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THE GREAT CREDIT UNWIND OF 2008
"The current crisis is not only the bust that follows the housing boom, it is basically the end of a 60-year period of continuing credit expansion based on the dollar as the reserve currency. Now the rest of the world is increasingly unwilling to accumulate dollars." ~~ George Soros, World Economic Forum, Davos, Switzerland
It is becoming evident in a hurry that Federal Reserve Chairman Bernanke's big 75 basis points cut in the Fed Funds rate last week has done nothing to slow down the credit deflation that began last year and has gathered steam this month. LewRockwell.com's Mike Whitney updates:
Global market turmoil continued into a second week as stock markets in Asia and Europe took another tumble on Monday on growing fears of a recession in the U.S. China's benchmark index plummeted 7.2% to its lowest point in six months, while Japan's Nikkei index slipped another 4.3%. Equities markets across Asia recorded similar results and, by midmorning in Europe, all three major indexes -- the UK FTSE "Footsie", France's CAC 40, and the German DAX -- were recording heavy losses. It is now clear that Fed Chairman Bernanke's "surprise" announcement of a 75 basis points cut to the Fed Funds rate last Tuesday has neither stabilized the markets nor restored confidence among jittery investors. ...
In Monday's Financial Times, Harvard economics professor, Lawrence Summers, made an impassioned plea for further government action in addition to the Fed's rate cuts and Bush's $150 billion "stimulus plan." Summers believes that steps must be taken immediately to mitigate the damage from the sharp downturn in housing and persistent troubles in the credit markets. He suggests a "global coordination of policy" with the other foreign central banks. It is a tacit admission that the Fed has lost control of the system and cannot solve the problem by itself.
Summers is right, although it is easy to wonder why he remained silent for so long while the markets were soaring and the investment banks were reaping trillions of dollars in profits on a "structured investment" swindle which has left the global financial system teetering on the brink of catastrophe. Now that the U.S. economy is sliding towards recession, Summers has suddenly found his voice and is calling for "transparency". How convenient.
Yes, exactly. While Wall Street is fobbing off its shoddy merchandise on the way up nobody complains (including the buyers). Then when the product recalls start coming in, a bailout is suddenly needed to save the system. Those that were cheerleaders, but not direct participants in, the whole scam can afford to tell everyone to come clean.
"Financial institutions are holding all sorts of credit instruments that are impaired but are difficult to value, creating uncertainty and freezing new lending. Without more visibility, the economy and financial system risk freezing up as Japan's did in the 1990s."
Right again. The banks are "capital impaired" because they are holding nearly $600 billion in mortgage-backed assets which are declining in value every month. This is forcing many banks to conceal their real condition from investors while they scour the planet for the extra capital they need to continue operations. As long as the banks are in distress, consumer and business lending will dwindle and the economy will continue to shrink. The main gear in the credit-generating mechanism is now broken. The rate cuts can provide liquidity, but they cannot bring insolvent banks back from the dead. Summers is expecting too much.
Not just the banks. The whole Wall Street credit multiplier mechanism has copious amounts of sand in its gears. Rate cuts are the equivalent to adding oil without cleaning out the gears first.
The U.S. has led the world into the greatest credit bust in history, and yet, few people have any idea of what has transpired. The U.S. current account deficit -- nearly $800 billion -- has been recycling into U.S. Treasuries and securities from foreign investors. Up to this point, American markets were an attractive place to put one's savings. The dollar was strong, and the stock market had a proven record of profitability and transparency.
But since President Bill Clinton repealed Glass-Steagall in 1999, the markets have been reconfigured according to an entirely new model, "structured finance". Glass-Steagall was the last of the Depression-era bulwarks against the merging of commercial and investment banks. As a result banking has changed from a culture of "protection" (of deposits) to "risk taking", which is the securities business. Through "financial innovation" the investment banks created myriad structured debt instruments which they sold through their Enron-like "off balance" sheets operations (SIVs and Conduits) to credulous investors. Now, trillions of dollars of these subprime and mortgage-backed bonds -- many of which were rated triple A -- are held by foreign banks, retirement funds, insurance companies, and hedge funds. They are steadily losing value with every rating's downgrade. Here is a graph which illustrates how the scam works.
Summers, of course, understands the enormity of the swindle that has taken place beneath the noses of U.S. regulators [which begs the question of whether the regulators noticed what was going on, but let it go], but chooses not to hold any of the main actors accountable. Instead, he draws our attention to a little-known part of the market which will probably lead the way to a stock market crash and a system-wide meltdown. ...
