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THE FED’S NOT-SO-BENIGN NEGLECT OF THE DOLLAR
Federal Reserve President William Poole spoke last week before the Industrial Asset Management Council in St. Louis. In the Q&A session, a member of the audience asked, in so many words, what effect printing all that money had on the value of the U.S. dollar on world markets.
Dr. Poole responded, “The depreciation of the dollar is something that is not explicable. And the way I like to phrase this – I like to put my academic hat back on. If you look at academic studies of forecasts of the exchange rates across the major currencies, you find that the forecasts are simply not worth a damn. Your best forecast of where the dollar is going to be a year from now is where it is now. There is no model that will beat that simple model. And people have dug into this over and over again. ... The academic literature is also full of papers trying to explain exchange rate fluctuations after the fact – after you have all the data that you can put your hands on – data that you can’t accurately forecast, but data that after you get your hands on it might logically explain the fluctuations of currency values. And those models aren’t worth a damn either. We cannot explain the fluctuations of currencies after they have occurred even with all the data that we can dig out. And therefore, to me, it is completely unsupported idle speculation not only to make the forecast but to talk about why the dollar has behaved as it has. I know the financial pages and the traders love to talk about that, but I would challenge any of them to construct a model that would stand up to a peer review journal in economics or finance. The models just are not that good.”
Post-event, a Bloomberg reporter asked, “I was hoping you could elaborate a little bit on the implications of the weakness in the dollar right now ... whether implications on inflation or just the economy in general.”
Dr. Poole: “I don’t see any implications for inflation, at least with the magnitude of the depreciation that we have seen so far. The evidence is that – there’s a literature that looks at what is called ‘pass through’ – pass through of changes in domestic prices. And the evidence is that the pass through coefficient has gotten small and smaller.”
Dr. Poole and the Federal Reserve more generally are at this point succumbing to Not So Benign Neglect of our nation’s currency. For a top U.S. central banker to claim today that the dollar’s ongoing 5-year devaluation is “inexplicable” is simply hard to swallow. And to seemingly dismiss analyses of the predictably deleterious currency effects stemming from unprecedented credit excess and resulting current account deficits (as “completely unsupported idle speculation”) is barren central banking. I would also suggest to Dr. Poole that there surely will not be a single hedge fund manager or Wall Street proprietary trader interested in submitting an academic paper on the issue of forecasting the dollar: They have been and remain far too busy making enormous and easy speculative profits from dollar debasement.
The nature of Dr. Poole’s dismissal of currency-induced inflationary ramifications is further indicative of what are increasingly evident deficiencies in our “academic” Fed. September’s 4.4% y-o-y increase in the PPI follows the report of a 5.2% y-o-y jump in the Import Price Index (monthly imports running almost $200 billion!). And with crude trading today above $84 for the first time – and commodities indices recently breaking out to new record highs – this is not the time for inflation complacency. Surging energy costs have already spread to the food complex and beyond. The nature of inflation dynamics will now ensure more pronounced “knock-on” effects throughout. It is also worth noting that the Baltic Dry Freight cost index last week increased y-t-d gains to 140% (up 5-fold since 2003). Especially with China, India and greater Asia’s heightened inflationary backdrop, to not expect a meaningfully higher “pass through” from foreign manufactures is wishful thinking, suspect analysis, and regrettably poor central banking.
While on the subject of less-than-exemplary central banking, the improved August trade deficit number is deserving of a brief comment. Not surprisingly, the dollar barely budged from multi-decade lows despite the news. At this point, any marginal beneficial improvement in trade-related financial flows is inconsequential when compared to the massive scope of speculative finance these days seeking to profit from further dollar depreciation. The fact of the matter is that the Greenspan/Bernanke “gradualist” approach completely failed to anticipate that multi-year dollar debasement would stoke powerful inflationary biases throughout “un-dollar” asset classes (certainly including currencies, commodities, international real estate, global equity and debt securities, and art/collectables). And once bubbles take hold ...
The fateful flaw in U.S. central banking has been to focus on a depreciating dollar as the key mechanism for rectifying excesses and imbalances, while completely disregarding credit and financial excesses. It was an easy – seemingly painless – expedient that had no chance of success. The pressing need to commence the process of financial and economic adjustment (“pressing” in respect to the nature of escalating distortions and structural impairment) required policies that would directly alter financial developments and restrain excess.
Instead, a declining dollar within the backdrop of Fed accommodation worked only to further bolster distortions and imbalances both at home and abroad. It can be viewed as the worst of all policy courses – virtually condoning a system of escalating credit and speculative abuses, while ensuring a major additional element (our weak currency) supportive of global excesses. To be sure, destabilizing monetary processes and monetary disorder sprang from the confluence of booming Wall Street finance, the burgeoning leveraged speculator community, and rapidly escalating inflationary biases and bubble dynamics throughout global credit and economic systems. Weak dollar policies could not have been more bubble friendly.
Cataloging inflation’s “pass through” effects.
Confronted abruptly this summer with acute financial fragility, the Fed in both words and deeds again aggressively accommodated bubble perpetuation. It is important to compare and contrast the current “reliquefication/reflation” with the previous episode. First, and foremost, when the Fed began aggressive post-tech bubble “mopping-up” accommodation in early 2001, the dollar index traded near 120 (today 78). Approaching $6.0 trillion, international reserves assets have inflated about 3-fold since 2001. Chinese reserves have ballooned from about $170 billion to $1.434 trillion. The price of oil is up almost 3-fold. Gold almost the same. The price of copper has inflated from about $80 to $350, lagging some of the other industrial metals. The price of wheat is up more than 3-fold. The Goldman Sachs Commodities index rallied from 250 to 550. Brazil’s Bovespa equities index has inflated from about 15,000 to 62,500, the Mexican Bolsa 5,000 to 32,500, Russia’s RTS 130 to 2,100, the Shanghai Composite from about 2,000 to 6,000, and India’s Sensex 4,000 to 18,000.
The median price of a home in California began 2001 at about $244,000, before topping out this April at $598,000. Contrarily, after spiking to 4,816 in March of 2000, the NASDAQ100 did not trade back above 2000 for more than seven years. Post-tech bubble liquidity (characteristically) avoided the technology sector like the plague. After all, a much more enticing inflationary bias was gaining momentum with fledgling mortgage finance and housing bubbles. The Fed may have believed it was conducting appropriate “mopping up” policies, but it was more a case of bubble accommodation.
The serious issues associated with the current “reflation” are many. For one, the dollar is structurally quite fragile while the most robust inflationary biases are in non-dollar asset classes. Previously, Fed reflationary policies provided a competitive advantage for U.S. risk assets that worked to incite sufficient financial flows to support or even boost the greenback. This proved a huge ongoing advantage for our expansionary credit system. Today, the negative ramifications associated with dollar weakness more than offset the Fed’s capacity to inflate U.S. securities prices. The Fed’s rate cut proved a bonanza for most foreign markets (currencies, commodities, equities, bonds, etc.), especially relative to dollar-denominated mortgage securities (the previous bubble asset class of choice).
The flow of finance will now pose extraordinary challenges and risks. The unfolding mortgage crisis (especially in “private-label” and jumbo) will prove stubbornly immune to “reliquefication” benefits. This dynamic places home prices, the consumer balance sheet, and the general economy in harm’s way. At the same time, there is the stock market bubble and an acutely vulnerable dollar. I will presuppose that the Fed is hopeful to ignore equities and currencies, while operating monetary policy with a focus on the credit market and real economy. Such a policy course, however, implies at this point much greater currency, market stability, and inflationary risks than our central bankers seem to appreciate.
I would furthermore contend that the nature of current intervention is seductively problematic. Short-term, enormous bank and money-fund led financial sector expansion has been sufficient to over-inflate non-mortgage credit. It has been too easy – and credit to sustain the boom too risky. Meantime, post-bubble risk aversion festers in mortgage-related finance that will creep ever-closer to spilling over into an economic downturn and a reemergence of financial turbulence.
Despite current market euphoria, these processes are significantly elevating the systemic risks associated with today’s ballooning financial sector balance sheet. A stock market bubble beset by destabilizing speculative dynamics only compounds systemic vulnerabilities. Such a backdrop seems to beckon for a currency crisis, a risk that leaves the Fed with much less flexibility than it or the markets today appreciate. There are major costs associated with not-so-benign neglect. The Fed had better at least start sounding like they have thought through some of the issues.Link here (scroll down).
VOLATILITY WRECKS FINANCIAL WORLD’S “VALUE AT RISK” MODELS
Seemingly virtuous circle turns vicious.
Seven months ago, the Bank of England issued a strikingly prescient warning about “value at risk” (VAR) models. While these models have become endemic in the financial world in recent years, they have a nasty habit of being self-reinforcing, or so the Bank observes.
When volatility is low in the markets – as it has been during most of this decade, when VAR models have flourished – these tools typically offer a very flattering picture of risk-taking. That prompts banks to take more risk, which reduces market volatility further as more cash chases assets. However, if markets ever turned volatile, this dynamic could quickly unravel, the Bank warned back in April.
What VAR essentially does is measure the money a bank is likely to lose, with 99% probability, in a specified time, based on historical data. If prices are swinging around, implied potential losses tend to rise. In April, the BoE estimated that a typical bank’s VAR might theoretically double, with the same assets, if volatility increased. Seven months on, that once-theoretical piece of analysis is coming back to bite the banks. In recent weeks, I am told that many investment banks have been furtively trying to reduce their published VAR levels in response to this summer’s tumultuous events.
