fund is aimed at high-net-worth expert and institutional investors and seeks to challenge the traditional “buy and hold” business model of investment funds.
According to AAA, the fund buys and sells art via its global network of dealers, renowned artists, auction houses and galleries. Returns are maximized through geographical price arbitrage and by removing market inefficiencies. The fund sources art from a bank of vendors and sells through a network of buyers. The firm says that the fund uses an objective investment process and essentially monetizes the substantial margins of a gallery and art dealing business – without the high fixed cost base of either – and passes that “alpha” on to the end investor. The investment managers add additional value through asset allocation and via a synthetic hedge that provides downside protection.
“Traditionally, investment funds concentrating on art as an asset class have ignored the opportunities provided by market timing and active trading. Our strong artistic and financial expertise means that we are able to take advantage of this opportunity,” said Chris Carlson, founding partner of AAA. “By launching the first art fund with a hedging mechanism, we are meeting investors’ desire to invest in an alternative asset class, but one that is not reliant on stocks or bonds which, as the market is becoming more saturated, are not providing the high returns they once were.” Justin Williams, another founding partner, added that a 4-year equity boom has created a lot of excess liquidity which has helped to create a thriving market in art.
According to the Economist, Sotheby’s set a record total for a contemporary art auction this month, raising $254.9 million in one night. However, this record was eclipsed by Christie’s, its rival, when $384.7 million in art was bought up in what the magazine termed an unprecedented “buying binge”. “There is a mood of speculation that I have never seen before in my 50 years in the business,” Richard Feigen, a Manhattan art dealer, was quoted as saying by the magazine.
The Financial Times reports that the Art Trading Fund has so far raised £10 million ($19.9 million) but it hopes to have raised £25 million in time for its summer launch. The fund has a minimum investment of £100,000 and is targeting annualized returns of 30%. The fund is based on three core strategies that incorporate the Impressionist, Post-Impressionist, modernist and contemporary art markets.Link here.
IS ETHANOL RUNNING OUT OF GAS?
Driving through the U.S. and being invited to several family farms over the last week or so has been enlightening, and fattening. At each stop, I got an earful of insight and knowledge on several topics, as well as a delicious piece of rhubarb pie and coffee. It is one thing to read about the ethanol debate and the challenges for farmers, and quite a different experience to actually meet and talk with them and walk around the fields. That is exactly what I wanted to do. In candid interviews with various grain and dairy farmers, ranchers, workers at ethanol plants, etc., over the last week or so, I have gained new insight into what the future may hold for us as commodity investors.
Ethanol from corn has been a mixed blessing for farmers, and those that got in early have done well. In Minnesota, they have 16 ethanol plants and five more under construction. When the ethanol boom started, most ethanol plants were created by a formation of a co-op of farmers in the local area. Many still are run this way. Obviously, each of these farmers has a vested interest in the plant, as it is where they take their grain to be processed into ethanol and taken to market. That all started back when corn was around $2.50.
The new plants that are being built today are mostly not co-ops but “private equity”, and the cost of these plants has skyrocketed. Of course, corn is now $4.00 a bushel. Farmers are concerned that simply cannot last. The farmer-owned ethanol plants are already moving into other alternatives, like biofuel made from soybeans. The concern is that while much of the nation has a mandated 10% ethanol mixture with unleaded, it may not be enough demand to sustain all of these new ethanol plants.
The corn-based ethanol craze is probably not being shown the door, but may be getting handed its hat. The costs for farmers in mounting food inflation is creeping up quickly: seed costs, fertilizer, fuel, irrigation, transport and leasing of acreage, etc. Costs of renting acres (for farmers who lease the land) have doubled in only a year. Most farmers I spoke with on my trip say it simply will reach a breaking point. They have seen it before.
