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CREDIT MARKET DISLOCATION
I am never comfortable with the idea of “yelling ‘fire’ in a crowded theater.” But Jim Cramer already did as much late last Friday afternoon on CNBC. His “We’re in Armageddon” tirade was made moments after Bear Stearns’s CFO Samuel Molinaro offered a disconcerting assessment of market conditions during the company’s hastily called conference call: “I have been out here for 22 years, and this is as bad as I have seen it in the fixed-income markets.” A highly-aroused Mr. Cramer, volunteering to speak on behalf of Wall Street, called for the Fed to aggressively cut rates and “open the discount window.”
The credit market has dislocated, liquidity has evaporated, and our academically-inclined new Fed chairman is in store for a historically challenging real world first test. Wall Street has been conditioned over the years to expect “bailouts”. Only months on the job, Alan Greenspan stepped up and assured the markets that the Fed was ready to add liquidity after the 1987 stock market crash. The Greenspan Fed acted aggressively during the LTCM crisis and, later, Dr. (“Helicopter”) Bernanke played an instrumental role in the Fed talking the risk markets higher in late 2002. To be sure, Fed “reliquefications” played a conspicuous role in fostering ever greater and more unwieldy bubbles – and this will remain in the back of FOMC members’ minds. The Bernanke Fed today would likely prefer to maintain a “hands off” approach for as long as possible – which has already been too long for an acutely fragile “Wall Street”.
And let us not forget the (unsung hero) GSE “backstop bid”. The GSEs ballooned their balance sheets $150 billion to absorb speculative de-leveraging during the 1994 de-leveraging and bond market rout – about double 1993’s expansion. GSE balance sheets (chiefly holdings of mortgages and MBSs) ballooned $305 billion during tumultuous 1998, $317 billion during 1999, $238 billion in 2000, and $344 billion during liquidity challenged 2001. Agency balance sheets mustered growth of $37 billion last year. Importantly, the GSEs are definitely in no position these days to aggressively create marketplace liquidity by expanding their (money-like) liabilities to aggressively purchase MBSs – in the process stabilizing market prices (especially for the leveraged speculators). Wall Street must all of a sudden feel short of friends.
Larry Lindsey called upon Fannie and Freddie to loosen lending standards to help ameliorate the rapidly accelerating mortgage credit crunch. I was immediately reminded of how Washington nurtured the $200 billion (or so) S&L bailout from what should have been resolved years earlier at a fraction of the cost to taxpayers. The GSE tab is today running out of control. Keep in mind that Fannie and Freddie already have combined “Books of Business” (MBS holdings and guarantees) of almost $4.0 trillion supported (in the best case) by stockholders’ equity in the neighborhood of $60 billion (current financial statements not available!). The thinly-capitalized Federal Home Loan Bank System has another $1.0 trillion of assets. Before all is said and done, taxpayer GSE exposure will likely reach the trillions – to add to other untenable ballooning federal contingent liabilities.
Last week, the unfolding financial crisis reached a problematic stage on several fronts. For one, illiquidity hit the gigantic “AAA” market for “private-label mortgage-backed securities”. The booming market for non-agency MBS has played an instrumental role in ensuring abundant cheap mortgage credit – on the one hand filling the liquidity void created by the constrained GSEs and, on the other, providing virtually unlimited inexpensive “jumbo” mortgage finance to inflate upper-end housing bubbles in California and the most desirable locations and neighborhoods across the country.
While the subprime implosion was a major marketplace development, in reality only a small segment of the mortgage marketplace was actually impacted by significantly tighter credit conditions. Today, we are in the throes of a dramatic, broad-based and momentous tightening of mortgage credit. Importantly, key players and sectors throughout the mortgage risk intermediation process are increasingly impaired and now in full retreat. This includes entities such as the mortgage insurers, MGIC’s and Radian’s faltering C-BASS securitization unit, REITs such as failed American Home Mortgage and others, hedge funds such those that failed at Bears Stearns and many more, the broker/dealer community and the expansive mortgage derivatives market generally. There is also the issue of exposed mutual funds, money market funds, pension funds and the banking system in general. Just like NASDAQ went to unimaginable extremes, and then doubled during a fateful “blow-off” – total mortgage credit doubled subsequent to the Greenspan Fed’s reckless post-tech bubble “reflation”. Risky mortgage exposure now permeates the (global) system.
The process of transforming risky mortgage loans into coveted perceived safe and liquid (“money”-like) credit instruments has broken down on several fronts. Not only is the risk intermediation community impaired, marketplace confidence and trust in the quality, safety, and liquidity of mortgage (and mortgage-related) securities is being shattered. There are apparently serious problems developing throughout the massive marketplace for (“repo”) financing MBSs. And it is precisely the market for financing the top-rated mortgage securitizations – where the perceived risk was minimal – where I suspect the greatest abuses of leverage occurred. The marketplace is now experiencing forced de-leveraging and a liquidity dislocation – with major systemic ramifications.
I mostly downplayed the marketplace liquidity and economic impact of the housing downturn last fall and the subprime implosion this past February. For the system as a whole, the credit spigot remained wide open. My view of current developments is markedly different. I cannot this evening overstate the dire ramifications for the unfolding credit market dislocation. There is today serious risk of U.S. financial markets – distorted by years of accumulated leverage and derivative-related risk distortions – of “seizing up”. A system so highly leveraged is acutely vulnerable to speculative de-leveraging and a catastrophic “run” from risk markets. At the same time, the bubble economy and inflated asset markets – by their nature – require uninterrupted abundant liquidity. The backdrop could not be more conducive to a historic crisis, yet most maintain unwavering confidence that underlying fundamentals are sound.
I am unclear how the enormous ongoing demand for new California mortgage credit will be financed going forward. With the market having lost all appetite for “jumbo” MBS, mortgages must now be priced generally in accordance with the standards of increasingly cautious loan officers willing to live with these loans on their banks’ balance sheets (a radical departure from pricing set by originators selling loans immediately in an overheated MBS market). And, let there be no doubt, the prospective credit tightening will hit grossly inflated and highly susceptible “Golden State” housing prices hard – a scenario that will force lenders to incorporate significantly higher credit losses into their loan pricing terms (perhaps Cramer was speaking to California homeowners when he jingled house keys in front of the camera and suggested it was perfectly rational to mail your keys to the bank). Furthermore, I expect the pricing and availability of credit required to refinance millions of rate-reset mortgages in California and elsewhere to turn prohibitive for many. And the home equity well is about to run dry – from a combination of sharply tightened credit conditions and accelerating home price declines.
A severe tightening in mortgage credit is in itself sufficient to pierce a vulnerable U.S. bubble economy. But there is as well an abruptly brutal tightening in corporate credit. The junk bond market has basically closed for business. The leveraged loan marketplace is in turmoil and scores of debt deals have been pulled. And, more ominously, the previously booming ABS and CDO markets have slowed to a crawl. Perhaps not immediately, but it will not be long before the economy succumbs to recession.
Credit market dislocation now dictates the assumption that Federal Reserve liquidity assurances and rates cuts are on the near horizon. And while they will likely incite the expected knee jerk response in the equities market, I do not expect they will have much lasting effect on our impaired credit system. Current issues are much more complex and serious than 1987, 1998, 2000, or 2002. The dilemma today is that confidence in “Wall Street finance” has been shattered. The manic bubble in credit insurance, derivatives, and guarantees is bursting. The manic bubble in leveraged speculation is in serious jeopardy. The currency markets are a derivative accident in waiting. Fed rate cuts risk a dollar dislocation and/or a further destabilizing (for spreads) Treasury melt-up.
A focal point of my macro credit analysis has for some time been the grave risks posed to markets and economies commanded by the seductive elixir of speculative liquidity. I have compared the current backdrop to that of 1929. For too long our bubble economy and bubble asset markets have luxuriated in liquidity created in the process of leveraging speculative securities positions. We are now witnessing how abruptly euphoric boom-time liquidity abundance can transform to a liquidity crisis.
I apologize for appearing overly dramatic. But I have nagging feelings that for me recall the disturbing emotions following the terrible 9-11 tragedy. I know the world has changed and changed for the worse – yet I recognize that I do not know how and to what extent. I fear for our markets, our economy, our currency and our system. I received an email this week to the effect, “You all must be happy in Dallas.” I can tell you we are instead sickened by what has transpired during the late-stages of this senseless credit and speculative orgy. The Great Credit Bubble has been pierced, and there will now be a very, very heavy price to pay. And, as always, I hope I am proved absolutely wrong.Link here (scroll down).
INNOVATION AND CONTAGION
It all really started during the Asian Financial Crises (1997-1998). The East Asian development state model came in for really hard times across the drop and aftermath. Wealth ran for cover – it ran for China and the U.S. China weathered the storm well and represented the new growth model and America had the biggest, “safest” capital markets and currency. American officials and firms sought access to the protected and underdeveloped financial markets in savings rich East Asia. Massive pools of savings at near zero costs and huge markets beckoned. The clean-up that followed created the conditions that built the huge international bubbles that are beginning to bust now. Multinational firms sought cost-minimized production for export. They went to China. Speculators went to America.
Hundreds of $billions in savings flooded into U.S. and global capital markets. Deregulations and growth of financial firms, exchanges and speculation went truly global. Conditions shifted. Vast pools of cheap capital became available for leveraged speculation and consumer debt. Interest rates plunged and stayed down. In the period following the opening of the world’s savings, East Asia, financial firms and indexes soared. U.S. markets soared. Until the internet bubble burst, the NASDAQ went vertical. Across the period China began eating everyone else’s manufacture for export lunch and the world’s commodities. China saved, built and lent. America borrowed, spent and speculated. Financial firms hit their stride. Global manufacturers and retailers raked in the cash.