In the current environment, no bank chief executive who hopes to hang on to that job can afford to give regulators or shareholders the impression that they are being cavalier about risk. And since VAR is often used to define what level of margins – or financial buffers – are set against trades, some banks are doubly keen to cut VAR, to reduce pressure on their own balance sheets. But as the banks embark on this task, some are finding themselves caught in an unpleasant trap. The easiest way to reduce a risk exposure is to sell risky assets, such as risky loans. But these sales have been occurring on such a large scale that they have pushed up market volatility. Thus, measured VAR has risen, exactly as the Bank warned all those months ago.
One big investment bank has recently analysed the impact of its own recent asset sales. These suggest that, while these sales should have cut VAR by half in recent weeks on constant volatility levels, in practice this gain was more than wiped out by ensuing market price swings. By scurrying to reduce risk, in other words, the banks may end up simply running to stand still.
This problem will undoubtedly leave many observers to conclude that there are flaws in the VAR concept. Behind the scenes, that is precisely what many risk experts now privately say. Earlier this week, I attended a conference of risk managers in New York where one expert cheerfully declared that “no one in the industry really has much faith in VAR any more.”
But the problem for the banks is that VAR has become so central to the financial world this decade – and so closely watched by shareholders and regulators – that it is difficult to ignore. It is a fair bet that, during the rest of the year, the banks will keep trying to lower VAR, while also knowing that their attempts to do this, by making asset sales, could be making their problems worse. It is a painful vice – or a timely reminder of the golden rule that you rarely get a seemingly virtuous circle in finance that does not turn into a equally vicious cycle later on.Link here.
SWITCHING OFF THE (COVENANT-) LITES
The balance of power in credit markets is finally shifting.
When a handful of big Wall Street banks reluctantly funded part of a $26 billion takeover of First Data, a transaction-processing firm, in early autumn, there was jubilation among those eager for any sign that the chaos in financial markets was abating. It did not mean debt would flow freely again, though. Indeed, it marked the first, feeble sign that creditors were regaining the upper hand after years of kowtowing to borrowers.
At the end of weeks of wrangling over the terms of the loan, the banks finally managed to squeeze from Kohlberg Kravis Roberts, a private-equity group buying First Data, a concession helping them make sure that the debt would be repaid. Such “covenants” vary, but the important ones are those that either prevent a company from borrowing too much (known as leverage covenants), or force it to earn enough to pay interest (coverage covenants). These girdles were fairly common until a few years ago. Companies that broke them had to pay a penalty to their creditors or were forced into bankruptcy.
In recent years as liquidity expanded, banks held on to fewer of the loans that they originated, syndicating them instead to money managers such as hedge funds. Borrowers found that such creditors, in their hunger for higher yields at a time of low interest rates, were quite willing to drop safeguards altogether, leading to a surge of “covenant-lite” loans. Because banks held on to fewer loans, they relaxed their guard. According to Standard & Poor’s LCD research unit, the share of non-investment grade loans held by banks in America fell by over 30 percentage points to around a fifth between 2000 and the first six months of this year. In Europe that share fell from over 90% to well under half.
But as the credit markets have slowed and institutional investment has clammed up, banks have returned, keeping more loans on their books. And they have also brought back covenants. It may be too late in some cases – Moody’s expects the proportion of lowly rated companies that default to rise from 1.3% to 3.5% globally in the next 12 months – but it is welcome nonetheless.
If credit conditions deteriorate, banks and other creditors will be far less patient with erring companies than they were. During the boom, borrowers could often get covenants waived. Not any more. Whereas covenants exist mainly to keep companies on the straight and narrow, they also earn banks a handsome fee each time they are breached. That is an incentive to be tough.
Banks have also sought to stop large borrowers, such as private-equity funds, from funneling money to companies they own that are in danger of violating covenants. This practice, known as an “equity cure”, was used to give companies a quick bill of health even if the finances were unsound. It is likely to stop. As William May of Fitch Ratings points out, companies hoping for a prepayment option on any new borrowing in order to refinance their loans at a cheaper rate, will almost certainly have to pay their lenders a premium for doing so. Finally, more exotic forms of borrowing such as payment-in-kind notes, which allowed companies to pay interest in bonds rather than cash, have faded – for now, at least.
The new conditions that the banks finally imposed on First Data after long negotiations with KKR are still considered to have been quite lenient. The liberal regime may not have been toppled, but it is tottering.Link here.
FINANCIAL BIGGIES’ CP FUND ADDS NEW PYRAMID SCHEME LAYER
“As long as the music is playing, you’ve got to get up and dance,” Citigroup CEO Charles Prince told the Financial Times in July. What happens, though, if the dancehall threatens to collapse before the band strikes up its next tune?
This week, the U.S. Treasury bullied Prince and some of his Wall Street buddies into creating a new fund, the snappily named Master Liquidity Enhancement Conduit. M-LEC is designed to keep the Structured Investment Vehicle (SIV) waltz upright by reviving the asset-backed commercial-paper market, which has shrunk by a quarter in the past 10 weeks amid a buyer’s strike.
It seems the way to reassure investors that it is safe to buy the repackaged junk that has torpedoed credit markets in recent months is to repackage the least-junky bits of the junk into more palatable securities. The pyramid just grew another layer.
The fund, we are told, could be as big as $80 billion. More banks and financial institutions might join the posse. Might. In which case, that $80 billion figure might start to look a tad optimistic, not to mention somewhat puny when stacked against the $320 billion of deteriorating assets that the SIVs own.
If this lifeboat is such a wonderful example of modern financial engineering, how come the guys at Goldman Sachs have not seen fit to clamber aboard? Or Morgan Stanley? Or Merrill Lynch, Lehman Brothers or Bear Stearns? The liquidity raft could not have an inbuilt autopilot headed straight toward Citigroup, which has the most to gain from a rescue of the SIV market and earlier this week posted third- quarter earnings that sank 57%, could it?
The plan has, rightly, been greeted with derision. “By insulating the junk from the sellers of junk, the holders of junk should be spared the problems of junk,” Nick Parsons, head of markets strategy at National Australia Bank’s NabCapital unit in London, wrote in a report. “The one flaw in this cunning plan, however, would be if investors took fright at being reminded just how much junk is still in the system.”
The conception of the new fund, co-sponsored by Bank of America and JPMorgan Chase, was far from immaculate. And its execution may still fail to resuscitate the SIVs, which are faltering because they cannot sell the commercial paper they rely on to fund themselves. U.S. Treasury Secretary Henry Paulson and Robert Steel, the Treasury’s top domestic finance official, acted as midwives for the fund, reminding the bankers where their enlightened self-interests might lie by prompting the discussions and keeping the negotiations going. There is no way to tell how hard arms were twisted, though the phrase “market-led solution” should probably be replaced by “government-enlisted laxative”.
The bigger problem is with how the fund will operate. “It looks as if the banks are really trying to create value via financial engineering when there is not a way to create such value via this game of musical chairs,” Nouriel Roubini, chairman of Roubini Global Economics and professor of economics at New York University’s Stern School of Business, wrote on his Web site this week.
The fund will sell commercial paper, working on the theory that buyers will be more willing to accept securities with the backing of Citigroup, Bank of America and JPMorgan. The proceeds will then be used to buy assets – mortgage bonds, subprime mortgage debt, and the like – from existing SIVs. Investor reluctance to buy paper issued directly by the SIVs has shrunk the asset-backed commercial-paper market to about $899 billion from its August 8 peak of $1.2 trillion, leaving it at its smallest since May 2006. The trouble is, if the fund only buys the highest-quality assets from the SIVs that are valued at close to face value, they will be left holding only the most toxic securities. If the fund buys the most damaged assets, it will have to do so at some current market value, forcing all of the holders of similar securities to revalue their holdings at the new, lower prices.
Don’t Ask, Don’t Sell
“The entire scheme seems like one that can work only if banks fully recognized now the losses on their SIV assets – in which case there is no need for this complex plan as assets can be disposed of at low prices today,” Roubini wrote. “If such losses are not allowed to be recognized, the scheme cannot work.”
I cannot decide whether the Treasury’s willingness to patronize such a misguided effort is evidence that the situation is more desperate than anyone thought, or a positive sign that financial markets will continue to evolve and might eventually wrestle the subprime demon to the ground. One thing is clear, though. I would not want any of my pension money invested in the M-LEC.Link here.
MANY SUBPRIME MORTGAGES DEFAULTING BEFORE THE TEASER RATES RESET
Stumbling home prices and already heavy monthly payments are a bigger problem for borrowers with adjustable-rate mortgages than the looming rise in the cost of their loans, and it could blunt attempts to ease the strain on homeowners.
With hundreds of billions of dollars of ARMs having reset so far in 2007, and almost $1 trillion worth expected to adjust to a higher interest rate by the end of 2008, many analysts have pointed to this as the main driver of surging defaults. But the worst-performing mortgages were made in 2006 and have not yet reset and will not until at least mid-2008.
The larger problem stems from the lax lending standards in 2006, which allowed many borrowers, particularly subprime and “Alt-A” mortgage candidates, to take on too much debt. Many now hold loans with monthly payments they cannot afford. “People have missed the boat on what is the underlying factor driving delinquencies in the present environment because ARM resets cannot explain the delinquencies that we have seen thus far,” said Nicholas Strand, manager within the mortgage strategy group at Barclays Capital in New York. “If you look at loan level data, it is really the very highly leveraged borrowers whose default rates have increased over the past year.”