Summers asserts that is critical that sufficient capital be infused into the bond insurance industry quickly. (See this entry from last week.) "Their failure or loss of a AAA rating is a potential source of systemic risk," he claims.
Some of the largest bond insurers are currently unable to cover the losses that are piling up from the meltdown in mortgage-backed securities (MBSs) and collateralized debt obligations (CDOs). Their business model is hopelessly broken and they will require an immediate $143 billion bailout to maintain operations. The largest of the bond insurers is MBIA. ... Barclay's estimates that the investment banks alone are holding as much as $615 billion of structured securities guaranteed by bond insurers. If the insurers default, hundreds of billions will be lost via downgrades. So, in practical terms, what does it mean if the bond insurers go under?
It means that the system will freeze and the stock market will crash. Here's how TV stock guru Jim Cramer summed it up last week in an interview with MSNBC's Chris Matthews:
"But, Chris, there is something I would urge all the candidates to think about and our Treasury Secretary, which is that there are a group of insurance companies which insure all these bad mortgages and, Cris, I think they are all about to go belly-up, and that will cause the Dow Jones to decline 2,000 points. ... I am telling you that these companies do not have the capital to "make good." And when they do fall, and I believe it is when -- if the government does not have a plan in action; you will not be able to open the stock market when they collapse. No one is even talking about the fact that these major insurers, who insure $450 billion of mortgages are all about to go under." (See the whole video.)
Cramer is correct in assuming that the market will not open. And yet, so far, nothing has been done to avert the disaster which lies just ahead. Maybe nothing can be done? So, how did things get so bad, so fast? How could the world's most resilient and profitable markets be transformed into a carnival sideshow peddling poisonous "mortgage-backed" snake-oil to every gullible investor? Author and stock market soothsayer Pam Martens puts it like this:
"How could a layered concoction of questionable debt pools, many of dubious origin, achieve the equivalent AAA rating as U.S. Treasury securities, backed by the full faith and credit of the U.S. government, and time-tested over a century of panics, crashes and the Great Depression?
"How did a 200-year-old 'efficient' market model that priced its securities based on regular price discovery through transparent trading morph into an opaque manufacturing and warehousing complex of products that didn't trade or rarely traded, necessitating pricing based on statistical models?" ...
How, indeed? The answer to all these questions is "deregulation". The financial system has been handed over to scam-artists and fraudsters who have created a multi-trillion dollar inverted pyramid of shaky, hyper-inflated, subprime slop that they have sold around the world with the tacit support of the ratings agencies and the U.S. political establishment. (wink, wink) Now that system is about to collapse and there is nothing that the Federal Reserve can do to stop the Great Credit Unwind of 2008. As economist Ludwig von Mises said:
"There is no means of avoiding the final collapse of a boom brought on by credit expansion. The question is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved."
Money: Pathology and Reality
Predictably, governments' ideas for resolving the current financial market and economic dislocations are anything except helpful. LewRockwell.com has some reading suggestions if one is looking for constructive responses:
Recent daily articles on Mises.org and LewRockwell.com have addressed the economic downturn, and the unbearably bad response from Washington and the Fed. These people have learned all the wrong lessons from the Great Depression. There is nothing that the planners will not consider at this point: wage and price controls, floods of new money, exchange controls, protectionism, hundreds of billions in public works -- you name it.
The good news is that all the literature necessary to combat this nonsense is in print. The Austrian perspective is there to make sense of the current economic mess.
Suggestions include Americas Great Depression and The Panic of 1819 by Murray Rothbard; Money, Bank Credit, and Economic Cycles by Jesus Huerta de Soto; The Causes of the Economic Crisis by Ludwig von Mises; and, finally, The Case for Gold by Ron Paul and Lewis Lehrmann. (Has the ever been a U.S. presidential candidate who wrote a scholarly economics text?)
Now They Tell Us
Moody's says it is hard to evaluate the risk in complex mortgage securities.
A common chacteristic of ratings from major debt rating agencies is that they are a lagging rather than leading indicator. They are pretty useless when major shifts occur. So you have to do your own research and analysis, as Forbes points out:
It is well known that debt rating agencies like Moody's Investors Service and Standard & Poor's underestimated the trouble brewing in subprime mortgages, awarding top marks to securities now creeping close to default. But now Moody's has released a report conceding that rating agencies were not up to the task. Any expectation it could fully uncover risk in the maze of complex financial instruments was, it says, "somewhat unrealistic." ...