Then the internet growth bubble burst. Central banks, led by The Greenspan Fed, began hurling liquidity and falling interest rate fuel on a still simmering speculative fire. Finance snapped back into action as China and newly integrated world markets began to spike. Hard assets were initially preferred. Lingering memory of the risks of equities and technology directed torrents of capital and credit toward hard assets. Commodities, oil and housing spike around the world. Mortgages and sovereign debt enticed. Vast buying of debt further pushed down interest rates and made speculation cheap, easy and lucrative. Japan offers an illustrative example. The long growth recession there and dedication to export lead economics, created a tsunami of credit and carry trades. Free money was on offer with a “promise” of cheap Yen. Newly integrated capital markets and endless cheap credit pushed up equity markets before long. Spiking oil and disastrous foreign policy misadventure drew attention to non-U.S. markets.
The last 3 years have witnessed an amazing period of correlated asset appreciation. New products have been celebrated as they diversify risk and spread upside and downside pressures through opaque, international channels. Our celebrated era of innovation has created a convoluted and highly correlated distribution of reward. By definition it has also created massively correlated downside risk. All of this is levered up by all the credit and the massive gearing used to achieve returns. No one really cared or even looked very closely as long as the brave new world delivered correlated robust returns. Risk was ignored and return became the obsession. Credit was on offer and only fools doubted or even asked questions.
That is the heady road we traveled. It felt great to insiders speeding down the yield superhighway. That was until the sub-prime tire blew-out. Forced to stop and unable to re-inflate the tire with the usual hot air, folks began to look under the hood. That is where we are now. Peek under the hood and you see a lot of shiny borrowed chrome, a debt fueled engine and a lot of rot!
It remains unclear if this will be the episode that forces an asset re-pricing and honest assessment of conditions. Either way, it is high time to adjust expectations and allocations to the new realities that have developed over the last 10 years.Link here.
LBO “FREEZE” SHUTS WALL STREET PIPELINE; $1.3 BILLION DRIES UP
While investment bankers feasted on an unprecedented $8.4 billion of fees for arranging leveraged buyouts in the first half, the rest of the year may prove to be a famine. “It’s impossible to conclude that it’s not going to be a tougher time for Wall Street,” said Steven Rattner, co-founder of New York-based buyout firm Quadrangle Group and former vice chairman of Lazard Freres. “There’s going to be an impact on revenues and profits.”
While no one is predicting a Biblical 7-year drought, the pace of buyouts has slowed more than 33% since June. Investors are cutting back on riskier assets such as the loans and bonds that fund LBOs after being burned by losses from U.S. subprime mortgages. At that rate, banks would miss out on at least $1.3 billion of fees in the second half.
JPMorgan Chase, the 3rd-biggest U.S. bank, has the most at stake after earning more than anyone else from arranging leveraged loans in the first half. Together with Credit Suisse Group and Deutsche Bank AG, it made a combined $919 million from loans in period. The three also got $426 million for advising LBO firms on takeovers and $190 million from bond sales.
Mortgage defaults by Americans with poor credit histories prompted the collapse in June of two hedge funds managed by Bear Stearns and triggered a worldwide rout in the debt markets. Companies such as London-based Cadbury Schweppes Plc, the world’s biggest candy maker, have delayed asset sales, and banks including New York-based JPMorgan and Frankfurt-based Deutsche Bank have been left on the hook for as much as $300 billion of debt they have agreed to provide for LBOs.
“There’s indigestion, as investors aren’t buying the paper to the extent that they were buying it before, and banks will be nervous about committing to any new significant underwritings of any size,” said Daniel Stillit, a London-based analyst at UBS AG. “There’s a significant risk of the LBO driver coming to a grinding halt.”
Private-equity firms announced a record $616 billion of buyouts in the first half, capping four lucrative years of deals. The takeovers have depended on the banks finding investors to buy debt. LBO firms use borrowed money to fund about two thirds of the cost of the deals. Bankers typically earn fees of 2% for underwriting loan sales for buyouts. Until last month, demand from investors was so strong that buyout firms were able to borrow with fewer restrictions, using so-called covenant lite securities and pay-in-kind bonds that allow companies to pay off debt by issuing new debt. Investors have put the brakes on the LBO market, rejecting sales to fund buyouts of Chrysler and Alliance Boots Plc, the U.K.’s largest pharmacy chain. The companies failed to sell enough debt, leaving the banks stuck holding the loans while the buyout firms completed their takeovers.
While the pace of leveraged loans is slowing, the market will probably be “back in business” by October, Johnny Cameron, head of corporate and investment banking at Royal Bank of Scotland, told reporters on a conference call on August 3. “Everybody’s thinking about when the music’s going to stop and I don’t think we’ve hit that yet,” said Ilan Nissan, a partner in the New York office of O’Melveny & Myers who works on buyouts. “We’re at a blip at this moment. Many people are saying ‘Let’s take a breather and see what happened.’” JPMorgan CEO Jamie Dimon, speaking on July 18, told investors that the drop in demand is “a little freeze.”Link here.
Bondholders punish Tyco, Kimberly Realty for buybacks, LBOs.
Corporate America is losing its cachet in the bond market. TXU Corp., the Dallas-based power producer, shopping center developer Kimco Realty and at least eight more companies bowed to investor demands and agreed to pay higher interest on their debt if credit ratings fall. Home Depot, the world’s largest home improvement retailer, may be next.
Just two months ago borrowers were dictating terms of debt sales as corporate defaults fell to a record low. Now, companies need to finance more than $200 billion of announced takeovers and $500 billion of planned share buybacks just as investors grow more skittish about declining credit quality. “The pendulum is swinging back to the investors’ side of the bargaining table,” said Tom Murphy, investment-grade bond manager at RiverSource Investments in Minneapolis, who helps oversee $95 billion in fixed-income assets.Link here.
THE BEAR STEARNS BUST
Up until a month ago, most stock and bond investors were convinced that the subprime mortgage slime was a small isolated cesspool with its own peculiar financing that would be contained and have no meaningful effects on their rock-solid investments. Stocks were hitting new highs and junk bond spreads vs. Treasurys were at all-time lows. No more. Complacency has been replaced by fear and foreboding.
Since late June, when Bear Stearns was forced to bail out its subprime debt-laden hedge funds, we have seen global de-leveraging along with the drying up of all that liquidity that has been sloshing around the world and fueling speculation. The deal postponements and restructurings since the Bear Bust make it evident that the private equity buyout era may be over. In just the week of July 22, the financing of eight major deals was postponed.
Takeover firms themselves are in trouble as they drop their “private equity-is-best” credo and go public. Investors who bought Blackstone stock at its initial $31 per share are way under water and those who invested in online travel firm Orbitz, which Blackstone took public on July 20, lost about 20% in the first eight trading sessions. With sinking junk debt markets closing off the private equity boom, KKR’s planned IPO will probably be postponed or canceled.
It is also not surprising that a number of highly leveraged hedge funds were caught by the Bear Bust. Sizable losses have been reported by Old Hill Partners and Wharton Asset Management. United Capital, with $500 million in assets, has stopped investors from withdrawing capital while Braddock Financial is closing its subprime mortgage-ladened Galena Street Fund and suspending redemptions until it can sell its $300 million holdings. London-based Caliber Global Investment got nailed in American subprime mortgage holdings and is closing after losing 53% of its $2 billion value. And in Boston, Sowood Capital Management announced that it lost over 50% of its $3 billion assets and is closing its two funds.
Troubles in subprime mortgage land has been well known since the beginning of the year. But with the Bear Bust, investors began to worry about the A, AA and AAA tranches. Then came the shocking announcement on July 24 by Countrywide that delinquencies of 30 days or more on its subprime loans leaped to 23.7% at the end of the second quarter from 15.3% a year earlier. A big jump, but no big surprise. But on prime home equity loans, delinquencies leaped to 4.6% from 1.8%. So the subprime slime has oozed up to the high rent district. Many of those Countrywide loans were piggybacks, loans on top of first mortgages that often bring total borrowing close to 100% of a house’s value.
It was only with the Bear Bust that stockholders began to realize how dependent equity prices are on junk securities. Debt markets have propelled stocks. Profits growth, which is slowing dramatically, is no longer the primary driver and interest rates, another important determinant of stock prices, have not declined enough yet to provide significant support. Stock buybacks are often financed with junk bonds. According to Federal Reserve figures, nonfinancial corporations removed $128 billion in stocks from the market in the first quarter and issued $130 billion in new debt. Buybacks put fresh buying power in shareholders’ hands and they have leaped, with $157 billion announced in the second quarter, up 58% from a year earlier. Private equity buyouts, primarily financed with junk securities, also have been a key propeller of stocks. They also put money in shareholders’ hands, and as an added bonus, encourage them to search for and buy the next likely LBO targets.
Financial stocks have proved especially vulnerable to the Bear Bust, but not just the big banks involved with hedge funds, CDOs and junk securities. Regional banks have come under a cloud as the value of their construction loans is questioned. So is the worth of the low-quality mortgage loans they hold. Homebuilder stocks have been in the doghouse and about to slip below book value, which itself is falling as writeoffs of unneeded land and other assets add to net worth-depressing operating losses.
And as far as mortgage lenders are concerned, they continue to leave the business one way or another. The latest was American Home Mortgage Investment, a large REIT that specializes in prime and near-prime loans and accounts for 2.5% of the U.S. mortgage market. On July 31, it said it can no longer fund home loans and may liquidate assets. Its stock promptly dropped 87%. This is clear evidence that credit markets are tightening as lenders, after the Countrywide bombshell, fear that the subprime slime is moving to the prime arena.