Many Washington policy initiatives have been aimed at helping subprime and Alt-A borrowers tackle the “payment shock” when their ARM resets to a higher rate. Legislative efforts to soften the increase of resets may prove fruitless as many borrowers cannot even meet the payments on below-market teaser rates, let alone higher rates that reflect the risk posed by their credit history.Link here.
Few lenders are willing to make mortgage modifications, survey says.
Mortgage lenders rarely help homeowners struggling with rapidly increasing adjustable mortgages, according to a survey of 33 California housing counseling agencies. Only one agency responding to the survey said that loan modification – adjusting a mortgage’s terms to make it more affordable – is among the most common outcomes for its clients.
Instead, foreclosures were the most common outcome for agency clients overall, according to the survey by the California Reinvestment Coalition, a statewide alliance that promotes access to credit. The second-most-common result was a short sale, selling a home for less than is owed on the mortgage.
Politicians, banking regulators and consumer advocates have urged lenders to avert foreclosures through loan modifications. Banks in turn have publicly embraced the concept but have not provided statistics to show how common loan modification actually is.Link here.
PMI Group mortgage insurer expects quarterly loss on borrower defaults.
PMI Group Inc., the 2nd-largest U.S. mortgage insurer, estimated a Q3 loss of $1.05 a share, as borrowers’ ability to repay their home loans “significantly worsened” in September. The company fell as much as 7.3% in New York trading. The cost to bail out lenders is expected to increase 5-fold from the same period a year earlier to about $350 million, the insurer said in a statement today. PMI also withdrew its earnings forecasts for the year.
Rival MGIC, the largest mortgage insurer, posted its first quarterly loss since it went public in 1991. MGIC said it will not be profitable in 2008 as foreclosures increase from a record and the housing market worsens in parts of California and Florida.
“PMI has the largest Florida exposure of the ‘big three’ mortgage insurers,” said Seth Glasser, a credit analyst at Barclays Capital, in a note to investors. “Loss severity in that state must be accelerating quickly.”
Credit-default swaps tied to PMI climbed 38 basis points to 195 basis points, according to CMA Datavision in London. The contracts are used to speculate on the company’s ability to repay its debt. It now costs $195,000 to protect $10 million in PMI bonds from default for five years.Link here.
Probe of Countrywide CEO’s stock sales sought.
North Carolina Treasurer Richard Moore has asked the SEC to investigate the timing of stock sales made by the chief executive of mortgage lender Countrywide Financial (CFC). Moore, the trustee of a pension fund that holds more than $11 million in Countrywide shares, said in an October 8 letter to SEC Chairman Christopher Cox that he was “shocked” to learn that CEO Angelo Mozilo “apparently manipulated his trading plans to cash in” as the subprime crisis was heating up.
“As one of many investors who have felt the painful losses in Countrywide stock, I am outraged at his manipulation of the system and this abuse of shareholders,” Moore wrote. “The timing of these sales and the changes to the trading plans raise serious questions about whether this is mere coincidence.” A spokeswoman for Moore said that he had not yet heard back from the SEC regarding his request for a probe.
Moore cited reports that Mozilo was unloading 4.9 million Countrywide shares worth more than $138 million between November 2006 and August 2007. Moore said that at least three times over five months starting in October 2006, Mozilo reportedly changed the plans that outline how many of his shares would be sold monthly. That, said Moore, allowed the CEO to sell the stock before prices fell dramatically.
Countrywide shares have fallen 56% this year. Most of Mozilo’s stock sales were at much higher prices. Separately, Countrywide said it financed 44.3% fewer mortgage loans in September than a year earlier, as it eliminated nearly 5,000 jobs to cope with lower lending volume and increasing delinquencies and defaults.Link here.
THE NEXT SHOE TO DROP?
Subprime pollution from housing is rapidly spreading into so many areas now that inquiring minds may be asking, “What’s the next shoe to drop?” Let us take a look at a few of the most promising ideas.
First is the rising credit card borrowing trends being seen in the wake of the subprime mortgage collapse. Homeowners, fearful of foreclosures, are continuing to borrow from credit card companies while payment defaults are much higher than last year. According to MSNBC, credit card companies have had to write off 30% more payments as uncollectible in H1 2007 than last year and delinquencies are expected to rise in the next six to 12 months. Many think that problems will be avoided as long as employment holds up, so let’s explore the idea that jobs may be the next shoe to drop ...
Temporary employment leads and the implications appear unpromising now that the year-over-year change in temporary employment has gone negative. This is bad enough, but one must also consider soaring mass layoffs. Layoffs began rising dramatically in August, and the financial sector was responsible for nearly half the cuts. Many mortgage and subprime lenders were forced into bankruptcy. This was highlighted by the collapse of Home Mortgage Investment Corp., who fired nearly its entire workforce.
Commercial real estate may be the next shoe to drop and in our opinion, we think it is going to get crushed. It is overbuilt, over-loved, and due for a collapse. If Ben Bernanke thinks he as a problem now, watch what happens when commercial real estate blows up. Fannie Mae and Freddie Mac might be able to keep people in their houses in lieu of foreclosure by renegotiating terms down and down again (for a while, anyway), but bank funding of unneeded strip malls is another thing, indeed.
Other shoes to consider would be a derivatives blowup, a massive unwinding of the carry trade, homebuilder bankruptcies, or a collapse of the U.S. dollar. But so many shoes are in the air and falling that it is going to be difficult to say precisely which shoe hits the ground first. It’s raining shoes.
And it is time to short short transports. Why? First, housing has clearly stalled and shows no sign of recovery. Things can, and likely will, get much worse. Shipping material for new construction will continue to weaken. Also, shipping needs, to furnish new homes, will continue to weaken as well. Next, commercial real estate deals are collapsing as people who can get out, are getting out. The rate of increase of building new stores, as well as the merchandise required to fill those stores, will fall. That clearly means reduced shipping demand. And, a weakening job market means less consumer demand. Falling consumer demand means fewer items need to be shipped.
Due to this falling demand, truckers can no longer pass on rising fuel costs. One leading shipping company recently cut fuel surcharges 25%, despite crude prices near all-time highs. These price cuts are not done out of the goodness of their hearts. There is a reduced demand for shipping. Coming out of the 2001 recession, shipments increased until 2005. They began leveling off, and then declined throughout 2006 and so far through 2007. It is not happenstance that this more or less mirrors the topping of the real estate cycle.
As the market continues to open its eyes to the effects housing is having on the broader economy, we are seeing important sectors of stocks break down from their bull trend. Now we have seen the transportation stocks follow suit. Over the past year, the Dow transports had rallied themselves into a wedge pattern that usually results in a significant top. Inbound container volume growth has slowed dramatically at U.S. ports over the past year, confirming the slowdown we are seeing in truck tonnage, and also suggests the consumer-led economy is slowing.
During the market sell-off from the July high, the transports broke down out of their wedge and have consolidated. Breakdowns like this one usually result in a swift move that retraces the entire wedge pattern, which would be more than a 25% decline from here. Smart investors should recognize this trend and plan accordingly.Link here.
AMERICA’S 200 BEST SMALL COMPANIES, ACCORDING TO FORBES
Our 200 Best Small Companies in America must pass through a gauntlet to qualify for the list. We judged candidates – all with revenue of $5 million to $750 million and share prices above $5 as of October 1 – according to return on equity, as well as sustained sales and net profit growth over 12-month and 5-year periods. Too much debt, signs of a downturn in the future or a whiff of legal troubles are all disqualifiers. We also exclude banks, utilities and REITs, since operational management has less of an impact on their results than market movements, industry regulation and requirements forcing them to pay out a majority of taxable income, respectively.
It takes more than solid books to make the cut. For a variety of reasons, 111 companies that appeared on our list last year did not make the cut this time around. Small businesses are dynamic, and sometimes volatile. You see that reflected in share prices (our list gained 26% over the last 12 months, compared with 8% for the Russell 2000). Annual turnover on the list is also an indicator of volatility, and this year the turnover reached its highest level since 2002. Clusters of hot industries chasing shifts in consumer demand, government spending and pockets of cyclical industries can cause turmoil even for small “value” companies. Last year the oil and gas patch dominated the list as oil marched to $70 a barrel. This year it is medical equipment players.
This volatility makes reviewing and selecting 200 companies a challenge. Earnings announcements, management turnover and acquisition activity can have a big impact on the make-up of our list. Soon after press time for the printed edition of this list, the U.S. military’s go-to maker of unmanned aircraft, #26, United Industrial (NYSE: UIC), announced it would be acquired by defense contractor Textron. The recipient of last year’s top honors, was Nutrisystem (NASDAQ: NTRI). The Pennsylvania weight-loss specialist announced October 5 that sales would miss analyst estimates by some 10%. Shares were down by a third at the close of trading that same day. The stock jitters might have been worse were it not for strong cash flow bolstering its balance sheet.Link here.
“All is change,” Euripides wrote 2400-plus years ago in his tragedy Heracles. He was dramatizing the terrible vicissitudes that can undo the greatest of men. But he might have been discussing the state of play in entrepreneurial America. This year we welcome 112 new members to our 200 Best Small Companies list. It may sound like a lot, but it is within the normal range of turnover. Entrepreneurs, after all, take chances – and constantly tempt fate.Link here.
The pick of the crop.