It sure looks like a case of lowering the bar after tripping over it. Pierre Cailleteau, Moody's chief international economist and head of its sovereign risk unit, says he wrote the report because he wanted to look beyond the symptoms and dig up the causes of the credit market turmoil.
One knock on agencies is that the most obvious risks seemed to surprise them. Standard & Poor's still awarded its top rating to deals that closed in June of last year, as concerns over exotic mortgage securities became widespread, only to downgrade a large swath of similar deals months later. The troubled bond insurer MBIA sported at press time a triple-A rating from both Moody's and Standard & Poor's, the same mark given to the U.S. Treasury. The $1 billion in notes it sold last month to stave off a downgrade wound up with a 14% coupon, a high payout even for junk bonds.
Of course, people have been beating up on the ratings agencies for years -- hardly a market drop goes by without allegations that they are overly optimistic, too slow to downgrade and beholden to the bond issuers who pay their bills (see chart). "We need to instill more uncertainty," says Cailleteau, who notes Moody's is mulling changes, such as adding a distribution of possible outcomes along with the letter grade. Or maybe investors need to do more of their own thinking and digging.
AGGRAVATING THE AGONY
"For a country, everything will be lost when the jobs of an economist and a banker become highly respected professions." ~~ Montesquieu
"You can count on Errol Flynn, he'll always let you down." ~~ David Niven
Continuing on the "unbearably bad response from Washington and the Fed" track from the post above, economist Robert Anderson assigns heavy blame for ill-advised government economic intervention to academic economists. They are apparently unable to see through their bogus Keynesian theories, and keep advising government to pursue the same idiotic policies time and again. Whether it is the fault of the economists, or is effect of the madness of crowds -- and government and government-plus-citizenry are surely crowds -- acting on the imperative to "do something" does not really matter. ("There is no more independence in politics than there is in jail," said Will Rogers.)
"Insanity is doing the same thing repeatedly and expecting a different result" has been repeated so frequently that it has become a cliche, but it is more than a propos to such meddling.
It began with Adam Smith telling us in 1776 that the sole end of productive activity is consumption, followed by Jean Baptiste Say telling us in 1803 that the great producing nations are the great consuming nations. But it took until 1936 for John Maynard Keynes to turn effect into cause by declaring that "consumption is the key to prosperity."
Today that fallacious belief is deeply ingrained in "macro-economic theory," another fallacious concept which is utterly useless to an understanding of economics. The consequence, as mainstream economists accepted these dual economic fallacies as valid truths, has been to inflict much economic harm. ...
Austrian economic theory explains fully why the manipulation of fiat money and fiduciary credit by government intervention is the sole cause of a general business cycle leading to "booms and busts." Further, it explains how an unhampered market is continually self-correcting as entrepreneurs respond to the vacillating signals of the market generated by the behavior of guiding consumers. It is only when these market signals, prices and interest rates, are distorted by government manipulation of money and credit that entrepreneurial errors get magnified and concentrated, resulting in significant mal-investments of scarce economic resources which brings forth the inevitable "government-sponsored" economic bust. ...
It is an economic tragedy of our time that manipulation of money and credit by government is considered an essential and necessary role to be performed by a monopoly monetary authority. Critically ignored is the economic truth that any manipulation of the money supply, up or down, generates an economic disutility resulting in resource pricing errors and, thus, future mal-investment of scarce resources. This government-imposed monetary manipulation, alone, is the singular cause which leads to the generalized phenomenon in an economy which is called an "economic boom." ...
Since the Federal Reserve's Board of Governors are unwilling to progressively expand the money supply further, which they know will lead to hyper-inflation, they are now confronting the inevitable economic bust stemming from their past actions. They have brought upon themselves a day of reckoning which can no longer be avoided.
The horrible irony is that the monetary authority, the Fed, which generated today's developing crisis is now viewed as the only entity which can resolve the crisis ... without question a case of the fox protecting the hen house. Even worse, the economic error (monetary manipulation) which has led to today's economic crisis is about to be compounded with the additional economic error that "consumption is the key to prosperity." Sadly, the cost of acting on an economic error, especially when it is compounded with another economic error, will be exceedingly high as this country is about to learn.