I foresee a 25% peak-to-trough decline in median single-family house prices nationwide. Remember, the earlier leap in prices was so exuberant that it would take a 50% fall to return them to the post-World War II norm, after adjusting for inflation and the increasing size of houses. I am also forecasting a 60% peak-to-trough decline in existing house sales – a forecast that many view as extreme. But between November 1978 and May 1982, sales fell 55% in what was a much less severe housing slump than is ongoing today.
The global recession that I expect to result from the spreading subprime slime, global de-leveraging and speculative bubble-breaking will benefit stocks by reducing inflation fears and thereby Treasury yields, aided by the usual Fed ease. But as is normal early in the recession, plummeting profits will more than offset those salutary effects to the detriment of stocks. Stocks at home and abroad are suggesting that worldwide problems lie ahead. Meanwhile, the leap in expected stock volatility indicates a newfound appreciation for investment risk, another drag on equities. I suspect that a full-blown bear market is starting, or soon will.Link here.
Bear Stearns ousts a top executive, trying to restore confidence after subprime debacle.
The crisis in the credit markets finally reached the executive suite of Wall Street firms last week, and the victim was an unexpected one: Warren J. Spector, a co-president at Bear Stearns who some had thought could become the firm’s next chief executive. The firm’s chief executive, James E. Cayne, called Mr. Spector into his spacious office in the Bear Stearns building on Madison Avenue. Mr. Cayne told Mr. Spector that he wanted his resignation. “I have to do this,” he said, according to people who were briefed on the conversation. “I can’t work with you anymore.”
The news is said to have blindsided Mr. Spector, 49, who had spent his entire 24-year career at Bear and who at one point had become the largest individual shareholder after Mr. Cayne, who is 73. Since two of its hedge funds collapsed in June, Bear Stearns and Mr. Cayne have become the public face of the plunging debt markets – a point that was underscored when Standard & Poor’s changed its outlook for the firm to negative from stable. In the months since the crisis at Bear became public, the firm’s stock is down 33%, to $108 a share, raising anew questions about the firm’s long-term viability as an independent company.
Alan D. Schwartz, Mr. Spector’s longtime co-president, who oversee investment banking, will take full ownership of the title – making him the probable heir to Mr. Cayne. The abrupt tightening of the credit markets recently has hit Bear Stearns particularly hard. In many ways it is a crisis that Bear, with its long expertise in bonds, structured products and in particular mortgage-backed securities, should have seen coming. Yet Bear, like many other firms on Wall Street, jumped into the market for bonds that backed subprime, or high risk, mortgages, offering a slew of racy fund products, one of which hit the market last August, just before the markets began to recoil from subprime assets. Mr. Spector, who was responsible for these areas, took the blame.
While other firms might have had as much or even more exposure, Bear had the misfortune of having two funds implode, prompting investors in the funds and the firm’s stock, to question its competence in this area. Mr. Schwartz’s fast ascension also raises the possibility that he might succeed Mr. Cayne sooner rather than later. While Mr. Cayne’s control over the firm and the board remains vise-like, he has said publicly that the recent damage to the firm’s reputation has been a “body blow”.
According to people inside the firm, Mr. Spector’s position became untenable shortly after the troubles of its two hedge funds became public in June. Not only did the asset management business report to him but he also had direct responsibility over the risk controls that were in place there. In recent weeks, Mr. Spector had been working long days to control the bleeding that started with the collapse of the two hedge funds, a crisis that Mr. Cayne has told people in the firm that ranks as one of the worst in the firm’s 84-year history.
Mr. Spector is a cool, aloof man who has the casual confidence of one who achieved significant professional success at a young age – he became a Bear director at age 32. But since the crisis broke in June, he had been pushing to find answers, accepting responsibility internally and telling people that Bear never should have introduced such a highly leveraged fund that carried so much risk, one of which would go on to lose all investor assets.
But that was not enough. According to people briefed on the events, Mr. Cayne, a tournament-level bridge player who is famous for keeping people in the dark about his intentions, felt that the move was critical to restoring trust in Bear. Few were aware of his decision, these people say.
For Mr. Spector, his abrupt firing marks an inglorious end to a career that from the beginning seemed destined to end with the top job at Bear Stearns. Indeed, with Mr. Spector’s own talent for bridge and his expertise in all varieties of bonds, it was widely assumed that Mr. Cayne would pass on the reins to Mr. Spector. But while bridge might have functioned as a bonding agent between Mr. Cayne and his predecessor, Alan C. Greenberg, it could not do the same for Mr. Spector – especially in the wake of the hedge fund meltdown at the firm’s asset management division.Link here.
EARNINGS GET OVERSHADOWED
During the past week, the deepening problem in the mortgage market has sent the markets into turmoil. It will take a while to fully grasp the consequences of the implosion of the subprime market, but it appears that the era of excess liquidity may have ended. Second quarter earnings were generally better than analysts expected, but earnings along with economic data took a backseat to the credit concerns.
With 75% of the S&P 500 having reported Q2 earnings, 65% have exceeded estimates and 20% have reported earnings that were below expectations. Analysts are expecting earnings growth to hit 9.2% for Q2. Just counting those that have reported results, earnings are up 10.3%. But that does not tell the whole story. The S&P 500 is a share-weighted index, which gives a higher weighting to companies with more shares outstanding. On an equally weighted basis, earnings are up only 6.8% and on a market-capitalization basis, earnings are up 14.6%. Clearly, the big companies are doing much better than the smaller companies. It is likely that international exposure is one of drivers for this difference in results. Larger companies are much more likely to have international sales. Besides global economies being stronger than the U.S., revenue growth is boosted by translation gains caused by the weak dollar.
For a long time the weakness in the housing market was contained to the homebuilders. Previously there were pockets of weakness surrounding the homebuilding industry, but in general businesses held up as the housing market weakened. The ongoing weak housing market has started to take its toll on a wider segment of the economy.Link here.
HOW CREDIT GOT SO EASY AND WHY IT IS TIGHTENING
An extraordinary credit boom that created many first-time homeowners and financed a wave of corporate takeovers seems to be waning. Home buyers with poor credit are having trouble borrowing. Institutional investors from Milwaukee to Düsseldorf to Sydney are reporting losses. Banks are stuck with corporate debt that investors will not buy. Stocks are on a roller coaster, with financial powerhouses like Bear Stearns and Blackstone Group coming under intense pressure.
The origins of the boom and this unfolding reversal predate last year’s mistakes. They trace to changes in the banking system provoked by the collapse of the savings-and-loan industry in the 1980s, the reaction of governments to the Asian financial crisis of the late 1990s, and the Federal Reserve’s response to the 2000-01 bursting of the tech-stock bubble.
When the Fed cut interest rates to the lowest level in a generation to avoid a severe downturn, then-Chairman Alan Greenspan anticipated that making short-term credit so cheap would have unintended consequences. “I don’t know what it is, but we are doing some damage because this is not the way credit markets should operate,” he and a colleague recall him saying at the time. Now the consequences of moves the Fed and others made are becoming clearer.
Low interest rates engineered by central banks and reinforced by a tidal wave of overseas savings fueled home prices and leveraged buyouts. Pension funds and endowments, unhappy with skimpy returns, shoved cash at hedge funds and private-equity firms, which borrowed heavily to make big bets. The investments of choice were opaque financial instruments that shifted default risk from lenders to global investors. The question now: When the dust settles, will the world be better off?
“These adverse periods are very painful, but they are inevitable if we choose to maintain a system in which people are free to take risks, a necessary condition for maximum sustainable economic growth,” Mr. Greenspan says today. The evolving financial architecture is distributing risks away from highly leveraged banks toward investors better able to handle them, keeping the banks and economy more stable than in the past, he says. Economic growth, particularly outside the U.S., is strong, and even in the U.S., unemployment remains low. The financial system has absorbed the latest shock.
So far. But credit problems once seen as isolated to a few subprime-mortgage lenders are beginning to propagate across markets and borders in unpredicted ways and degrees. A system designed to distribute and absorb risk might, instead, have bred it, by making it so easy for investors to buy complex securities they did not fully understand. And the interconnectedness of markets could mean that a sudden change in sentiment by investors in all sorts of markets could destabilize the financial system and hurt economic growth.Link here.
I am organizing a pogrom aimed at all the chief investment officers at Harvard, Princeton and Yale who crammed so many billions into alternative investment houses like Blackstone Group and Kohlberg Kravis Roberts. LBOs created the tons of bridge loans now choking the system. My Westchester-Fairfield Dressage Association riders will trash Greenwich, Connecticut, and all hedge fund plutocrats will be horse-whipped. I advise these money managers to hide in their wine cellars. Their 1982 first growth Bordeaux inventory will be confiscated, earmarked as collateral for families earning under $50,000 with an adjustable-rate mortgage resetting this year.
Shed no tears for the heartburn that is discomforting banks, brokers, insurance underwriters – anyone connected with buying or selling speculative fixed-income paper. Those who played the yield curve the past few years show burnt fingers now as spreads widened rapidly from below-historic norms of 3 percentage points to 4-5 points even for BB corporate debentures.
Wall Street is in a cement mixer, repricing risk for mortgages, hundreds of billions in bridge loans and collateralized debt. Unfortunately, the stock market is vulnerable. Nobody is mouthing the “r” word as yet, but some deceleration of GDP momentum is in the cards. The Fed has its eye on mortgage delinquency stats. It would not surprise me to see them lower Fed funds rates soon to save the housing market from imploding and the economy from recession.