Small-company stocks have outperformed over a 7-year stretch, a good run that nearly equals their best one, 1974-83. The advanced age of this rally is just one reason to expect that it will soon be big companies’ turn to lead the market. Another is that the Federal Reserve is slicing interest rates in the face of slowing economic growth, and rate cuts historically have favored larger stocks. Finally, note that the market is unusually volatile and that small stocks are most vulnerable amid such turbulence. Investors diving into this sector of the market should do so with their eyes open.
Sam A. Dedio is plunging ahead at Julius Baer Holding, the Zurich-traded asset manager. Dedio left DWS Small Cap Growth Fund last year to take over Julius Baer U.S. Small Cap Fund, a young fund with just $11 million in assets, no load and expenses of 1.5% of assets yearly. Since he came aboard in July 2006, the fund has delivered a 23.7% total return (appreciation plus dividends) vs. the small-company Russell 2000’s 14.1% and the S&P 500’s 18.8%.
Dedio knows that the best earnings growth prospects will always lie with smaller companies, so he sifts for ones that have sterling outlooks, regardless of the megatrends. For each, Dedio asks a simple question: Does the company’s product or service change the behavior of the consumer or capital spender?
As most of his stocks are covered by few or no analysts, Dedio has to do his own work, meeting with managers, interviewing customers and reading product reviews. Judging products is a subjective endeavor, so Dedio looks for those that are hard to switch away from once a customer tries them out.
From this year’s 200 Best Small Companies list, Dedio found six stocks he especially likes for investors building a small-cap portfolio amid the market’s gyrations (see table). Some have P/E multiples on the high side, but they mostly have good growth, justifying the loftier price tags.
Last year’s Best Small Companies picker set a high standard for Dedio to meet or beat. Gerald Van Horn, manager of the Stratton Small-Cap Value Fund, selected five stocks from our roster that went on to deliver a 45% return. Our entire Best Small list returned 26% over the past year. The Russell 2000 had an 8% return. Van Horn’s picks were helped by his value bias, as value has been in favor of late. Dedio’s tastes run more to growth.Link here.
THREE ENTREPRENEURS MAY HAVE UNLOCKED A “NEW” SOURCE OF FLUID ENERGY: COAL
Inside a metal-clad tower at the gas technology Institute in suburban Des Plaines, Illinois sits a narrow, 40-foot steel tube bristling with instrumentation ports and pressurized pipes. Inside the tube, coal is being converted into natural gas at a rate that could transform the debate about one of the nation’s dirtiest fuels.
There is nothing new about turning coal into gas. 19th century street lamps burned “town gas”, a dangerous mixture of carbon monoxide and hydrogen, produced by blasting coal with steam. The Nazis later ran their war machine on synthetic fuels made from coal. The U.S. government sank $2 billion into a synfuels plant in North Dakota in the early 1980s, only to see it go bust when oil and gas prices collapsed and the project no longer made economic sense.
Hardly an inspiring history. Yet the company that has been operating the experimental reactor for 18 months now, GreatPoint Energy, has raised $137 million from some of the biggest names in industry and venture capital. All have been drawn in by GreatPoint’s claim it can make natural gas at 40% below current market prices.
GreatPoint was founded by a trio of Boston friends who have made a career out of scrounging through old scientific literature for business ideas. They started with the vague idea of doing something in alternative energy and spent months researching fuel cells, only to discover what countless others have found – fuel cells are temperamental and run on expensive fuels like hydrogen and natural gas. What about a cell that runs on cheap fuel? They found some papers on coal-fired fuel cells but decided they probably would not work.
Discouraged, the trio took some time off to build Coatue Corp., a firm that made polymer microchips. They also helped put together Sirtris Pharmaceuticals, a firm started by Harvard researchers looking into compounds in red wine that boost longevity. At the same time the partners were trolling through the literature on converting coal into more versatile fuels. Finally they stumbled across research, extending back to Germany in the 1920s, suggesting that coal and catalysts might produce economically viable gas.
Gasification has always been an energy hog. Most systems heat the coal to as high as 2,600 degrees Fahrenheit, consuming 40% of the coal’s energy. Even then the resulting syngas can be used only in a nearby power plant. It is incompatible with the more common methane in the interstate pipeline system. To convert syngas into methane takes three more processes that consume yet more energy. Catalysts speed the reaction, making more fuel at lower temperatures.
Thinking the catalyst idea had legs, they read the research, found out who the authors were and tried to lock up all those people. That part was easy enough. The scientists who were not dead were mostly retired or working at universities. The trio named the new venture GreatPoint after the site of a former coal-gas plant in Nantucket, Massachusetts, where they had all spent summers as kids.
From the beginning the challenge was coming up with an inexpensive catalyst that could be reused in the reactor, driving the cost of the process below the market price of gas. GreatPoint relied on widely available technology wherever possible, including the fluidized-bed reactor, common in power plants across the country, in which pulverized coal is combined with oxygen so it burns more efficiently. Catalysts have long been a dark art, more inspired guesswork than analytical science. But by using scanning electron microscopes and computers, GreatPoint’s experts were able to rapidly assess the effectiveness of different catalysts and fine-tune the formula. They also developed a process for applying a catalyst directly to the coal and recovering the catalyst (probably potassium) from the char that emerges from the reactor.
They got another lucky break when they found that the Gas Technology Institute had built a $60 million test plant and was looking for revenue after losing government funding. GreatPoint leased most of the plant and spent $10 million refitting the test reactor to use for its process. For the past 18 months engineers have been testing coal, petroleum coke (a refining by-product) and other fuels in the plant, tinkering with the catalyst and gathering data. Partner Andrew Perlman says the process consumes about 15% of the energy contained in the coal going in – far more efficient than the integrated gasification combined-cycle plants promoted by GE.
GreatPoint has plans to build a $50 million demonstration plant, perhaps in Wyoming, which has plenty of cheap coal. Construction on a full-scale plant costing $1 billion or more could begin in two or three years. Eventually GreatPoint’s technology may shift the economics of coal. Wall Street values the reserves of coal companies at 7 cents per million BTU of chemical energy. Reserves of natural gas, which is easier to transport and cleaner to burn, are valued at $2 per million BTU.
Bechtel is willing to hazard that GreatPoint can make gas for $4 from a plant digesting 18,000 tons of coal a day. That assumes GreatPoint can bring the plant in on budget. The viability of such a plant hinges on gas prices staying above $4. (Recent spot price: $6.55.) It might not. Gas spent most of the 1990s under $2.Link here.
WHY THE MILLER-COORS MERGER DOES NOT MATTER
SABMiller and Molson Coors have announced a merger that is supposed to go through by the end of the year and will be a closed transaction by mid-2008. It will bring the #2 and #3 U.S. brewing giants together to better compete against Anheuser-Busch, which controls half of the entire U.S. market. The new joint venture will be called MillerCoors.
As I was listening to the joint press conference, the thing that stuck out to me was the emphasis on how competitive the U.S. market is. What they were undoubtedly talking about was the rock and the hard place they find themselves in. At the top, they have to compete with the giant Anheuser-Busch, maker of everything Bud. And on the other side, they compete against a seemingly unlimited number of craft beers.
The beer market, as a whole, has been taking a nosedive compared to spirits and wine sales, but those numbers are skewed. The top three – Anheuser, Miller and Coors – make up around 90% of the market. Sales from these three have dropped like a sack of bricks in the past decade or so. But craft beer sales are up 31.5% over the past three years and are going higher.
Back in July, I wrote that the last time the major U.S. brewers started consolidating they changed the whole landscape of the U.S. beer industry. That was in the 1970s. This consolidation period brought the total number of beer makers in the U.S. to 44. Experts expected it to go to five. But something quite the opposite happened.
Due to crucial legislation by the Jimmy Carter administration, companies like Anchor Brewing and Boston Beer (maker of Samuel Adams) started up to bring consumers a change from the light beers that the Anheusers and Millers of the world were selling. This revolutionized the business, bringing the number of U.S. brewers from 44 in the 1970s to over 1,400 today. If this recent merger is any indicator, it appears that these macrobrewers are trying to deal with this grassroots craft beer revolution. It looks like we are on our way to round two of consolidations.
But it will not really matter what the big nationals do. With new demand from Europe and Asia for U.S. craft beers, the industry is going to stay around for a long time. There will be lots of profits to be had too. Sam Adams was the first craft to make it from just a new type of beer to a top tier brand that rolls off almost everyone’s lips. Just take a look at what they have done in the past few years.
We can expect this as the standard once some of the smaller craft beers shoot out of the gate. I would keep my eye on Redhook Ale Brewery (HOOK) and Pyramid Breweries (PMID). These could be the next two out of the starter’s box for the public craft brewers. I also suspect that many more will be going public in the next few years.Link here.
$400 MILLION BURIED IN THE MISSISSIPPI RIVERBED ...
On August 1, every child’s worst nightmare actually came true. The I-35W Mississippi River bridge collapsed in Minneapolis, killing 13 and injuring 100 motorists. “This is a catastrophe of historic proportions,” said Minnesota Gov. Tim Pawlenty.
For decades, federal inspectors knew that a flaw in the structure of the 8-lane bridge could easily take down the entire bridge. But year after year, the government let the bridge pass inspection. Today, Minneapolis workers continue removing the hundreds of tons of steel lining the Mississippi riverbed. The government has plans to build a new bridge, with costs for rebuilding projected in the $250-million range.
According to the U.S. Department of Transportation, 756 steel deck truss bridges span America’s waterways, just like the one in Minnesota. Built in the 1950s and 1960s, approximately 11% of these steel bridges have weaknesses much like the one that caused the I-35W bridge’s collapse. 80+ bridges at $250 million a pop?