In some sense, one's well-being or "prosperity" today is indeed a function of one's consumption today. An inherent tradeoff in life is, of course, that consumption today comes at the expense of consumption tomorrow, for an individual or for a whole economy. One of the pernicious theories that came out of the Great Depression was that it was caused by people saving "too much." The "cure" was to encourage them to consume more now. The idea is fallacious to the core (see "The Keynesian Corner"), but ever since government has acted as if it were gospel. It provides an all too convenient justification for government to act as it is inclined to act anyway, and defer today's problems until tomorrow.
Obviously the proper behavior toward past mistakes is to stop making them. Thus, the correct course for monetary policy now is simply to do nothing. If the Federal Reserve Bank truly wanted to achieve a successful, long-term market response for its past blunders, it would simply stop meeting and go home! Of course that is not going to happen. Nor will the Fed respond with a policy of higher interest rates and monetary deflation, even though such an unwise policy would abruptly end the economic boom with economic agony of another magnitude. Mises used to say that responding to past inflation with future deflation makes no more sense than backing over a person who has just been run over by a truck. The proper solution to inflation is always to simply stop doing it!
With the markets now facing credit default swaps threatening counter-party solvencies, collapsing leverage among hedge funds, defaulting loans consuming bank capital, rising home mortgage foreclosures, and most importantly, debt-burdened consumers forced to reduce future spending, the inevitable economic bust is now rapidly developing. We know if the market process were left unhampered it would correct the economic problems which the government's earlier monetary manipulation had generated, and after markets once resolved those economic problems, the market process would once again restore a viable economic recovery. ...
Unfortunately, government intervention imposes a heavy hand on all of us. The erroneous interventionist policies which are advanced now to "stimulate the economy" assure a long and painful economic period ahead. The fallacious Keynesian belief that "consumption is the key to prosperity" is about to cost our economy dearly ... again! ...
Toward such hopeless ends the Federal Reserve is now lowering interest rates in a futile effort to resolve the harm which their earlier inflation has caused. In addition, the politicians are about to forcibly transfer money from tax victims to tax beneficiaries through "rebate checks," a destructive act they call "fiscal stimulus." Economic destruction inflicted by government manipulation of the market is painful to watch! ...
It is utterly astounding that a government policy of encouraging consumption through "rebates," an action which when the rebates are consumed can cause only further wealth destruction, cannot be seen as a means to further impoverish the economy. An economic understanding of wealth creation should cause us to know that only increased savings and the productive employment of those savings can raise an economy's real material standard of living. As Jean Baptiste Say told us over two centuries ago, "In the aggregate production and consumption are one and the same. To consume we must first produce." It is merely fantasy thinking to believe that government, the seizer and plunderer of wealth, can somehow enhance the economic well-being of its citizens by forcibly transferring wealth from one person to another through rebate checks.
Pursuing economic fallacies always leads to harmful economic consequences. And clearly that is what is happening today. Consequently, the outlook for our economic welfare ahead is indeed bleak, and will remain so until either the agony caused by these erroneous ideas, or new economic enlightenment, lets the freedom of the market process once again restore prosperity and the higher material standard of living which it always brings forth.
The more government interferes with the natural workout process, the longer the workout will take, at greater cost to everyone. The Russian default crisis in 1998 was over practically before it began, because people took their medicine and moved on. Debt holders wrote down the value of the debts quickly, risk-oriented buyers stepped in, asset ownership got reshuffled, everyone dusted themselves off and bellied up to the bar for another round. On the other hand, it has been almost 20 years and Japan has still not recovered from the collapse of its 1980s boom, because, well, let the incomparable "Mogambo Guru" explain:
[I]in the last 18 years or so, Japan had the lowest interest rates in the world since their stupid economy collapsed in 1990 because their stupid central bank had stupidly created too much money and credit for too long, and instead of letting the stupid idiots and stupid crooks lose their stupid money, the stupid Japanese government forced interest rates to almost literally zero so that stupid bankrupt businesses could always borrow enough money to keep from having to declare bankruptcy! Hahaha! What racket!
Economic Outlook: More Darkening Clouds
"Fasten your seat belts; it’s going to be a bumpy ride."
More inveighing against government interference in the economic sphere, starting with the staggering economic ignorance displayed in this year's political campaign:
Every American, from the top Fortune 500 CEO to the youthful fast-food hamburger flipper, owes his standard of living -- the highest in the world -- to free market capitalism. It is capitalism -- private property and free markets -- that provides the information and the incentive that allows each of us to maximize the value of our economic activity. Yet to hear the (mostly) Democratic presidential candidates tell it, free markets are faulty, unfair, and inherently unstable; indeed, government should constantly regulate markets and ride to the rescue whenever recession threatens.