Our present misery dates back to Alan Greenspan’s easy money policy of a few years ago. When the risk-free rate was pegged at 1%, financial market players, starved for higher yields, moved out on the quality spectrum for long maturity goods. Insurance underwriters, brokers, banks and some hedge funds that play the carry trade game have taken hits to their net asset value, but not enough to cripple them permanently.Link here.
This credit crunch is largely self-induced.
Understand one thing. The seizure in the credit markets is not due to any lack of liquidity. Nor is it due to regulations that impede the flow of money and credit. No, it is due to nothing more mysterious than the sudden realization of lenders and investors that they were taking on more risk than they realized, and that they needed to get compensated for this.
As recently as early June, the spread between rates on so-called junk bonds and top-quality Treasury securities was near historic lows. What a difference two months make! Today you cannot get a quote on some of the dicer issues – and even top-quality corporate debt is becoming more expensive at the same time that Treasury yields have fallen.
All this is taking place amid the backdrop of a substantial amount of liquidity that was created over the past few years, thanks to the Federal Reserve, as well as other central banks around the world. Meanwhile, Wall Street added to the amount of credit available through derivatives and other exotic instruments that few understood.
Remember, also, that there is no cap on rates like the old Regulation Q. No longer on the books, that regulation limited the rates banks could pay for deposits and the rates they could charge for loans. When market rates went above the Reg. Q ceiling, money flowed out of banks (remember disintermediation?) and into Treasuries and other instruments, thereby depriving the banks of the funds they needed to lend. That was a real credit crunch. Today’s seizure is mostly self-induced.
Low rates caused investors to take risks, ranging from buying homes to lending and investing. The subprime issue was like a splash of cold water. It caused people to wake up and realize that with reward comes risk. By acting as though these subprime loans could infect other parts of the market for fixed-income debt, investors in effect made this a self-fulfilling prophecy. This knee-jerk reaction is unfortunate, although understandable. In effect, people now want to see the bottom of the pool before jumping in.
This may take a while. We do not know how many more hedge funds will run into trouble, nor do we know how many more bank loans will have to be marked down. We do not know what this means for those pension funds that took a flyer in these issues, nor do we know how badly confidence in the fixed-income markets has been damaged.Link here.
Anatomy of a credit crunch.
The German bank IKB has been the recipient of an $11 billion bailout. $64 billion of LBOt financings have been withdrawn in the last month. Standard and Poors have talked of down-rating Bear Stearns, two of whose funds have collapsed. We are clearly in the beginning phase of a classic credit crunch, and it is therefore worth looking at how these have played out in the past, and where and how holes in the fabric of the world’s financial system are most likely to appear.
Credit crunches are relatively rare. Rarer than stock market downturns. There was no credit crunch in 2000-02, though the stock market downturn was substantial. In 1989-92 there was a mild credit crunch in junk bonds and New England real estate, but relatively little spillover to other areas of the credit market. In 1982, there was a credit crunch in emerging market debt, which was eventually solved by a mass debt forgiveness and bailout of the New York banks which were most heavily exposed. Even during that period, there was no great credit crunch in the domestic U.S. market.
The last true credit crunch was thus that of 1973-74, which was particularly severe in Britain but spread throughout the international debt markets. That is before the working lifetime of most market participants today. Sam Molinaro, CFO of Bear Stearns said last week that conditions in the fixed income market were “as bad as I have seen in 22 years.” Since he is 49 he was presumably referring to his period of participation in the market rather than some hitherto obscure crisis in 1985, from memory a placid and bullish year. One can pause for a moment to mourn the length of institutional memory of 1950s London, where Morgan Grenfell’s chairman Lord Bicester served until his death in office at 89, thus being able to give his junior colleagues a first hand account not only of the 1929 crash but of its predecessors in 1890 and 1907.
It is worth looking at how the credit crunch of 1973-4 developed ... and the lessons we can learn from this history about the credit crunch we appear to be entering.Link here.
A BROKEN ACCORD: THE LOSS OF INDEPENDENCE BY THE FED
The Federal Reserve Board was established in 1913 to oversee the nation’s money supply. But it took almost four decades before it could truly perform this function. In fact, in its early years, the Fed acted almost as an adjunct to the Treasury Department. Specifically, it was called upon to keep bond yields low by buying Treasury bonds, thereby artificially increasing the money supply.
By the late 1940s, the Fed balked at being a de facto arm of the Treasury Department, and in 1951, managed to reach the so-called Accord with the Treasury. This allowed the Fed to use its own discretion in buying Treasury securities, and otherwise become a financial policy-maker independently of the executive branch, effectively creating a fourth branch of government. As a sop to the Treasury, William McChesney Martin Jr., originally a Treasury official, was appointed chairman of the Fed, where he became its longest-serving head (Alan Greenspan was a close second). In this role, he was supposed to be as a “Trojan Horse”, for the Treasury, but surprised everyone by upholding the Fed’s independence more than any chairman before or since.
With memories of the 1930s Great Depression fresh in peoples’ minds, the Fed’s implicit mandate was to prevent a recurrence. Martin vividly described the Fed’s role as to “take away the punch bowl.” In essence, the Fed was supposed to be the “chaperone” at an economic party that was likely to get out of hand. Thus, the Fed was supposed to allow, even induce, if necessary, the occasional recession to cleanse the excesses of the economy. This would ensure that short-term imbalances did not persist for the longer term. The Martin mandate later gave way to one of pursuing steady growth, which would allow full employment (the lack of which was considered the major bane of the Depression). But this new mandate would not address the longer term problems that have since ossified into intractable trade and budget deficits.
Even so, the Fed’s most celebrated moment came around 1980, when a newly-appointed chairman, Paul Volcker, broke the back of inflation by controlling the money supply, come what may for interest rates. It also probably had a major impact in limiting the Presidency of Jimmy Carter to one term. But this was the last time that the Fed dared to “lean against the wind,” of an Administration, to use another expression of its earlier mandate.
Under Mr. Volcker’s successor, Alan Greenspan, Fed policy became increasingly aligned with that of prevailing Administrations, both Republican and Democrat. In part this was because of the nature of the crises, such as Black Monday, in 1987, and the Y2K scare. Both of these were basically one-time shocks, rather than being endemic to the economy, and therefore, it was easy to agree on solutions. And backed by some major political tailwinds (the collapse of the Soviet Union, the 1991 Persian Gulf War victory, and the resulting decade of artificially low oil prices and cheap money), the Fed and the Administration managed in the 1990s to co-operate in creating an unprecedentedly long peace time expansion. It may have been this success that caused the Fed to lose sight of its “check-and balance” role vis-à-vis the executive branch.
This abdication was most apparent around the turn of the millenium. I believed then, and am confident now, that the Fed made a mistake when it lowered rates aggressively in 2001 in order to ward off an impending recession. Greenspan probably saw a looming case of “financial bronchitis.” Mr. Greenspan opted avoided the “bronchitis” several years ago. This, however, led to excesses in the U.S. trade accounts and the housing markets that seem likely to soon lead to a far worse “pneumonia”.
The Fed is, in fact, very good at solving short-term problems. But that misses the point. The Fed is not just supposed to manage for the short term, but rather to anticipate longer term problems. Greenspan’s claim that a bubble in say stocks, or housing, could not be foreseen until after the fact is a cop-out. The Fed’s main job is precisely to do this, as it did in the 1950s, 1960s, 1970s, and early 1980s under Martin and Volcker.
But the real problem is that the Fed’s policies are now hostage to those of the Administration. Such policies may be successful or not. But because they mimic those of the executive branch, they will be wise or foolish according to whether the underlying policies of the ruling Administration are wise or foolish. The Fed has resigned its earlier chaperone role. Or to paraphrase Warren Buffett, the Fed’s conduct no longer “rises to that of a responsible bartender, who, when necessary, refuses the profit from the next drink to avoid sending a drunk out on the highway.” The spirit, if not the letter of the 1951 Accord has been violated, and de facto, the Fed is no longer an independent entity.Link here.
STAYING A STEP AHEAD WHEN INVESTING IN RETAILERS
The fortunes of retailers can turn on a dime. Here are some unusual metrics for investors to consider.
Investors mulling retail stocks have well-established metrics to look at, among them inventory turnover (cost of sales divided by inventory), same-store-sales growth (the change in sales for stores open at least one year) and sales per square foot. But the better known a financial measure is, the more likely it is to be fully incorporated in the stock price. What about the less-well-traveled statistics for this industry? Says Marc Bettinger, an analyst with the Stanford Group, a Miami investment bank, “You don’t take gross margin or same-store sales at face value. You have to look at what is making them tick.”
Start with gross margins. Higher is, in the first analysis, better: A billion dollars of sales at jeweler Tiffany (TIF) with a 55.4% gross margin is worth more to its owners than the same volume at discounter Costco (COST), with a gross margin of 12.2%. But there is another side to the story. Most retailers are in a position to boost their profits, at least in the short term, by widening the gross margin – jacking up prices, that is. It may take a while for the uncompetitive pricing to take its toll in customer departures. So, look twice at companies whose gross margins are widening. They may be sacrificing long-term growth for a short-term profit advantage.
During the October 2006 quarter Wal-Mart (WMT) posted a gross margin of 23.7%, its highest in four years. But that Christmas shopping season Wal-Mart slashed prices on toys, flat-screen televisions and other electronics as it warred with Target (TGT) and Costco. During the last two months of 2006 Wal-Mart’s margin slipped and its shares dropped 10%.