But it gets even scarier, when you realize America’s infrastructure crisis involves roads, schools, dams, power grids, and water pipes too. The American society of Civil Engineers now warns that the U.S. has fallen so far behind in maintaining its public infrastructure – roads, bridges, schools, dams – that it would take more than $1.5 trillion over five years just to bring it back up to standard. Uncle Sam needs $1.5 trillion just to sprinkle Band-Aids across America’s degenerate body.
How will the public pay for all that, we ask? We are not sure. But it seems to us that he will pay for it with dollars ... and that is the heart of the problem. Every imaginable rescue mission for the overly indebted American consumer, not to mention the overly indebted American government, leads to increasing quantities of dollars and credit, which can only mean one thing. Dollar-holders beware.
Strong economies need strong infrastructure. Strong infrastructure needs strong spending. More spending means more government contracts. More contracts mean more campaign donations. It gets better. Every elected official represents a district with a broken bridge. A new bridge needs a new ribbon and a new name. Hence, the more bridges they build, the more votes they receive. Everyone in Washington can play along.
It is a win-win for Washington. Its charitable handouts, i.e., debts, will buy the bridges that buy the votes. Those debts will undermined the dollar. The cheap dollar creates cheap exports. More exports create more jobs. More jobs ... more votes. And, devaluing the greenback devalues the foreign debt that started this whole mess to begin with.
It is a win-win for Wall Street, too. The municipal underwriting business takes off. Banks now repackage municipal debt like mortgage debt. The fees keep rolling. Seven figure bonus days are here once again.
However, this game has one or two setbacks. First, higher spending sans higher taxes works only when foreigners demand our debt. But that may not be the case much longer. Second, more debt means we print more money, which means more inflation. You have not noticed the effect yet, because Chinese imports have delayed the hangover. But the days of importing Chinese deflation are coming to an end, as well. Despite what others may think, Alan Greenspan is no dummy. He knew when to jump ship.
Unfortunately, high inflation combined with high interest rates kill the middle class. That is the real long-term problem of fiat currencies. A fiat money system prompts legislative profligacy and inevitably produces inflation. The system stimulates the growing gap between the haves and the have-nots. The have-nots will turn to their elected saviors in Washington. They will demand a change.
Washington will listen with empathetic ears. They will yell at the rich while they tax the poor (municipal bonds financed on taxpayer revenue). Like Alan, they are no dummies. They know who really puts them in office. In the end, they will placate their disgruntled voters with more contracts for more new bridges. Which, in turn, will most likely precipitate further inflation. Remember, personal taxes can go only so high before even the rich revolt. Most studies project that watermark near 50%. So tax hikes can go only so far.
As Bill Bonner points out, “The goal here – as with all government programs – is to produce the desired benefits while pushing the costs onto someone else. That’s how politics work. You promise something ... and you force someone else to pay for it. You rob one Peter voter ... and spread the loot among the Pauls.”
And so we will beat on, dear reader ... like boats against the current.Link here.
FISHING WITH THE BEAR
Discounting near perfection, both domestic and foreign stock markets could crack at any moment. The smallest problem threatens to send them down, as we have seen this past summer. At best that makes staying invested like angling for landlocked salmon in northern Maine, which I like to do whenever I can. The fishing is wonderful there, but every once in a while you see black bear tracks right underfoot.
The market’s bearish signs, from a growing subprime mess to the fretting over whether somebody should bomb Iran’s nuke labs, lead many to suggest that now is the time to cut bait and run for safety. Not me. I think what makes more sense is learning to fish with the inevitable bears that will cross our paths.
Today the market has rebounded and we are back to setting records (Dow Jones Industrials) or near there (S&P 500). This year the Dow has had more record closes than you could fit into a 31-day month. Now we are armed with a Federal Reserve aiming to fend off the bear with rate cuts and a savaged dollar that benefits our multinationals, whose products have rarely been cheaper overseas.
Still, thus far in 2007 the bear has attacked us twice, first in late February and then in mid-July – more than enough to dissuade a reasonable person from staying in the river. Swipe one saw the S&P 500 lose 5.9% of its value in 10 trading days last winter, as it appeared that Asian markets were on the verge of collapse. Swipe two tore into a midsummer’s dream of a rally (the S&P had risen 13.5% since the previous attack), sending the broad-market index down 9.1% between July 13 and August 16.
So in a wild landscape where the bear roams, which investments have the most staying power? I have looked at the past two maulings to find what recovered the best from its lows. Plus I factored in how different markets, whether domestic or foreign, commodities or currencies, had fared throughout the year, to get a context for individual picks.
Extending our wildlife metaphor, my research shows that individual stocks are the equivalent of a .22 rifle. They do not pack enough firepower to stop the bear. Small things can hurt their performance. And buying into a wide index such as the S&P 500, via a mutual or ETF, has the opposite problem. They are clumsy instruments that, like a shotgun, can miss a fast-moving target. The wider-ranging S&P is more susceptible to the bear than is the Dow, the oldest measure of the U.S. stock market, made up of 30 global leaders you can name in your sleep. The Dow fell less than the S&P in the late-summer slump.
The way to play the Dow is with an ETF called Diamonds Trust (DIA, 140), which mimics it. If the world economy, or just our own, stumbles, then the big blue chips in this index do not have to outrun the bear, but merely the mid- and small-cap stocks that tend to be hurt the worst in a bad market.
China has the ability to emerge as the world’s largest economy by 2030. You should be buying there today. Consider either the iShares FTSE/Xinhua China 25 (FXI, 193) or the SPDR S&P China (GXC, 93) as the best way to put the yin in that market’s volatile yang.
Thanks to hedge fund proliferation, the wildest market around is foreign exchange. The BIS estimates that forex trading has increased to $3.2 trillion a day. The PowerSharesDB G10 Currency Harvest Fund (DBV, 29) is the ETF I like for this. The dollar, which has suffered a lot lately, is one of 10 currencies covered by the ETF, which follows the Deutsche Bank G10 Currency Future Harvest Index. The other nine denominations, including the yen, the pound and the euro (but not China’s yuan), are what you are after for diversification. If there are no further changes in exchange rates, your return from this basket would be flat, minus overhead (0.75%). If the dollar weakens further, you will outperform a dollar-only money market fund.
Gold, the best bear-proof investment, can be efficiently owned through the iShares Comex Gold Trust (IAU, 73), an ETF that in effect owns bullion and runs up an annual overhead of 0.40%. Gold has doubled over the past four years to $732 per troy ounce.
A hypothetical portfolio that bought equal amounts of the four securities recommended here would have earned 27% so far this year, to the S&P 500’s 11%. If the market sinks, the four should continue to outperform.Link here.
COULD THE CRASH OF ‘87 HAPPEN AGAIN?
For most of today’s investors, the stock market collapse of October 19, 1987, was a defining moment – the biggest financial crisis in memory and a stern reminder about the nature of investment risk. On that Black Monday 20 years ago, the Dow Jones Industrial Average dropped a stomach-churning 508 points, or 23% – the equivalent of 3,200 points for today’s high-flying Dow. It was the second-biggest percentage drop ever for the market, eclipsed only by the war-related Panic of 1914.
While the causes are still debated, the biggest question remains: Could it happen again? For a quick answer, it is instructive to compare the Crash of ‘87 with the credit crunch that swept through financial markets in August, challenging an untested Federeral Reserve Chairman Ben Bernanke much as his predecessor Alan Greenspan was tested two decades ago.
The credit crunch roiled financial markets and depressed stock prices briefly, although this year’s event played out largely behind closed doors in the murkier waters of the credit market. The crunch of ‘07 underscored the fact that as long as investment decisions are made by human beings, financial markets will remain vulnerable to future selloffs fueled by runaway emotions. But the stock market today is very different than it was 25 years ago. The odds have been sharply reduced that we will see a a replay of the 1987 crash.
While most recollections of the 1987 crash focus on October 19, the slide was well under way when Black Monday rolled around. In fact, the seeds of the crash had been sown years before. The 1980s saw individual investors pour money into the stock market through mutual funds and the rapid expansion of 401(k) retirement plans. By 1989 some 32% of U.S. households owned stocks, up from 19% just six years earlier. Institutional investors were also piling into stocks. Private investment firms, relying on research that purported to show that “high yield” debt (aka “junk bonds”) were not as risky as market prices reflected, generated a multibillion-dollar wave of leveraged buyouts paid for with freshly printed paper. All that money had to go somewhere, and much of it ended up pushing stock prices to new highs.
The party began to unravel in the summer of 1987, when the DJIA hit an interim high of 2,722 on August 25 and then began to slump. At first, the decline looked like a routine pullback. The Dow began bounceed back a bit in September after an 8% decline. To many, it looked like stocks were just taking a breather after years of rapid advance. But by early October, the downdraft was back – and gaining speed. In the four trading days preceding Black Monday, the Dow dropped 10.4%.
Economists and financial analysts have attributed the decline to a number of causes. Worries about inflation and a weakening dollar had pushed interest rates higher, making the safe haven of Treasury bonds more appealing. Congress was debating raising taxes on capital gains from stock investments. Fresh data in mid-October showed the U.S. trade deficit widening. Though most of the data pointed to continued strength in the U.S. economy, some analysts had been warning clients that stocks looked “overvalued”.