The overall economic ignorance displayed in this year's political campaign has been staggering. Instead of calling for balanced budgets, sound money, permanent tax reductions, and less regulation, most of the candidates have called for more inflation and more government intervention.
Hillary Clinton, for example, has said that she personally intends to "manage the economy" not understanding, apparently, that the "economy" is simply a metaphor for the billions of individual decisions made every day that no one person could ever "manage". Recently, all of the Democratic candidates and several of the Republican candidates (and President Bush) have advocated various economic "stimulus" programs (including rebate checks in the mail) not understanding, apparently, that any one-time spending shot (with borrowed money) will fix precisely nothing. (Lower individual and corporate tax rates would be helpful, however.) And finally, several of the candidates want a short-run government moratorium on millions of impending mortgage foreclosures not understanding, apparently, that breaching contractual agreements and postponing the economically inevitable is not necessarily a smart thing.
The most significant area of economic ignorance, of course, is with respect to the Federal Reserve policy. All of the candidates, both Democratic and Republican (excepting Congressman Ron Paul) have applauded the Central Bank's recent decision to dramatically lower the federal funds target rate to 3.5%; it may even be pushed lower. (The federal funds rate is the rate at which banks lend to other banks). To accomplish this reduction will require massive purchases of government securities by the Federal Reserve Open Market Committee which, in turn, will make mountains of new liquidity available to potential individual and institutional borrowers both here and abroad.
Now this is a good thing, right? WRONG.
During deep recession with high unemployment and significant idle industrial capacity, some economists (not me) would advocate an aggressive "easy money" policy to jump-start the economy. Be that as it may, that is emphatically NOT the current situation. Additional liquidity from the Federal Reserve now would only serve to prop up tottering malinvestments (mostly in housing and finance) that are themselves the creature of the last Federal Reserve money bubble. Further, additional liquidity will give rise (at the margin) to additional malinvestments that themselves will never be successfully completed due to a dearth of real savings. Were all of the candidates asleep during the "business cycle" lecture in Economics 101?
Further, any new aggressive easy money policy will only further weaken the value of the dollar and eventually lead to more price inflation. ... To save Wall Street speculators and influential financial institutions (that took absurd risks), the Fed now appears willing to drive the real rate of interest (rates adjusted for inflation) to near zero. Now if that does not deepen and aggravate all of the on-going economic distortions already in place, I do not know what will.
In conventional terms, the only thing worse than a recession in the U.S. would be world-wide INFLATIONARY recession. Well, the Federal Reserve and the Bush Administration have now set us up for exactly that dismal scenario. As Betty Davis growled in All About Eve: "Fasten your seat belts; it's going to be a bumpy ride."
THE D BOMB IS DROPPED
Bob Prechtor and his associates at Elliott Wave International are an interesting riddle. More than a few of his/their big picture prognostications have been spectacularly right. In the late 1970s and early 1980s Prechtor was extremely bullish on the prospects for stocks. In 1982 the Elliott Wave Theorist published a prediction that the Dow Industrials would hit 4000 when it was still in the 800s. In 1983 he foresaw a "mania" in stocks. The EWI staff also was correctly long-term bearish on gold all the way through the metal's 20-odd year bear market that began in 1980.
They have been equally wrong in their trading advice at times. It is as if they sometimes forget how ornery markets are in practice. In 2001/02 the EWI people were predicting that the long bear market in gold would culminate in a plunge below $200 before a new bull market commenced. (Reminiscent of those -- not Prechtor -- who thought the Dow would take one last dip into the 600s in 1982 before bottoming, and instead got a lesson in the wisdom of Baron Rothschild's success formula: "I never buy at the bottom and I always sell too soon.") Gold followed a different drummer and refused to fall below the mid-200's. As it started a steady march upwards, EWI's analysis kept arriving at the conclusion that what looked like a bull market was a bear market rally. Now here we are at $900+.