Which retailers have margins that may have peaked? J.Crew has raised prices and shifted its focus from being a purveyor of bargain apparel to selling $265 Versailles dresses. The strategy has helped widen the $1.2 billion (sales) retailer’s gross margin by two percentage points in the past year and its stock has doubled to $54. But J.Crew now competes with the likes of Coldwater Creek (CWTR) and Ann Taylor Stores (ANN), which have considerably higher gross margins. What if they defend their turf? J.Crew is a Wall Street darling, as you can see in its high enterprise multiple, defined as the ratio of enterprise value (market value of common, plus debt, minus cash) to EBITDA (earnings before interest, taxes, depreciation and amortization). Perhaps too much of a darling.
The converse: A retailer whose profits are disappointing but whose gross margin has narrowed may be a bargain. The table “Less Might Be More” shows five retailers whose gross margins are narrowing, suggesting that their strategy is to steal shoppers away from the competition, and five whose margins are widening, which could come back to haunt them. Other things (notably, P/E multiples) being equal, you are probably better off with the former.
Chico’s FAS, a $1.7 billion (sales) retailer of women’s apparel, has seen its gross margin drop 3.4 percentage points in the past year as its store count increased to 930 from 763. Why? The new stores have had difficulty building traffic and have sold more marked-down goods to move the inventory. The company recently began marketing a new underwear line and is planning to slow down its rate of expansion. If Chico’s can get the necessary traffic to boost sales per square foot back to its 2006 peak of $1,028, a case can be made that the company’s current earnings are understated. On Wall Street this company is cheap; the enterprise multiple is only 10.
Bettinger likes $1.3 billion (sales) Urban Outfitters (URBN), which operates 207 lifestyle stores with the Urban Outfitters, Anthropologie and Free People brands. Urban’s gross margin has decreased 2.7 percentage points the past year, stunting earnings growth. Bettinger says the company stumbled with fashion last year, finding itself too far ahead of the trend toward wider tops and tighter-fitting bottoms for women, which started in Europe two years ago. “The company has excellent management and is in a good position to rebound with its product mix,” he says. Last seen at $22, Bettinger says the stock is worth $29.
Here is an unconventional way to look for unrealized potential among online retailers: Check out the amount of time visitors spend on their sites, in relation to the number of sales. (Visit minutes and transaction volume statistics are tracked by Nielsen NetRatings.) There is huge variation in the numbers: eBay logs a purchase for every 8 minutes visitors spend on its site, while Overstock.com (OSTK), an off-price vendor, gets only one sale per 137 minutes. On the theory that getting the eyeballs is half the battle, you might bet on the laggards like Overstock. Any gain in sales per hour of eyeballing would translate into more revenue, with only slightly higher overhead costs. This is, to be sure, a risky bet, since Overstock is a moneyloser. But it spent $68 million on advertising last year. If visibility is an asset on the Web, this outfit may yet prove its perennial short-sellers wrong. This table shows e-tailers with the potential to turn window shoppers into spenders.
Inventory turnover is one of the classic measures of retailing success. The higher the number, the better, since that means the retailer is getting more mileage out of the assets it has tied up on its shelves. But Robert F. Buchanan, an analyst at A.G. Edwards, has a different take on turnover. He asks if there be a way to give credit to store owners who get their suppliers to finance their inventory? So on his retailing scorecard accounts payable are subtracted from inventory. The net is a measure of how much capital the store has sitting on its shelves. Then Buchanan divides this number into gross profit to arrive at a turnover-like number that we will call “capital efficiency”. Important is not just the number per se, but whether it is improving. “I liken this ratio, along with same-store sales, to taking a retailer’s blood pressure, pulse and heart rate,” says Buchanan. “When these are healthy, it’s time to at least consider opening new stores.”
By Buchanan’s yardstick J.C. Penney (JCP) looks good, improving its capital efficiency from 13.1 in the 12 months leading up to the January quarter to 16.1 in the period ending in April (see table “Other People’s Money”). Buchanan also likes Costco, whose capital efficiency is so good that it cannot be measured. At Costco payables (as of its May quarter) were greater than inventory, meaning the wholesaler is selling goods before it has to pay for them. That nifty arrangement makes up for Costco’s slim profit margins.
Instead of chasing after retailers using the old standby of return on assets, consider a variation: Go for companies whose ROA measures will remain unscathed if and when rulemakers lower the boom on lease accounting. Current accounting rules allow retailers that sign certain long-term leases to omit the leased property from their balance sheets. But this may change that next year. Such a move would spell trouble for Walgreen (WAG), the $53 billion drugstore chain. Using current figures, Walgreen’s return on assets (net income divided by assets) would decline from a handsome 12% to 5%. In contrast the ROA for Nordstrom (JWN) and O’Reilly Automotive (ORLY), which have only modest doses of leases that would be affected, would barely budge (see table, “Lease Trouble Ahead?”).
Here is one last score for retailers you might not have thought about: The affordability of health insurance. Employers that already cover their employees will (if past trends continue) confront big cost increases. Those that do not provide wide coverage may be forced by state or federal legislation to do so. Retailers whose sales per employee are high are better able to withstand these cost pressures. This table lists some.Link here.
THE TAWDRY RICH
Richistan: A Journey Through the American Wealth Boom and the Lives of the New Rich reviewed.
One million dollars sure is not what it used to be, at least not in Richistan, the competitive, cash-flush world inhabited by the super-rich – a world where even a billion dollars does not guarantee you a spot on the Forbes 400 and Jaguars are considered pedestrian. Where parents worry about how to back-date their trust-funded offspring with a semblance of work ethic, and multi-millionaires go into debt purchasing alligator-skin toilet seats for their private yachts.
Richistan is the name author Robert Frank bequeaths on America’s booming microcosm of super-wealth, a demographic whose relative financial power and unique woes has created a kind of “country within a country,” increasingly isolated from the workday mainstream.
Frank points to the growing complexity of finance as fueling Richistan’s population growth. Hedge-fund fees, overnight IPOs and private equity buyouts create instant wealth via “liquidity events,” Frank’s coy term for a sellout. Such “instapreneurialism” has helped ratchet up the number of billionaires in the U.S. to 367 from just 13 in 1985. And they are a powerful lot. The richest 1% of Americans control 33% of the country’s total wealth.
Frank’s investigation into how this wealth is being spent makes for an entertaining spin through the mansions of Aspen and charity galas of Palm Beach. We visit their homes (Greenwich Tudor mansions, a modernist Manhattan penthouse), gawk at their toys (in-house ice rink with personalized Zamboni, private Boeing 767) and meet their staff-in-training at Butler Boot Camp.
We also get a glimpse of a few of the unusual challenges posed by life in Richistan: How to make the most of philanthropic giving, how to avoid raising the next Paris Hilton and yes, even how to avoid falling into debt through extravagant living. We meet Pete Musser, a former billionaire now leading a phantom Richistani existence after losing everything in the 2000 dot-com crash, and we attend a Financial Life Skills retreat where the progeny of wealth are taught fiscal responsibilities such as broaching the subject of pre-nups with significant others.
Frank, The Wall Street Journal’s designated “wealth reporter”, is a skilled guide: His foreign correspondent background lends itself well to exploring the contours of Richistan through the eyes of an alien visitor – curious, but with a modicum of subjectivity. He has clearly worked hard to try and penetrate the inner sanctum of Richistan. Even Frank admits, however, that many Richistanis are highly private people. And if Richistan is as varied a landscape as he outlines, one can only wonder how representative the millionaires depicted here are of today’s wealthy. Too many of the millionaires we meet come across as clueless, shamelessly arrogant or just plain nutty.
Nevertheless, the tackiness and extravagance of new rich and old rich does make for entertaining reading. Though Frank could have done a service to readers by delving deeper into the future of this Richistani culture, he does provide an insightful overview of how this wealth came about and how it is transforming (some) of its recipients.Link here.
RICHARD RUSSELL IS STILL GOING STRONG AT 83
What does the preeminent Dow Theorist say about recent market action?
The Sunday sun was still high above George’s At the Cove restaurant, overlooking the Pacific in the idyllic California beach town of La Jolla. But Richard Russell, editor of Dow Theory Letters since 1958, was ready for dinner. He would be getting up at 3:15 a.m. Monday as always, preparing to write the several thousand words of commentary he posts every day that the market is open.
Russell and his wife Faye just celebrated Russell’s 83rd birthday there. But the waitress says he usually arrives early and leaves quickly. Deadlines, and markets, are always on his mind. A particularly intense week was looming for Russell. The stock market had staggered in the wake of his recanting his tenaciously-held view that the post-2002 rally was a just a blip in a primary bear market, which seriously angered many of his subscribers.
The Dow Jones Industrial Average closed on Friday, July 27, just below its June low of 13,266.73. Russell’s reaction? A Dow Jones Transportation Index close below its June low of 4994.82 will confirm a Dow Theory Sell Signal. But Russell has been overriding Dow Theory when he feels like it.
Juncture recognition is key to Russell’s reputation. He was unrelentingly bearish after 1966, but dramatically called the 1974 bear market bottom. He got out of stocks two months before the 1987 crash. And again he got out of stocks in late 1999, six months before the March 2000 blow-off. Russell remained stubbornly bearish right through the subsequent 2002 slump, when most advisers were faked into thinking that happy days were here again.
Of course, it is not a completely clean picture. After 1987, Russell did not get back into stocks until 1989, when they were considerably higher than his exit level. Arguably, the same thing has happened now. But the point is that Russell is not a stopped clock, as some of my Russellphobe readers, who focus only on this last decade, keep complaining. And by getting out before the big breaks, he has dramatically reduced risk for his subscribers. According to the Hulbert Financial Digest, Russell is tied for top place as a market timer on a risk-adjusted basis since 1980.