After a weekend of mulling all of this over, Wall Street reported to work on a mild, summery day in lower Manhattan ... and started selling. After first, the decline was fairly orderly. But as the day wore on, computerized sell programs – set to bail out of stocks en masse at preset levels – overwhelmed the trading system, which still relied heavily on human beings matching buy and sell orders. Prices posted on the Quotron terminals of the day plunged from one trade to the next. By day’s end, more than 600 million shares made it through the system — more than triple normal levels. But many more never made it. That erratic trading – including the periodic “seizing up” of some of the 30 stocks in the Dow – contributed to the steep drop in prices recorded at the close.
When the dust settled, and traders, analysts and investors saw what had happened, many returned the next day believing the sell-off was overdone. That widespread assessment – coupled with a highly visible announcement by the Fed that it stood ready to flood the system with money to put the fire out – touched off a huge buying spree on heavy volume. Over the next two days, the stock market recouped more than half of Monday’s losses. The panic appeared to have ended as quickly as it began.
Contrast that with the financial panic that swept the credit markets this summer. The root causes of what would become the credit crunch of 2007 had been widely reported well before the panic hit, including the rise in risky subprime lending backed by complex securities valued primarily by computer, not market pricing. A boom in mega-buyouts backed by cheap money helped fuel what amounted to a credit bubble. One major danger signal that investors were ignoring risk and money was flowing too freely – that interest rates on risky bonds were not much higher than much safer Treasuries – had been flashing red for months.
Unlike 1987, when the sickening slide played out publicly, the credit crunch of 2007 was a members-only event. With much of the questionable debt held by unregulated hedge funds, even the Fed had only anecdotal information to guide it. That is why the credit crunch played out in slow motion. Without the transparency of a public market, no one could be sure where the fire was burning, or how badly. As it did in 1987, the Fed fire brigade responded by flooding the market with money until the smoke began to subside. Only in the past few weeks, as banks and brokerages have fessed up to huge losses in quarterly earnings reports – have investors been offered a glimpse of how bad the damage was. With a clearer picture of the extent of the losses, financial markets have begun to gain confidence that the worst is over.
Could it happen again?
In every meltdown, market players adjust to try to prevent a repeat. Since 1987, massive investments in technology and electronic trading systems have vastly expanded the stock market’s capacity. The 1980s-era, computer-driven trading models – once thought to be so foolproof they were referred to as “portfolio insurance” – were long ago rewritten to avert another 1987-style rush to the exits.
The credit crunch of 2007 is still unwinding, but much of the easy-money lending that fueled the bubble has already receded. Some of the megamergers announced before the bubble burst have been quietly shelved. Mortgage standards have tightened sharply, and state and federal regulators are prosecuting cases of lending and appraisal fraud. But it remains to be seen whether the now-burst housing bubble – the legacy of easy-money mortgage lending since 2001 – will create a wider drag on the economy.
While it is unlikely that either the stock market or the credit markets will replay the scripts that led to their collapses, nothing can rule out the possibility of future panics. The stage for both events was set by hubris as the wizards of Wall Street thought they had somehow outsmarted the risks that had reined in their forebears. Investors – both individuals and institutional money managers – willingly went along for the ride. Once that confidence began to unwind, the resulting panics fed on themselves, fueled by fear.
So as long as investment decisions are ultimately made by human beings – governed by those primal emotions of fear and greed — there’s little chance that financial markets can be insulated from future panic-driven sell-offs.Link here.
Paul Tudor Jones II: The man who won as others lost, 20 years ago.
Paul Tudor Jones II leans back in his chair and grins. The stock market is going to crash, and he knows it. “There will be some type of a decline, without a question, in the next 10, 20 months,” he says in his rich Memphis drawl. “And it will be earth-shaking. It will be saber-rattling.”
Coming from a financial speculator as prominent as Mr. Jones, a man with about $19 billion of short-term trading capital at his disposal, the words might be enough to send ripples through a stock market that, apparently defying logic, has been hitting new highs each day. Except that the crash to which Mr. Jones refers occurred October 19, 1987. His prognostication – brazen, and as impudent as the man himself – was made in a documentary called Trader, which was filmed in the year preceding that day.
Now, 20 years after the 508-point decline, several strategists are anticipating that the earth will shake again. Valuations are stretched beyond historical comparisons. The market, ever more volatile, is reaching new highs, ignoring a buildup of bad news. Most crucially, the strategists say, the sentiment that the market’s rise is infinite seems to have taken permanent hold.
“The overvaluation of stocks is more extreme than the 1929 high,” said Robert R. Prechter Jr., an independent market forecaster and well-known follower of Elliott Wave theory, which examines the extent to which investor psychology creates stock market patterns. “Which tells me the next bear market will be the biggest in many years, probably since 1929-32.”
At the end of October 19, 1987, stocks were down 22% – precisely the “Acapulco cliff dive” predicted by Mr. Jones in the video. The day ruined the careers of many, but it made the reputations of Mr. Jones and Mr. Prechter, whose professional relationship dates to the mid-1980s. In the video, Mr. Jones can be seen huddled over a graph, comparing the market’s peak in 1987 with a previous high in 1929.
As Elliott Wave theory would have it, the two market tops may have been 60 years apart but the herdlike exuberance of investors pushing stocks ever upward was the same. On October 5, 1987, Mr. Prechter, then and now the best-known proponent of the theory, told his subscribers to sell. While the rest of Wall Street counted its losses, Mr. Jones, at age 32, returned 200% for his investors that year and drew a payday of an estimated $100 million for the year, an almost unheard-of sum at the time.
No one, including Mr. Prechter himself, claims that Mr. Jones relied solely on Mr. Prechter’s call. Indeed, in the video Mr. Jones can be seen as early as 1986 making a case that the market would fall. But the crash did not last long. Prices rebounded the next day, and within two years, the market had regained all that it had lost that day.
Now, Mr. Prechter is suggesting that the country is facing not just a market crash, but also a depression. On every measure, he says, the market is more overvalued than it was in 1987 before the reversal. The price-to-book ratio of the S&P 500 is 4.04, compared with 1.73 in 1987. And measures of the bullishness of Wall Street traders confirm Mr. Prechter’s assessment of the overvaluation.
To be sure, the one feature of every long-running bull market is the small clutch of market pessimists whose clamor that the end is nigh seems to rise in pitch with each successive peak. But Mr. Prechter’s gloominess may resonate, especially in light of Mr. Jones’s high regard for him. “Prechter is the best because he is the ultimate market opportunist,” Mr. Jones said in the book Market Wizards, a collection of interviews with successful traders compiled by Jack D. Schwager.
That is not to say that Mr. Prechter has any undue sway over Mr. Jones, who since he started Tudor Investment in 1986 has generated a return of 26% a year and has seen his assets grow from $125 million to $19 billion. Indeed, Mr. Prechter’s relentless bearishness has not made him a favorite of bullish hedge fund managers.
At a time when hedge fund trading is dominated by computer trading programs and traders with Ph.D.’s, Mr. Jones is of the older style, relying on intuition, market smarts and the force of his personality. A macro trader, he is known for making big sweeping bets on the direction of stock exchange indexes, commodities and currencies. As for his view on the market, Mr. Jones declined to comment. Over the last 17 years, he has rarely publicly expressed an opinion about stocks, bonds or currencies – a reflection of his influence as a trader.
This summer, his funds were hit by the credit crisis and lost 5% in August. Through September, Mr. Jones is barely ahead, up 2.5%, and he could end up having his worst year in more than a decade. “He has had a tough time lately,” said Byron R. Wien, a friend of Mr. Jones and a strategist at Pequot Capital Management, a rival hedge fund. “But he is a talent. You go through cold periods, but you don’t lose it.”
Although all the top traders preach the discipline of not letting your losses get to you, the video suggests that even the best feel the almost physical pain of trading defeats. In one scene, Mr. Jones, his knee jiggling with such violence that his tie sways, is shown losing $6 million in one day, in December 1986. It was a big loss, given that he had only $125 million under management at the time. “This is what is known as the agony,” he says, slumping in his chair. “This is devastating. An intellectual blow.” He stops talking. He looks distant and distracted. “I hate it.”
Mr. Prechter, who keeps in touch with Mr. Jones through e-mail and the occasional phone call, says that Mr. Jones, his recent rough stretch notwithstanding, is best placed to survive a crash. “He does not go cold and clammy,” Mr. Prechter said. He does not know if Mr. Jones shares his dark view of the market, though he allows that “Paul is certainly aware of the risk of an extensive bear market” and “is well aware that stocks are vulnerable.”
But do not expect Mr. Jones to relive his 1987 glory. One investor who has spoken with him in the last week, who asked not to be identified because he is not authorized to speak publicly about Mr. Jones’s investment strategies, said that the recent rate cut had made Mr. Jones increasingly bullish. Indeed, as opposed to 1987, Mr. Jones is said to be reminded of 1998, when cuts by the Federal Reserve led to the stock market boom of the late 1990s. “I have not heard him mention Prechter in a long time,” this investor said.
The 1987 video offers an intriguing window into the everyday life of big-league traders, and it has the feel of a time capsule. Full of swagger and braggadocio, Mr. Jones can be seen skiing in Gstaad, Switzerland, or riding a horse on his estate overlooking the Chesapeake Bay – when he is not screaming out orders to his traders. He comes across as a young Gordon Gekko. Greed was not only good, it was fun.
Although the video was shown on public television in November 1987, very few copies exist. Those that do are hoarded by traders who watch the hourlong movie in the hope of gleaning possible trading tips from Mr. Jones. On the Internet, bids for the video start at $295. According to Michael Glyn, the video’s director, Mr. Jones requested in the 1990s that the documentary be removed from circulation.