In the commodities arena, corn has still probably got some room to the upside into 2008, but our gears will be shifting to look at soybeans, as biofuel seems to be getting much more interest and is likely a much more viable alternative. The other market that could be a real sleeper here is sugar. The sugar market has been beaten down so badly and is in a significantly oversold position right now. As a key ingredient in ethanol from Brazil, as well as a food product, sugar is a commodity that should be at a much higher level right now. Yet temporary surplus supply has taken the price lower. That will not last.
The ethanol craze almost seems like a game of musical chairs, and before the music stops, we will want to grab whatever profits we have on corn and move on to the next hot commodity.Link here.
COMPANY MANAGERS DO A BAD JOB INVESTING CAPITAL, AND THEY DO NOT PLAN TO IMPROVE
Shareholders expect one thing above all else of management: that they maximize the use of the capital invested in the company. A new survey has bad news for investors. Most managers are not very confident about their ability to do so.
According to a poll by Deloitte Financial Advisory Services, 55% of executives doubt their company will be able to “optimize” returns on the capital they invest. Their reasons vary from the flood of projects they face to an inability to quantify which new projects will best mesh with existing ones. Not to mention office politics, inefficiency, and other corporate woes.
The news gets worse. Most managers do not have any plan to improve that situation. Just 41% of the 595 executives queried said that they were looking to change their methods for picking projects to fund. Charles Alsdorf, director of valuation services at Deloittte FAS, says he was surprised to discover a heavy reliance upon “qualitative” measures – such as group discussions and PowerPoint presentations – to make investment decisions. In fact, 28% of companies lean on such methods, rather than statistical tools, to pick projects. Alsdorf suggests a “valuation framework” to measure risks, costs, and benefits of new strategies. “With a proper framework in place, boards and executives can pick the ‘winners’ from hundreds of projects,” he says.Link here.
WHY A CHINESE MONETARY TIGHTENING COULD BE FOLLOWED BY A GLOBAL DEPRESSION
As the world’s largest holder of dollars, the People’s Bank of China is now the world’s de facto central bank. That is a scary thought because China is a nouveau riche nation that is not ready for a principal role in global economy. In 1929, the U.S. was similarly an upstart, a country that held 50% of the world’s monetary reserves (in the form of gold) even though its central bank, the Federal Reserve Bank, was only 16 years old.
Moreover, China is facing the essentially same dilemma today as America did in 1929. The U.S. in the 1920s flooded the world with liquidity in order to hold down a fundamentally strong dollar and prop up a weak pound at the behest of Britain’s central banker and a Treasury Minister named Winston Churchill (who failed at everything he did in public life before World War II). China has been similarly accommodative until recently to support the weak U.S. dollar, despite making heroic efforts to “sterilize” these dollars. But some of the liquidity inevitably found its way into the Chinese and global economies, helping to bring about torrid (and probably unsustainable) double-digit percentage growth in China.
This growth is also taking place in a relatively unbalanced fashion. For instance, Chinese consumer spending growth is only about half of industrial spending growth – in the mid-teens. The high single digit percentage difference has to be made up by exports, which led to the problems just alluded to, large trade surpluses for China, and large trade deficits for the U.S., causing major imbalances for both countries. Excess capacity in industrial goods could lead to an economic bust in China, at about the same time that a U.S. bust comes from downward pressure on consumer spending because of the collapse of the housing bubble.
Such runaway growth is also threatening to overwhelm China’s relatively primitive commercial and physical infrastructure. The country has some of the most modern industries in the world, side-by-side with Stalin-era state-owned enterprises (SOEs) – and a banking system that has to serve both sectors. World-class economic officials exist at the highest levels of the government, alongside corrupt local bosses that threaten to derail the economy for their own ends. Even the smooth functioning of basic utilities cannot be taken for granted.
As a result, the Chinese stock market is waking up from a long slumber. One to two million brokerage accounts are being opened every week in China. These accounts are being opened by all the usual suspects of a market top, “cab drivers, house cleaners, college students, and Buddhist monks,” according to Adam Shell of USA Today. Meanwhile, Chinese stocks are now selling at 30 to 40 times earnings – bubble levels. New legislation allowing Chinese to invest overseas may give a temporary lift to other markets including that of the U.S. Given the lack of sophistication of investors like those just noted, the change of stock ownership that we are now seeing can be called “distribution”. We have seen this movie before.