The HFD monitors only Russell’s market timing, on the austere grounds that the rich smorgasbord of investment mutterings, musings and mentions that he serves up each day does not lend itself to systematic tracking. But these ideas are often cited gratefully by my equally numerous Russellphile readers.
Russell in his 84th year looks absolutely, extraordinarily, wonderful. He apparently never travels or takes vacations, and he rarely gives interviews. His 10-minute commute is a worthwhile disruption, Faye Russell says, because the office provides him with his only social life. Russell does admit to 20 minutes on the exercise cycle after the market closes. And this week he cut back his Wednesday comment, saying he plans to rest midweek in order to “keep doing this for the next 15 or 20 years.” It looks distinctly doable. Faye Russell, 32 years her husband’s junior and a corporate lawyer who says she went back to school because she assumed she would be a young widow, now wryly predicts he will outlive her.
Russell comes from an old South Carolina Sephardic family. He was born and raised in Manhattan. Russell himself served in World War II as a bombardier in the U.S. Air Force, flying more than 20 missions, an experience that obviously marked him profoundly. Then Russell worked as a textile designer, studying the stock market in his spare time. Married three times, and still on remarkably good terms with his ex-wives, he has five children, plus grandchildren who are being raised Catholic. Russell says he is not drawn to organized religion. Although Russell has ruthlessly bugged his subscribers into getting online – he says he only has 500 unreconstructed snail-mailers out of some 10,000 – he turns out to be still something of a print primitive. He reads several newspapers a day. He even eschews email on weekends.
What about the market? With Russell, what you read is what you get, not surprising when you consider how much of his life is spent writing. But what you get is nuanced and Delphic, which I believe is an honest reflection of his subtle and sensitive intellect. And, importantly, his intuition.
I asked Russell directly: Is there a “Greenspan put”? Have the authorities been committed to maintaining the markets, risking ultimate collapse? In his esoteric way, Russell has excited his readers, who tend to become devoted Russellologists, by hinting that he thinks equity markets in general and the gold market in particular are being manipulated in the interests of an inflationary boom. But, needless to say, Russell did not answer me directly. He said he does read Lemetropolecafe.com, the leading proponent of the manipulation theory. But Russell is not about to endorse it. He pointedly says that his favorite columnist right now is Bloomberg.com’s Caroline Baum, a vociferous critic of the view that official-sector intervention, in the form of the rumored “Plunge Protection Team”, exists at all.
On the other hand, Russell says flatly that “the central banks won’t let deflation happen.” (Hmm ... and how, exactly, will they do that?) If there is a put, Russell quips, it is a “China put”, the unprecedented demand unleashed by China’s economic awakening. But Russell instantly agrees when I challenge him with the argument that no one really knows what is happening in China.
Maybe my questions had an influence. Looking at the dramatic last-hour rally on Wednesday night, Russell wrote, “Amazing action but the session was not a total triumph for the bulls. Breadth was about even, and new highs rose to 492. I had the distinct feeling that near the close of today’s session somebody or some group decided to ‘save the day.’ Who could that be? Who would have the power to buy, say, a few thousand S&P futures? It doesn’t matter. The true and decisive direction of the market will become clear as we move along.” And on Thursday night, “The sudden buying, seemingly ‘out of nowhere,’ left me just a bit suspicious.”
Russell really does not like this bull market. He has repeatedly said that it cannot be justified in terms of fundamentals, such as P-E ratios. He does respect the fact that it has happened anyway. But it is not a surprise that he is worried now. Russell wrote during this last week, “Fundamentally, the big question is the action of U.S. consumers. Will they pull back on their buying and maybe even start to save? If they do, it will be bearish for the economy and the markets? And oh yes, thanks Alan Greenspan for loading America up with loans, credit and debt!”
As Russell often does, he posed a question to himself: “Question Russell, do you think we’re at the beginning of a primary bear market? ... Answer Of course, this is the most important question that can possibly be asked today. And my answer is, ‘No, I don’t believe we are in a primary bear market. But this is too important a question to be arrogant about. And that’s the reason I bring up the 50% Principle (i.e., the primary trend is intact as long as stocks don’t give up more than half their gains since the bull market began). The 50% Principle will tell us whether we are experiencing a correction a primary bull market or whether the bull has indeed died.
“Of course, a major problem is that the 50% or halfway level of the entire rise from the 2002 comes in at Dow 10,643. Will we have to wait for a huge decline to Dow 10,643 to find out whether it’s a bear market or not. All I can say is that ‘I hope not.’ There will be indications along the way.”
Last word: After a wild week of routs and rallies, the stock market finally broke down badly late Friday. After the close, Russell wrote, “This is turning into one mean-looking decline. The Dow and the Transports BOTH closed at new lows for the move today. From a Dow Theory standpoint, that an ugly picture and calls for defensive action on the part of investors.”
Russellologists note that he has not actually proclaimed a Dow Theory signal, but if you go by his earlier comments, Friday’s close was one. Stocks are now right at or below the point at which Russell recanted his bearishness. Torturing thought: At this point in his brilliant career, could Russell have been a contrary indicator?Link here.
THE LAST OF THE GREAT RESOURCE CONSOLIDATIONS
The Senate passed the Clean Energy Act of 2007 in late June. This act will require 36 billion gallons of renewable fuel production in this country annually by the year 2022. It also mandated a 35 miles per gallon minimum on new cars by 2020. The wait to see what Nancy Pelosi and the House would do about it is over.
In a 241-172 vote on Saturday night, another energy bill was passed in the House with slightly different requirements. In the new bill, there is a provision requiring electric utilities to generate 15% of their electricity from renewable energy sources. Currently, only 2.6% of our energy comes from renewable sources. This new requirement could spell some big changes elsewhere.
Currently, coal accounts for about half of all electricity production in this country. This bill would significantly hurt the already damaged coal industry, or so one would think. The coal industry has been in bad shape for the past few years because of higher diesel prices and new safety rules. Industry experts are now expecting a massive consolidation will hopefully change things.
Compared to other mining industries, coal is the only one in the U.S. that has not undergone a consolidation. The three major drivers of acquisitions in other commodities have been resource scarcity, high cash flows that companies are eager to reinvest, and favorable valuations of companies based on strong pricing models of commodities. All are lacking in U.S. coal. This is about to change.
Whichever bill comes out on top (if any), the coal market will be affected, but not as much as people are guessing it will. Even if the U.S. goes 15% green, that is only 15%. Plus, it will not affect exports one bit. Look for the big international mining companies to come down from their perch and devour the small U.S. coal companies to exploit their reserves.Link here.
PROFITING FROM THE WALL OF WORRY
In this article, I want to address what stage of the market cycle resource stocks are in, why, what is likely next, and what you should do about it.
For pretty much all my adult life, I have been a speculator. That is to say, someone with an appreciation for the relationship between risk and reward, an appreciation far too many people clearly do not share. Take for example, ostensibly conservative investments such as money market funds and T-bills. To my worldview, these are just bad jokes being played on the masses. Piling all your assets into increasingly worthless paper paying next to no interest is the financial equivalent of a death of a thousand cuts, guaranteeing that a large swath of the nation’s senior citizens will spend their golden years sporting paper caps while tossing fries. My view is that, certainly in today’s world, it is much more prudent to risk 10% of your capital with a prospect of getting a 1,000% return than risk 100% of your capital for the prospect of a 10% (or less) return.
This brings me to the current market in natural resource stocks, a sector in which I have been an active investor for almost 30 years. That is enough time to have witnessed all manner of cycles and market action. As is to be expected, especially in the early years, I made mistakes, most of them attributable to the hubris of youth. On one memorable occasion, the error was serious enough that I felt the need to spend a day in bed pondering the magnitude of my losses. But most humans (politicians and most economists being the exceptions) learn from their mistakes, and I learned from mine. As a direct consequence, I have made considerable money in the resource sector.
Further, I am convinced that if I were wiped out tomorrow, I could start with a small grubstake and recoup most of my losses in a few years’ time. In fact, I believe I could do it even if I was airdropped into the Congo, with no money at all. And so could anyone with an entrepreneurial spirit, who knows the difference between something’s price and its value, and understands how to balance risk and reward. A relatively small amount of money, skillfully deployed in the right market at the right time, can compound quickly.
With that in mind, perhaps the most critical thing for people now in resource stocks is to examine the nature of bull markets. Many believe that, since resource stocks have had such a big move since their absolute bottoms in the 2000-2002 period, the bull market is, if not over, at least long in the tooth. I do not think so. And the reason goes back to an understanding of the way bull markets work – at least major, secular bull markets. They generally have three stages: (1) Stealth, (2) Wall of Worry, and (3) Mania.
The Stealth Phase
The best time to buy in any market is when shares can be purchased on the basis of value alone. Of course, that is generally only possible when nobody wants to own them because they have been so beaten up in the previous bear market. It is then, when people are most bearish, that new bull markets are born – quietly, unbeknownst to almost anyone.
In the case of mining stocks, the bottom came between early 2000 and mid-2002, when few investors were even aware that a market in resource stocks existed any longer. It was so beat up that many companies were selling for less than their cash in the bank. Every week, several would change their names, roll back their stock, and make themselves over as dot-coms, or China telecom parts distributors, or some other then fashionable fad business.
In March 2002, for instance, when the risk-averse investing masses wanted nothing to do with precious metals stocks, I advised my International Speculator subscribers to “back up the truck” and buy junior gold stocks. Attentive subscribers joined me in making a lot of money by buying solid resource stocks while they were almost being given away. Another term I use for the Stealth phase is the “Easy Money” phase, because almost anything you buy in this stage will make you a lot of money, with little actual risk – although perceived risk is very high.