It is no surprise that Mr. Jones wants some distance from that version of himself. He was a bit of a cowboy, out to prove he was the best. Now, 20 years later, he sits atop the new hedge fund rich. He is married to a former model from Australia, has a mansion in Greenwich, Connecticut, and owns a big-game reserve in Tanzania. Forbes estimates his net worth to be $3.3 billion.
On Wall Street, the roles are reversed. Mr. Prechter foresees a return to the Depression. Mr. Jones, who himself said a depression would follow the 1987 crash, may well be fully invested.
“People will be gasping,” Mr. Jones says with glee in the video, referring to the 1987 crash that he was sure would come. “It will be total rock ’n’ roll.”Link here.
THE “ANTI-DOLLAR” IS ON A MOON-SHOT RIDE. CAN IT CONTINUE?
You do not have to be a trader to know the dollar is falling. Just the other day, my grandmother was talking about the falling dollar. The next day, a woman who works in the computer industry was “concerned” that the dollar might fall more and further erode her 401(k) investments. So obviously, the average Joe investors on “Main Street” are well aware that the dollar is falling.
Even when good news has helped the dollar rally recently, the dollar lost those meager gains again within hours. So what does this tell us? It tells us the big money investors on Wall Street and in the central banks are still NOT convinced that they should move money back into dollars. Instead, they are betting on the strong euro.
The euro has been one of the biggest beneficiaries of this dollar fall. While the economic numbers have been dire in the U.S., the Eurozone Industrial Production came in at 4.1% growth vs. 2.3% expected. This means that the Eurozone industry is strong and continues to heat up. When this happens, it means that inflation in the Eurozone could be on the rise once again. If so, the ECB could raise rates further – which would give the euro an additional boost.
Formerly, it was anticipated that the ECB would actually hold rates and possibly even start to cut them before long. Now the sentiment has shifted away from that and back into an inflation fighting bias. That has fueled the euro/U.S. dollar trade cross rate (EUR/USD) to new highs above 1.4200.
The EUR/USD has a lot going for it. The European housing market, inflation, and GDP numbers all look good vs. similar U.S. numbers. Obviously, the Eurozone has outpaced the U.S. lately. So here is the question. Where would you want your money to be? In the U.S., with sub-prime mortgage problems, a slumping housing market, lower inflation and slower growth? Or would you rather have your money in a faster growing economy with the chances of rising interest rates and a better housing market? I would pick door #2.
Money likes to be in a place where it feels “safe and cozy”. Right now, the Eurozone is that place – not the U.S. If you leave the U.S. with your money, where is the next stop where you will think of to drop your money? If you are like most, you will tend to head for Europe. Also, would you rather have your money in something with a declining interest rate (like in the U.S.) or in one that will either hold their rates steady or raise them? Again, I would pick door #2. As you can see from this chart, many traders have agreed with me. (The red/blue line is the EUR/USD cross rate.)
It is not about which country is doing good but rather which country is doing better. It is not about which economy is doing bad but rather which economy is doing worse. So with that said, we want to pair a strong economy with a weak one. This has led me repeatedly to the EUR/USD.Link here.
Paulson pressured by G-7 calls to aid dollar.
A former Master of the Universe like Henry Paulson does not often find himself on the defensive. At international meetings this week in Washington, he will be. Under pressure from European governments to abandon his hands-off approach to financial regulation and the depreciating dollar, the U.S. Treasury secretary and former Goldman Sachs CEO may be forced to accede to the first while resisting the second. “The U.S. is no longer able to give a flat ‘no’ to some of the suggestions” coming from overseas, says Brad Setser, a former Treasury official and now a fellow at the Council on Foreign Relations in New York.
As Paulson, 61, prepares to host G-7 finance ministers and central bankers in Washington on October 19, his ability to fight back has been undermined. He lacks the bully pulpit the U.S. had in recent years, when its economy was the strongest in the industrial world, and the August credit-market turmoil has tarnished his reputation as a financial authority. “You have a Treasury secretary who comes from Wall Street, who is supposed to know about markets,” says John Kirton, director of the G-8 Research Group at the University of Toronto and a former Canadian government official. “We have not heard from him that he has got a handle” on the situation.
European nations are leading the charge against him. With the euro hitting a record high versus the U.S. currency, European exporters are being priced out of foreign markets. “Sales of German exports are falling off drastically in the U.S.,” says Anton Boerner, president of the Berlin-based BGA association of wholesalers and exporters. “We have stepped beyond the pain threshold.” France has been particularly vociferous in advocating action to stem the euro’s rise, with Finance Minister Christine Lagarde even pushing the ECB to sell the currency. She has also called on Paulson to say “loud and clear” that he still backs a strong dollar.
While Paulson has said repeatedly that a strong dollar is in America’s interest, he says the value of currencies should be set by the market. Under President George W. Bush, the Treasury has never intervened in the currency market, either to buy or sell dollars. John Taylor, Bush’s former Treasury undersecretary for international affairs and now a professor at Stanford, says it is “unlikely” Paulson’s rhetoric will change.
Paulson should be able to fend off pressure in part because the Europeans themselves are not united on the issue. In spite of complaints from exporters, Germany has made clear it does not want to weaken the euro. Paulson may also be loath to take a more activist line on the dollar because of his efforts to persuade China to let its currency trade more freely.Link here.
INCREASINGLY ELUSIVE EARNINGS
As the earnings season in the U.S. stock market gets into full swing, the Dow Jones and Standard and Poors indices go from strength to strength, setting records about every other day. Yet their exuberance has failed to focus on one important factor: Corporate earnings have peaked for this cycle and are set to decline substantially in the quarters ahead.
The reasons for the peaking are pretty obvious. The credit squeeze in August may have eased, but there is now no doubt that it was a primarily U.S.-led event, centered on the home mortgage industry. That is leading to earnings disasters throughout the financial services sector, with the surprising exception of Goldman Sachs. (It is also bringing into question current risk management techniques. The Morgan Stanley “quant” operation lost $390 million on a single day in August, far more than the theoretical “value at risk” that was the centerpiece of their risk management calculation.)
Losses from subprime mortgages are not going away, and they will be recorded in earnings over the next several quarters. As subprime mortgages default, more housing is brought onto the market, and house price declines accelerate. That process causes more previously sound mortgages to become delinquent, either because the homeowner loses his job or simply because the homeowner needs to move but is trapped by a mortgage that is now underwater. Any mortgage made at a higher loan to value ratio than the traditional 80% is endangered by a house price decline extending into the 15-20% range, with more than that on the coasts, as now seems likely.
In the mortgage market that existed before 1980, there would have been a stabilizing factor, in that the great majority of mortgages had been taken out several years earlier, when house prices were much lower, and so would remain sound. However the extraordinary volume of mortgage refinancing that took place in 2002-06, each of which refinancings resulted in a 2-4% fee for some hyped-up mortgage broker/salesman, has destroyed that cushion.
Today, a high percentage of consumers refinanced their mortgages using a valuation close to the peak, and have subsequently spent the money raised on vulgar ostentation. They are now busily refilling their credit card balances to continue enjoying the excessive consumption that they have come to regard as their due. The arrival of reality on their front doormats, in the form of a credit card bill they cannot pay, including atrocious increases in interest charges due to their lowered credit standing, will not only produce losses for the lenders, it will also decimate those consumers’ consumption.
The home mortgage sector, the housing sector and real estate brokerage were the largest job creators in 2001-05, accounting for 40% of the jobs created during that period, with the second largest engine of job creation being the inexorable increase in the size of governments at all levels. The rest of the economy has since 2000 proved weak at job creation.
The real estate market has nowhere near bottomed. New home sales are still running at close to 800,000 per annum, compared to the 400,000 per annum at which they bottomed in the last four housing downturns, all of them milder than this one is proving. Since employment tends to lag activity, it is likely that there is a considerable further employment squeeze in the real estate-related sectors still to come. If household consumption, the great engine of the U.S. economy for several decades, is due to fall back in real terms, capacity and profit levels in consumer-related industries will also be squeezed.
The only offset will be profit increases in export industries, buoyed by the decline in the dollar and increase in U.S. firms’ competitiveness. Here however a reality has to be recognized. Operations that have been outsourced since 1990, and are now producing goods and services from low wage countries in the Third World, are not coming back. The initial costs of restructuring a production and distribution chain are immense, there is thus a gigantic amount of inertia in the global economic system. If a firm requires a 20% operating cost advantage to outsource, taking account of all the up-front expenses and disruptions involved, it will also require a 15-20% cost differential to bring production back onshore. That would mean the dollar would have to decline around 40% in real terms against the currency in the offshore center before the production concerned was repatriated. Measuring from the dollar’s recent levels, that will not happen (the 2002-06 decline was merely a reversal of the over-exuberant 1995-2002 rise), or if it did the effects on the financial markets, in terms of collapsing bond prices as foreign investors fled, would cause massive further disruption.
There are thus a number of factors likely to cause profit levels in the U.S. economy to decline. That would not be surprising. Even by the conservative government measurement, corporate profits are currently at record levels in terms of GDP. That is not surprising either. Monetary policy has been extremely loose since 1995, so the share of capital in the economy has steadily increased and the returns to that capital have caused profit levels to soar. As real interest rates revert to their norms, probably now accompanied by a rapid increase in inflation rates from their current alleged 2% per annum and actual 5% per annum towards or even beyond the 10% level, causing a collapse in bond markets, profits will be squeezed back towards their historic levels and decline as a percentage of GDP.