It is easy to say with the benefit of hindsight that the U.S. Fed erred in keeping monetary policy too tight in the 1930s. But that came about because the Fed was too loose in the 1920s, as has been the case in the 1990s and so far this decade. And the most immediate threat in the Western world prior to 1929 was the German hyperinflation of the early 1920s (which destroyed the German economy and middle class and ultimately brought Hitler to power). In avoiding the Scylla of such inflation, the Fed opted for the Charybdis of deflation. China had a similar, and first-hand, experience with hyperinflation in 1949. More than anything else, it brought the present (Communist) government into power. With that heritage, China is going to err on the side of tightness. In fact, the country is using all three major monetary tools, open market operations, raising discount rates, and raising reserve requirements in a concerted effort to cool down its economy. Such a confluence of policies is seldom seen in the western world.
A more seasoned Fed in the 1930s might have barely avoided a depression. But to hold the 1930s Fed to the elevated standards of today would have been too much to ask. Likewise, more experienced hands at the helm of the People’s Bank of China might possibly avoid the oncoming bubble and crash. But that is asking a lot of an institution and country that are just beginning to make the transition from Communism to capitalism. The PBoC is about as seasoned today as America’s Benjamin Strong-led Fed was just before 1929. More to the point, it is not about to listen to the U.S. because we are a major part of the problem in other respects.
I believe that China is setting a massive tightening of the global money supply in progress, and that this tightening could soon be followed by a global depression. Either event may happen or ultimately fail to happen. But in either case, it is basically out of America’s control. Like a lot of other goods that Americans now import, the modern 1929 – or a somewhat better outcome – will have been “Made in China”.Link here.
THE GLOOMY ROAD AHEAD
In a week when U.S. GDP was revised down to a level slower than the growth in population while inflation continued strong, it must surely be clear that the collection of economic policies followed since 1995 by both parties and the Fed has failed. The Fed can neither cut rates nor increase them, yet it needs to do both. The Bush administration is finding that its 2001-03 tax cuts are untenable in the face of the inexorable rise in public spending and the Democrats in Congress are coming to the reluctant conclusion that if they try to implement even half their wish-list of changes, the sums do not add up. So what next?
Reality has not yet dawned on the political classes. The Fed is currently claiming that the U.S. economy will turn up after its weakness in the first quarter, even though there is absolutely no evidence of it doing so and indeed the collapse in subprime home loans happened only in late February, so has hardly had time to affect the aggregates. The Administration is continuing to bloviate about its success in cutting the budget deficit and the magnificent economic effect of its 2003 tax cut, omitting to notice that the budget deficit is still very substantial when social security is taken into account. Meanwhile the Democrats are continuing to claim that their increase in the minimum wage will have a magical effect on increasing low-end incomes, while omitting to notice that their immigration policies will have an equally magical and much larger effect in depressing them.
And the stock market goes on rising, while investors go on putting money into hedge funds. They are ignoring the troubles of one of the most celebrated hedge fund operators, John Henry, who has lost 36% of his investors’ money and is likely to have to scale back operations drastically if not wind up his funds altogether. Fanatical supporters of the Boston Red Sox were charmed by Henry’s purchase of the team in 2001. They should about now be enduring a horrible sense of déjà vu. In 1920 the Red Sox’s financially strapped owner Harry Frazee sold Red Sox legend Babe Ruth to the hated New York Yankees – the rest was history, a history of 26 Yankee World Series wins and an 86-year Red Sox drought. Frazee’s financial wheeler-dealing resulted in quite a good Broadway musical, “No, No Nanette”. Regrettably, none of Henry’s deals appear likely to produce anything of such lasting quality.