Then, as is the nature of things, word got around and investors began rediscovering the resource stocks. Two things happened, as they always do. One, a new wave of investors started pouring into the sector, eager to join in the fun and willing to throw money at any good story (and most are good stories, whether they are true or not). Two, a new wave of resource companies was launched to meet the demand. Predictably, the tsunami of money, which started hitting the market in the second half of 2003, floated all boats, pretty much regardless of merit. This put an end to the Stealth market. Early investors looked like financial geniuses and began to believe trees grow to the moon. Actually, they will – but not until the third stage of the bull market.
The flood of money also did one more thing: It provided the juice needed by the well-run companies to lock up new properties and fund the exploration required to come up with a mineral discovery.
Wall of Worry
The approximate C$12.8 billion of IPO and private placement money that materialized over the last two years acted like a rainstorm in the desert, causing stock prices to blossom. There were quite a few that went up 1,000% and more. But stocks – especially mining exploration stocks – are not heirlooms. They are highly volatile trading vehicles. Seeing momentum diminish, speculators with (sometimes) huge profits started selling to realize them. This led to the second stage of a bull market, commonly called the Wall of Worry stage. That is where we have been for a little more than two years.
Periodically in 2004, and intensively in 2005 and 2006, prices of most resource companies have been driven down, casting a dark cloud over the psychology of most investors and market observers. People are worried for a number of reasons. Technicians fret about the huge run-ups and subsequent losses of momentum. Fundamentalists are concerned that a recession will cause commodity demand and prices will fall. They worry that the boom in China will soon come off the rails. They worry that all the money that has been raised will result in gigantic new supplies of metal, depressing prices. They worry that environmentalists will make it impossible to develop new properties at any price. They worry that feckless and bankrupt governments might nationalize good-looking discoveries, or tax them into unprofitability. They worry that new technologies will radically reduce the use of some metals, collapsing their prices. They worry that anything that can go wrong will go wrong. And they are right – but their timing is wrong.
As a consequence, even good news out of a resource company is often met with selling as investors decide to use any volume to liquidate positions in order to “watch from the sidelines.” But in this stage, despite all the fear and sharp sell-offs, the market slowly climbs the Wall of Worry. It eventually digests selling from the profit-takers and the timid, as new buyers overwhelm them.
As a speculator, this phase of the market is almost as good as the Stealth phase, because while the easy money has been made, the big money is still ahead. It will come once the market enters the next phase, the Mania stage. That is when the broad base of individual and institutional investors becomes convinced the market is going to the moon, pile in, and drive it halfway to that destination. By positioning yourself in the right companies before the mania phase begins – and then having the intestinal fortitude to stay invested, and even buy more, through any periods of weakness – your investments can make you rich.
But, what makes me so sure that this actually is a major secular bull market for the resource stocks? There are lots of reasons. Enough that even a cursory discussion of them will take another article. But in brief, to refute some of the current worries: We are coming off the longest and deepest secular commodity bear market since the Depression of the 1930s. Commodity prices are still far below their historic highs, at least in “constant” dollars, which is what counts. The world economy is evolving away from the debt-burdened U.S. and toward China, India, and numerous smaller countries. Their growth will be volatile, but it is for real, and they will consume unbelievable amounts of raw materials in the coming years. There has been very little mineral exploration for a full generation, the industry has come nowhere near replacing reserves, and a historic supply crunch in many commodities is in the making. Governments will always act stupidly, but the long-term trend is inevitably toward freer markets, higher standards of living – and higher resource consumption.
If I am right about these things, and I am confident that I am, then the current Wall of Worry will be followed by a mania.
The fundamentals – although of a much different sort than we saw in the Stealth stage – will drive these stocks much, much higher when the third, the Mania, stage hits. And thanks to the 1980-2000 bull market in the general stock market, everybody now has a stock account. They know little about stocks except to get on board anything that seems to be headed up. The commodity story tells well, and a whole generation of investors are going to hear it for the first time. Remember, even during the secular resource bear market of 1980-2000, there were three spectacular cyclical bull markets in exploration stocks that took them up an average of 1,000%. The power behind the coming Mania phase will drive the resource stocks we are currently covering up like the contents of Hoover Dam trying to fit through a garden hose.
I expect the Mania stage to resemble what we saw with the Internet stocks in the late ‘90s.
What to Do Now
If you are going to be successful as an investor in this phase of the market, you are going to have to suppress your fight-or-flight response and take the time to identify those companies with the goods: adequate financing, great management, realistic market capitalization, and solid properties in the right locations.
How long will you have to wait for your payoff? Not long. The typical exploration cycle lasts about 2-3 years, and we have already started seeing some important discoveries in 2006 and early 2007. That stream of news should pick up momentum as a result of all that money raised in 2003-2006 – and it is already delivering the goods. Consider this table of recommendations made in June 2006 and their results as of June 2007 (note that we would not necessarily recommend the same set of companies today, so please do not rush out and buy these stocks).
As far as the Mania stage, that will make mere 80% gains in a year look like chump change. It will begin once people get over the Wall of Worry, likely triggered by a resumption of the downward trajectory of the U.S. dollar. I would be surprised if it did not start materializing within the next year.
In the final analysis, it is the worrisome aspects of the current market – when you and everyone else are feeling on edge about the risk – that make this such a good time to invest. People do dumb things when they are scared. Like sell great companies. Or sit on the sidelines, keeping their powder dry for a brighter day. And when the brighter day comes, they will do even dumber things, like spend twice, or 10 times, the current ask for the same shares. They will be buying those shares from me. The key, if you agree with me that the long bear market of 1980-2000 is over and the new bull market has only gone through its first stage, is to buy when everyone is afraid, like now, and sell when everyone is confident ... in the coming Mania.
Finally, for the record, let me emphasize that if you do not have a tolerance for risk, or a willingness to do enough homework to reduce the risk of falling for a good story without substance, you really should not be investing in this sector – any more than you should invest with money you cannot afford to lose. By definition, any investment that can turn dimes into dollars can also turn dollars into dimes if you are not attentive. This is not an arena for amateurs – although I expect millions of complete amateurs will be in it over the next few years.
But if you can handle the risk, there is a very serious opportunity – and maybe the last in this cycle – for you to get well positioned in this “Wall of Worry” stage. Don’t miss it.Link here.
TOP CALLS AND CATCALLS
It is extremely difficult to call a top in anything. But sooner or later, someone has to stick his or her neck out and do it. Typically, it gets chopped off. Things go on far further than bears can imagine. They always do.
Nonetheless, I was fortunate to call the top in real estate in the summer of 2005. A few others did, too. My rationale was the cover of Time magazine touting “Why We’re Going Gaga Over Real Estate” in conjunction with people camping out overnight to buy Florida condos. My thought at the time was, “It cannot get any sillier than this.”
Well, it did not get any sillier than that in housing. But I sure was wrong about how long it would take for housing to finally start affecting the markets. The housing bubble morphed into a debt-financed stock buyback bubble, into a merger-mania bubble, and, finally, into buyout bingo. The markets have a way of humbling nearly everyone. You either get humble or you go broke. The Bear Stearns hedge fund blowups should be proof of that. Two Bear Stearns hedge funds essentially went to zero. A third is waiting in the wings with redemptions suspended.
Based on intuition, greed, and other factors, I thought that the Blackstone IPO was going to mark the end of the LBO (leveraged buyout) silliness. Given that CDOs (collateralized debt obligations – typically, subprime mortgages) were plunging like mad, and given that LBOs, CDOs and merger-mania transactions were accounting for a huge portion of Wall Street profits, I thought that Blackstone was ringing a bell in complete silliness. And because of Chuck Prince, the Citigroup CEO, announcing, “No end to the buyout boom,” I decided to take a stab at calling a market top on my July 10 Global Economic Analysis Blog daily commentary.
Chuck Prince, in essence, told everyone to keep playing the “Greater Fool’s Game” on the basis that buyout bingo would keep on running. Since then, over 60 LBOs have been canceled or delayed, and Citigroup is stuck in a commitment to finance TXU, whether the deal makes any sense or not (it does not). And it may cost Citigroup $1 billion to break the deal, if the deal can be broken at all. If not, Citigroup is stuck financing the deal, as opposed to securing financing for it. The difference is extremely significant.
Perhaps it would have been prudent to allow for one last blast to blow out the remaining bears. Who knows? I still could be wrong yet, as we are now bouncing off the 200-day moving average. But so far, the call has missed by about four days and 15 S&P points – not bad, given where we are today. Nonetheless, I have been amazed by the taunts and jeers of bulls in the face of the decline since then. The more the markets plunged, the louder the catcalls became, smack in the face of this.
Among catcall arguments is the idea that valuations are sound. This is certainly questionable. Merrill Lynch, Lehman, Goldman Sachs, Citicorp, etc. all made countless billions underwriting CDOs, LBOs, and mergers. In addition, debt-funded stock buybacks helped keep P/Es reasonable. All of the above were made possible by cheap funding. Profits have peaked for financials, housing, and transportation. For more on valuation, please see Tightening Cycle.
Finally, I would like to address the idea that the Fed can save the economy and the markets by slashing interest rates. The idea is actually rather silly. The short rebuttal is that the Fed created the housing bubble by slashing interest rates to 1%. If that were the problem (and it was), that is simply not going to be the cure. It is simply illogical to assume the problem and the cure are the same. But Jim Cramer thinks otherwise. I take on Jim Cramer in “Will Rate Cuts Save the Economy?” This explains a lot about Cramer, bulls, and the idea that the Fed should be willing to react to save the stock markets.Link here.