Profits reported to shareholders, those taken in calculations of price-earnings levels, are likely to decline further than the economic profits used in government statistical calculations. The gap between the Bureau of Economic Analysis measurement of corporate profits and Wall Street’s reported profits has soared in the last few years, as it did in the late 1990s. That is almost certainly a reflection of lax accounting standards, e.g., not expensing stock options, and playing games whereby “extraordinary items” were transferred “below the line” and expensed directly against equity, allowing reported profits to maintain a steady upward trend.
Asset valuation has been a particular area of profit inflation in recent years, and should be a fruitful source of disasters in the forthcoming downturn. One particular sector to watch will be the investment banks, which normally benefit as the stock markets worldwide climb, as they have in 2007. As the most active participants in financial markets, they have the highest exposures to financial market chicanery. Goldman Sachs, for example, reported this week that the “Level 3” assets in its books, those for which liquidity is lowest and valuation most difficult, had jumped by a third in the quarter to $72 billion. Set against Goldman’s capital of $36 billion, that is a frightening figure. At some point, probably in a downturn, the real value of those “Level 3” assets will have to be recognized. No doubt the resulting losses will be written off against capital, but even Goldman’s brilliant and gloriously paid accountants will find it difficult to write off $72 billion of losses against $36 billion of capital.
Corporate profits are Wall Street’s main justification for the current over-inflated level of the U.S. stock market. They have been increasing in every quarter since 2002 and are held to justify an S&P 500 P-E multiple of “only” 18. However, Thomson Financial reported that Q3 earnings were likely to come in fractionally below Q2 earnings – the first quarterly decline since 2002. If we have indeed passed the peak of earnings in this cycle, then unexpected losses and the need to return corporate accounting to a reasonably conservative basis will make the downward slope in earnings long and steep. Even if 18 P-E ratio held, it would imply a massive drop in the stock market. Such a drop in the stock market, particularly if accompanied by an inflation-caused drop in bond markets, will decimate Wall Street’s profits, throwing overpaid bankers out of work and further pressuring consumer spending. It is a vicious circle, spiraling ever more rapidly into an almost (but not quite) bottomless pit.
It might be time to speculate in a few long term put options – or move your money overseas – but where?Link here.
THE “SUBPRIME” MENTALITY IS A METAPHOR FOR THE WHOLE U.S. FINANCIAL CULTURE
Too many people think that the issue of subprime lending is a local problem that will be contained. In the unlikely event that you are in this camp, think again. First of all, the fallout from subprime lending will be bad enough as it stands. But the real problem is that “subprime” is a metaphor for the whole U.S. financial culture.
At its worst, subprime lending consisted of giving loans to people that probably could not pay, on low- (or no-) “doc” terms (because lenders did not want to ask). They were initially targeted at people on the economic margins of society, precisely the kind of people that could not qualify for mortgages or other loans on conventional terms. (The latest “hot” market is illegal immigrants, who often live and work “off the books”, and therefore cannot document their income or assets.) “Alt-A” loans are aimed at higher paid people with similarly variable incomes who are otherwise very much in the economic mainstream, e.g., commission salespeople, or investment bankers whose base salaries are low relative to bonus-driven total compensation.
Because subprime loans, by definition, are made to borrowers who are unqualified, lenders demand higher interest rates, which supposedly compensate for the risk. Except that they don’t. When a borrower who is already on financially shaky ground is charged an above-market rate, the excess payment means that s/he becomes an even greater risk than before. In short, the act of subprime lending itself creates the very problem it is supposed to solve. Subprime lending was about finding someone stupid enough to borrow (on such terms), and honest and solvent enough to repay. Barring such rare birds, subprime products were fit for “only crooks and deadbeats,” in the words of wise underwriter named Jack Ringwalt (who sold his company to Warren Buffett in the 1960s).
The supposed cure for payment problems was another monstrosity – adjustable rate mortgages (many of which are “prime”). The whole point of such mortgages and low “teaser” rates was to “qualify” people for loans they really could not afford. This incentive consisted of submarket rates for a period of time, typically two or three years, enough time for a loan to get “seasoned”, with a monthly payment that was temporarily affordable. Until the recent resets, beneficiaries of such loans had an artificial incentive to pay on time to keep the low rates. After the resets, however, the incentives run the other way, which explains the recent hockey-stick rise in foreclosure rates. In essence, overextended home borrowers were made to appear as better credits (during the “teaser” period) than they actually were. It was an artifact of the “lend now, collect later”, mentality that pervades today’s banking system. Such practices violate the old J.P. Morgan dictum of a “first class business done in a first class way.”
If only the problems of such stupid lending could be confined to the lenders and the soc-called “investors” that act as their backers. ... But the abnormal spending that was made possible by the “housing ATM” effect of home equity loans is now coming to a screeching halt. More to the point, “normal” consumer spending – that which would have occurred if the consumer were not severely loaded down with debt, will soon be severely crimped. Such borrowers probably will not end up going hungry or unclothed. But they might end up eating Sloppy Joes, and wearing secondhand clothes purchased at garage sales for the two or three decades that it will take to pay off their homes – as their grandparents did 70 or 80 years ago. (What is more, many of them live in housing developments that threaten to turn into modern “Hoovervilles”.) Slavery has been abolished, but not “indentured servitude” in what Warren Buffett recently termed a “sharecropper society”.
Nor are any solutions likely to provide relief. One idea is to penalize the lenders. Suppose, for instance, that a political consensus formed around the proposition that loans with “teaser” rates for the first 2 years and market rates for the remaining 28 years were “deceptive” to the average consumer. (Individual lawmakers already feel this way.) In this case, legislators or judges might rule that those low teaser rates should remain in effect for the life of the loan. That would certainly provide the consumer – or selected consumers – relief, in the form of an interest subsidy. But lenders and investors who foolishly bought such loans would suffer as a result, meaning that a large number of banks and/or hedge funds would go bust.
Many of these bad loans were packaged and sold to foreign investors, meaning that they now contaminate the banking systems of our major trading partners. German banks for instance, whose staples are fixed income products, were “shocked ... shocked!” to find that their “tranches” of loan packages carried properties more characteristic of options, a much riskier security. Such shaky paper is now often treated as nearly equivalent to Treasury paper at the Federal Reserve borrowing window. And this comes at a time when the Fed is lowering its benchmark rates toward “teaser” levels. What happens when foreign investors wake up to the fact that they are being paid “teaser rates” to hold paper of a very questionable quality. Will the U.S. Treasury then be able to roll over its debt (of which 40% or so is held by foreigners)? Or will there be a “default event” that is allowed to occur about once in the lifetime of a nation before others wise up? Although their grandparents presided over steadily improving U.S. credit, Baby Boomers and their immediate predecessors and successors may end up insuring that their children and grandchildren will have impaired credit in global markets for at least a century.
The U.S. government cannot prevent someone from taking losses on the foolish lending/borrowing discussed above, because those are losses on loans that have already been booked. What the government can do is to determine who gets to eat the losses – borrower, lender, U.S. taxpayer, or foreign investor. There is no question that the piper is about to be paid, and in a big way.Link here.
IS IT TOO LATE TO BUY GOLD?
What gold owners can learn from the stock bull market of the 1990s.
For contemporary market analysis, history begins in the year 1971 when the dollar was detached from gold and the era of free floating gold and exchange rates began. First, we had a gold bull market which began in 1971 and lasted until roughly the 1982/85 time period. Then we had a stock bull market that began in between 1982/85 and topped in roughly 2000. The current bull market in gold began in 2000 and, if it were to follow form, could be expected to top sometime around 2015-2017.
There is a lesson to be learned from the history of the stock market for contemporary gold investors – particularly those reluctant to purchase gold at the current prices because it seems “too high”. Those holding back may be guilty of short-term thinking. Let me tell you why.
Most analysts say the stock bull market began somewhere between the years 1982 and 1985. The Dow Jones Industrial average traded in the 800 range through the late summer of 1982. In January 2000, it peaked during intraday trading at 11,750. Many analysts see the 2000 top as the end of the bull market. The DJIA rose nearly 15 times over that 18 year period.
If you were to apply the same arithmetic progression to gold from the inception of its bull market in late 2001, when it traded at roughly $270, a top comparable to the Dow’s would put its price in the neighborhood of $4050. When viewed from this perspective, gold at $750 looks very reasonably priced. Some things to consider:
History’s lesson is that there is no predictable top to the price of gold during a fiat money binge or crisis. Theoretically, the top extends to infinity, or as long as the inflation lasts, or until the arrival of the inevitable bust. Even then, gold will serve more than adequately for the more cautious savers among us.
* Monetarily speaking, everything progressed smoothly on the island of Yap where large stones weighing hundreds of pounds were transported around to serve as money. That is until something unforeseen happened to the value of the money. For centuries, the stones served in exchange because there was not much of this type of rock on Yap itself. The depreciation of the stone money began when an enterprising Western businessman realized he could produce stone money cheaply and in copious quantities on a neighboring island and transport it to Yap, where it could be used to procure goods in demand elsewhere. In other words, this oceanic cousin of John Law printed Yap stone money to buy his wares at what might be called a “favorable” discount. By this process, the yap stone money was debased until it became worthless. Little did the citizens of Yap know that they were deprived of their wealth, and their money destroyed, by the process of monetary inflation.Link here.
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