Outside the dreamland of Red Sox baseball, the outlook is equally grim. The U.S. economy appears to be slowing further, while inflation stubbornly refuses to disappear. At some point, either the stock market wakes up to the problem or revenue shortfalls appear at the U.S. Treasury or the bond markets exhibit an inflation panic, or all three. Whatever the trigger, the bubble of investor confidence is now stretched very tight indeed, and will not repair itself once a shock to the system has occurred.
Once the stock market has burst, decline will feed on itself. The unconquered inflation will cause a rise in long term bond yields, which itself will cause a swathe of bankruptcies in the world of private equity and hedge funds. Indeed the fallout here may well be greater than any other seen in history, with an overall debt default rate peak higher than the 9.2% one-year bond default peak of 1932. The only factor preventing a Great Depression-like bond market collapse will be inflation, which will cause the real value of debt obligations to decline rather than increase as it did in 1929-33.
The decline in house prices, already apparent while the bond market has remained ebullient and credit quality problems have been confined to the over-extended subprime mortgage sector, will extend much further. I forecast last August an eventual house price drop of 15% nationwide and 30% on the costs. I now think that was conservative, although possibly not drastically so. With house prices declining sharply, any junk bonds they have bought showing a tendency to disappear into default and the stock market under pressure, consumers, particularly affluent consumers, will cut back sharply on spending. In this case, the retrenchment will be concentrated at the high end rather than the low end. Low and middle income consumers that keep their jobs and who do not have excessive mortgage or credit card debt will initially not be deeply affected.
The overall effect of reduced consumer spending will be to reduce the U.S. trade deficit. Huzzah! This will export deflation around the world, particularly to economies such as China and Japan whose economies depend on exports to the U.S. However China will have its own problems by this stage. It is most unlikely that a downturn in the U.S. stock market will leave the China stokcs bubble unaffected.
The other devastating effect of a consumer spending and asset price downturn will be on the U.S. federal, state, and particularly local budgets. These are already in poor shape. Local governments’ normal budgetary constraints have been removed as rampant property price increases have caused revenues to soar.
The worst possible solution to this would be the one Herbert Hoover chose: Aimless public spending to fight recession, followed by a panic increase in taxes as deepening recession leaves a huge hole in the budget. Had this downturn occurred in 2004-05, that pattern would almost certainly have been repeated, with the switch from Republican to Democrat control of Congress producing the tax increases. Instead, spending is being increased by the Democrat-controlled Congress, but the Democrats wish to demonstrate their fiscal discipline and the irresponsibility of President Bush’s tax cuts. Thus tax increases are likely to accompany the spending increases. This will limit both, and ensure that the further state encroachment on the economy which recession inevitably causes will be moderate.
Meanwhile, the trajectory on inflation will depend on Fed Chairman Ben Bernanke’s life expectancy. How long he can stay in the job before the market rebels and ousts him, as it did G. William Miller in 1979? If Bernanke can remain in office, it is likely that a downturn will cause him to lower interest rates, in an effort to reflate the economy. This in turn will cause inflation to surge, and make the process of recovery longer. On the other hand, inflation will reduce the real value of debt and make the debt default crisis less. Conversely, if Bernanke is forced out quickly, the recession may be over more quickly, because inflation will remain under control, but debt defaults in a Volcker-like period of tight money could be very severe.
Thus the choice is between a short sharp depression, albeit presumably less severe than 1929-33 (unless the forces of protectionism take a hand as well) or a lengthy period of stagflation like the 1970s, probably with a deeper dip than 1973-75. The third possible pattern, a prolonged period of stagflation like Japan in the 1990s, now seems rather unlikely. Nobody is saying this yet. But then, everybody has been forecasting a “soft landing” for the U.S. economy. That would be the only possible outcome that might save the Red Sox from being broken up. It thus looks like they had better make the most of any success in 2007.Link here.
“GO WHERE THERE IS NO PATH”
The problem these days is finding a road less traveled.