KINDLING FOR THE REAL ESTATE INFERNO
It is the “Bonfire of the Builders”, says BusinessWeek. By the time BusinessWeek gets onto a story, it is usually too late to profit from it. If BW is announcing the bonfire of the builders, maybe it is time to buy?
On June 19, the U.S. Census Bureau released the residential construction report for May 2007. It showed that housing starts are down 24.2% year over year, permits are down 21.7% y-o-y, and completions are down 19.3% y-o-y. In addition, the Census Bureau report showed that permits are plunging, inventories are rising, and to look for a decline in construction jobs.
Survival Report’s Mike Shedlock noted, “"Given that housing permits tend to lead starts (and starts provide jobs), the signs are all in place not just for a continued housing recession, but also for a full-blown severe consumer-led recession. I’m still on recession alert.” Meanwhile, a cousin reports from Maryland that his business of installing septic systems has fallen off. “I used to have 50 jobs backed up. Now I am going from one to the next, and happy to have work.”
How big will the problem be? The last crisis in the property market occurred in the early ‘90s – both in America and in Britain. In the U.S., the Resolution Trust Company was set up to sort out about $300 billion in bad loans. But that was when America had an economy of only about $7 trillion. Today, U.S. GDP is closer to $11 trillion. Back then, consumers had only about half as much debt. And the housing boom of the ‘80s was nothing compared to that of the last 10 years. This blow-up is likely to produce a couple trillion dollars worth of casualties ... and a long period of rest and rehabilitation for housing values.
“The Great Unwind May Be Here”, says the Wall Street Journal. We did not read the article. We did not think we needed to. We have been asking the same question already. When people talk of “unwinding” they are usually referring to the carry trade – speculations involving borrowing in a low-interest currency and placing the money in higher-yielding investments. Typically, the carry trader borrowed yen and bought New Zealand bonds, or U.S. dollar CDOs. So far, the New Zealand bonds are still making their coupon payments as promised, but other things have begun to go wrong. Mortgage backed securities, for example, have proven no more valuable than the flakey mortgages that backed them. And the yen (JPY) has begun to move up. Having borrowed yen to gain leverage, the carry trader is, effectively, short the Japanese currency. If it goes against him, he can lose big. So many speculators are faced with unwinding their positions.
But there is a larger unwind going on. It is what happens at the end of the credit expansion. Little did they know it, but ordinary Americans were conducting a carry trade of their own. They borrowed from mortgage lenders at 6% or so, and invested the money in houses, which they thought were going up at 10% to 20%. The trade was a good one as long as houses kept rising. When housing stopped rising, they went into “negative carry” and many soon found the burden just too much for many of them to carry at all.
By the way, we reported that the big hump in mortgage resets would occur in October of this year. But our old friend John Mauldin says that instead of peaking out at $55 billion worth of mortgages subject to upward adjustment in October of this year, the total actually reachs $110 billion worth of mortgages to be reset in March of 2008. Thereafter, the numbers go down. Not surprisingly, a lot of housing speculators are eager to unwind their positions before the carry gets any more negative. Others wait ... and have their burdens reduced, courtesy of the bankruptcy courts and foreclosure proceedings.
A substantial decline in housing is like a substantial leak on a big ship. Once she starts taking on water, the whole boat sinks lower. As long as seas remain calm, she can stay afloat for a long time. But as soon as a storm brews up – it’s every man for himself.Link here.
CHINA’S “NUCLEAR OPTION” IS REAL
24 hours after I reported China’s announcement that China, not the Federal Reserve, controls U.S. interest rates by its decision to purchase, hold, or dump U.S. Treasury bonds, the news of the announcement appeared in sanitized and unthreatening form in a few U.S. news sources.
The Washington Post found an economics professor to provide reassurances that it was “not really a credible threat” that China would intervene in currency or bond markets in any way that could hurt the dollar’s value or raise U.S. interest rates, because China would hurt its own pocketbook by such actions. U.S. Treasury Secretary Henry Paulson, just back from Beijing, where he gave China orders to raise the value of the Chinese yuan “without delay,” dismissed the Chinese announcement as “frankly absurd.”
Both the professor and the Treasury Secretary are greatly mistaken. First, understand that the announcement was not made by a minister or vice minister of the government. The Chinese government is inclined to have important announcements come from research organizations that work closely with the government. This announcement came from two such organizations. A high official of the Development Research Center, an organization with cabinet rank, let it be known that U.S. financial stability was too dependent on China’s financing of U.S. red ink for the U.S. to be giving China orders. An official at the Chinese Academy of Social Sciences pointed out that the reserve currency status of the U.S. dollar was dependent on China’s good will as America’s lender.
What the two officials said is completely true. It is something that some of us have known for a long time. What is different is that China publicly called attention to Washington’s dependence on China’s good will. By doing so, China signaled that it was not going to be bullied or pushed around.
The Chinese made no threats. To the contrary, one of the officials said, “China doesn’t want any undesirable phenomenon in the global financial order.” The Chinese message is that Washington does not have hegemony over Chinese policy, and if matters go from push to shove, Washington can expect financial turmoil. Paulson can talk tough, but the Treasury has no foreign currencies with which to redeem its debt. The way the Treasury pays off the bonds that come due is by selling new bonds, a hard sell in a falling market deserted by the largest buyer.
It is true that if China were to bring any significant percentage of its holdings to market, or even cease to purchase new Treasury issues, the prices of bonds would decline, and China’s remaining holdings would be worth less. The question, however, is whether this is of any consequence to China, and, if it is, whether this cost is greater or lesser than avoiding the cost that Washington is seeking to impose on China.
American economists make a mistake in their reasoning when they assume that China needs large reserves of foreign exchange. China does not need foreign exchange reserves for the usual reasons of supporting its currency’s value and paying its trade bills. China does not allow its currency to be traded in currency markets. Indeed, there is not enough yuan available to trade. Speculators, betting on the eventual rise of the yuan’s value, are trying to capture future gains by trading “virtual yuan”. China does not have foreign trade deficits, and does not need reserves in other currencies with which to pay its bills. Indeed, if China had creditors, the creditors would be pleased to be paid in yuan as the currency is thought to be undervalued.
Despite China’s support of the Treasury bond market, China’s large holdings of dollar-denominated financial instruments have been depreciating for some time as the dollar declines against other traded currencies. China’s dollar holdings reflect the creditor status China acquired when U.S. corporations offshored their production to China. Reportedly, 70% of the goods on Wal-Mart’s shelves are made in China. China has gained technology and business knowhow from the U.S. firms that have moved their plants to China. China has large coastal cities, choked with economic activity and traffic, that make America’s large cities look like country towns. China has raised about 300 million of its population into higher living standards, and is now focusing on developing a massive internal market some 4 to 5 times more populous than America’s.
The notion that China cannot exercise its power without losing its U.S. markets is wrong. American consumers are as dependent on imports of manufactured goods from China as they are on imported oil. The profits of U.S. brand name companies are dependent on the sale to Americans of the products that they make in China. The U.S. cannot, in retaliation, block the import of goods and services from China without delivering a knock-out punch to U.S. companies and U.S. consumers. China has many markets and can afford to lose the U.S. market easier than the US can afford to lose the products on Wal-Mart’s shelves that are made in China. Indeed, the U.S. is even dependent on China for advanced technology products. If truth be known, so much U.S. production has been moved to China that many items on which consumers depend are no longer produced in America.
Now consider the cost to China of dumping dollars or Treasuries compared to the cost that the U.S. is trying to impose on China. If the latter is higher than the former, it pays China to exercise the “nuclear option” and dump the dollar. The U.S. wants China to revalue the yuan, that is, to make the dollar value of the yuan higher. Washington thinks that this would cause U.S. exports to China to increase and for Chinese exports to the U.S. to decline. This would end, Washington thinks, the large trade deficit that the U.S. has with China.
This way of thinking dates from pre-offshoring days. Today about half of the so-called U.S. imports from China are the offshored production of U.S. companies for their American markets. The U.S. companies produce in China, not because of the exchange rate, but because labor, regulatory, and harassment costs are so much lower in China. Moreover, many U.S. firms have simply moved to China, and the cost of abandoning their new Chinese facilities and moving production back to the U.S. would be very high. When all these costs are considered, it is unclear how much China would have to revalue its currency in order to cancel its cost advantages and cause U.S. firms to move enough of their production back to America to close the trade gap.
If China were to increase the value of the yuan by 30%, the value of China’s dollar holdings would decline by 30%. As revaluation causes the yuan to move up in relation to the dollar (the reserve currency), it also causes the yuan to move up against every other traded currency. Thus, the Chinese cannot revalue as Paulson has ordered without making Chinese goods more expensive not merely to Americans but everywhere. Compare this result with China dumping dollars. With the yuan pegged to the dollar, China can dump dollars without altering the exchange rate between the yuan and the dollar. As the dollar falls, the yuan falls with it. Goods and services produced in China do not become more expensive to Americans, and they become cheaper elsewhere. By dumping dollars, China expands its entry into other markets and accumulates more foreign currencies from trade surpluses.
Finally, consider the non-financial costs to China’s self-image and rising prestige of permitting the U.S. government to set the value of its currency. America’s problems are of its own making, not China’s. A rising power such as China is likely to prove a reluctant scapegoat for America’s decades of abuse of its reserve currency status.
Economists and government officials believe that a rise in consumer prices by 30% is good if it results from yuan revaluation, but that it would be terrible, even beyond the pale, if the same 30% rise in consumer prices resulted from a tariff put on goods made in China. The hard pressed American consumer would be hit equally hard either way. It is paradoxical that Washington is putting pressure on China to raise U.S. consumer prices, while blaming China for harming Americans. As is usually the case, the harm we suffer is inflicted by Washington.Link here.
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