When financial markets become excessively frothy and bubble-like, investors should be mindful of Ralph Waldo Emerson’s words: “Do not go where the path may lead; go instead where there is no path and leave a trail.” Unfortunately, in today’s liquidity-driven global investment environment, I find it hard to identify any asset class “where there is no path.” There are far too many smart – and not so smart – treasure-hunters who have bid up every imaginable investment class right around the world. It is only in the most unusual places that I can find true value, as opposed to relative values – which certainly do exist.
The problem for investors is that, as the German theologian Dietrich Bonhoeffer wrote, “If you board the wrong train, it is no use running down the aisle in the opposite direction.” (Bonhoeffer opposed Nazism and was ultimately executed.) I mention this because it will become increasingly important for investors not only to decide which asset-class train they want to board, but also, and even more importantly, whether they want to board ANY of the asset trains.
If we look at the economic and financial history of capitalism, we can see that over periods of 5 to 10 years there were always some assets that performed well. But there were times, such as in the early 1930s and the 1970s, when very few assets appreciated. Gold and gold shares performed well in the early 1930s. And in the 1970s, precious metals, and energy and energy-related shares, appreciated dramatically. But what were the chances that, in 1929, an investor would have had all his assets in gold, or, in the 1970s, in energy and precious metals-related investments?
Moreover, in both cases, these investments had to be liquidated at some point because, as is always the case, “over-staying” eventually led to huge losses. And this is where I see the biggest problem in the current investment environment. At the beginning of a bull market in an asset class, there are very few participants. But by the tail end of the boom the vast majority of market participants have become convinced that the boom will last forever or that a greater fool will soon emerge and take them out at a higher price. So the majority of investors eventually get caught when the investment bubble bursts, as was the case in 2000 with dot-com stocks and in 2006 with U.S. housing.
A peculiar feature of the bull market in asset prices since 2002 has been that all asset prices around the world have appreciated in concert, as a result of highly expansionary monetary policies, which has led to a credit bubble of historic proportions. Therefore, if my theory of slower credit growth in the future holds, it is conceivable that, for a while at least, all asset markets – with the exception of bonds and cash – could come under pressure, albeit with different intensities. Asset markets would also come under pressure if credit growth merely continued at the present rate, and did not accelerate. In this instance, investors would be better off not boarding any investment train at all and, instead, staying at the station loaded up with cash.
However, they would still have to decide what kind of cash to hold – U.S. dollars or an alternative. For now, there is some hope for the U.S. dollar. The Fed has not tightened monetary conditions, but the marketplace has through the collapse of the sub-prime lending industry. Since the housing market is more likely to deteriorate further than to recover, credit problems could get much worse. Illiquidity in the U.S. household sector, along with the reluctance of the Fed to cut rates right away, combined with the requirements for enormous capital investments for infrastructure in emerging and developed economies, could lead to some tightening of liquidity around the world.
Therefore, I expect a more meaningful setback in asset prices and would certainly defer the purchase of financial assets. In particular, I am concerned by the inability of financial stocks to rally convincingly from their March 2007 lows (see chart), since financials have been leading the market up and down.
In my opinion, there is an ongoing deterioration in the U.S. stock market. In the summer of 2005, the homebuilders peaked out. Last year, it was sub-prime lenders’ turn to top out. And early this year, financial shares, including brokers, made their highs. The economy is likely to follow this slow stock market erosion and gradually deteriorate, with disappointing corporate profits to follow.
Investors who must own U.S. shares may find some relative outperformance among pharmaceutical companies, and oil and coal stocks. For the reasons outlined above, I do not expect the U.S. dollar to collapse immediately. However, in the long run the purchasing power of the USD will continue to decline against sound currencies such as precious metals. Therefore, I continue recommending the accumulation of gold and silver.
But it is increasingly likely that something will give soon. Either asset prices will decline in a tighter liquidity environment, or the U.S. dollar will fall sharply if the Fed continues to pursue expansionary monetary policies. This means either weak U.S. equities and a strong dollar, or strong U.S. equities and a weak dollar. Not a particularly appealing scenario!Link here (scroll down to piece by Marc Faber).
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