Prechtor and staff also repeatedly and prematurely called for a stock market top during the 1990s. Having foreseen the mania, and seeing what would logically follow, he pushed his luck by trying to call its top with precision. In 1995, when the Dow had yet to see 5000, Prechtor's book At the Crest of the Tidal Wave: A Forecast for the Great Bear Market, was released. The book vividly depicted the then-current excesses of the credit mania, and the comeupance sure to follow. The only trouble was, the book made a compelling case that the dangers were imminent. The first claw swipe of the "Great Bear" was 5 years off, and that one was not fatal. Finally vindicated by the brutal bear market of 2000-2002 (in tech stocks and the major indexes, but not in the value stocks that sat out the mania), they then failed to see the major revival to new highs in the Dow and S&P that followed.
Bottom line: (a) We are not privvy to an in-depth analysis of their trading calls, hence cannot say how profitable in real life EWI's advice has been. (b) We think there are limits to any technical approach such as Elliott Wave analysis. Times when the model and the market are out of synch are especially dangerous to one's wallet.
Per the warnings in At the Crest of the Tidal Wave, EWI has consistently and vocally "called out" the credit expansion/bubble. Their view was that this decade's excesses were the culmination of a trend that has been going on since the debt liquidation of the 1930s gave way to debt rebuildup. They forecast the credit expansion would exhaust itself, to be followed by credit revulsion and contraction ... and then deflation and depression -- and in no uncertain terms. From Prechtor's Conquer the Crash (2002): "The U.S has experienced two major deflationary depressions. 1929-1932 followed a period of substantial credit expansion. Credit expansion schemes have always ended in a bust. This bust, however long it takes, will be commensurate." Now such thinking is creeping into the mainstream. You can be sure it has done more than just creep into the thinking of Bernanke & Co.
It has happened. One widely read financial daily very recently dropped the "D" bomb. The article compared today's economic situation not to the 1987 affair with a happy ending, but to the much "darker metaphor" of the Great Depression in 1929.
The main similarity, according to the article was this: The all-out rescue efforts of the financial powers-that-be to stop a downturn and push the economy onto solid ground. Then as now, two main bodies carry out the task: the central bank and the White House.
1929: The Federal Reserve promises "cheaper credit" and slashes the discount rate from 5.5% (1929) to 0.75% (1932). At the same time, U.S. President Herbert Hoover creates an "Economic Stimulus Plan" to provide $160 million in tax relief to the public.
2008: On January 22, the Federal Reserve approves an emergency 75-basis-point rate cut, the largest single reduction in 23 years (and fourth cut in four months). Days later, U.S. President George Bush encourages Congress to support a $150 billion "Economic Stimulus" through tax rebates.
We know how the first story ended. But, whether the failure of the 1929 rescue is likely to be the ultimate comparison to 2008, the mainstream "experts" are divided: On one side, the pragmatist: It is too early to say.
And the other, the optimist: Yes, the three largest pillars of the U.S. economy -- real estate, credit, and banking -- are enduring their most severe downturns since the Great "D", and every other area from hedge funds to high-end housing, commodities to AAA credit is starting to show cracks in the armor, ONE major difference stands this experience apart: the stock markets.
Case in point: From its all-time September 1929 peak, the Dow Jones Industrial Average plunged a throat-gulping 90% to its 1932 low. Today, in spite of a sharp sell-off since October 2007, the Dow Industrials remain in the outer galactic 12,000 region.
Or does it? The fact of the matter is, only the "Nominal" Dow (as measured in U.S. Dollars) is orbiting record-high territory. The "Real" Dow (as measured in the only true currency standard, Gold Ounces) is actually 64% below its 1999 peak. (The "Real" NASDAQ is also down more than 80% from its 2000 peak.)
Which is to say, it is no exaggeration to compare the current economy to the environment which preceded the Great Depression; the facts speak for themselves. And, even if mainstream financial "experts" are beginning to acknowledge those facts, in truth they are years late in doing so. ...
Bottom line: The success of any economic stimulus plan depends on support by way of a positive social mood. In 1929-33, consumer spending on food, housing, clothing, and automobiles plummeted 40% to 60%, despite extraordinary efforts by the Fed and White House to open the floodgates of easy money.
SELL THE GARBAGE STOCKS SHORT
Dan Amoss, editor of Agora Financial's new Strategic Short Report newsletter, shares a sample of the offerings from the publication. Stocks that have levitated on nothing but hype during a bull market are prone to falling far and quickly when stock traders recover their senses. As always with shorting, you need good timing to go with a fundamentally sound appraisal.
2008 will be a good year for short sellers. The credit cycle is turning, and it threatens to bring consumption, also known as GDP, along with it. Nothing stirs up public fear quite like seeing sharp drops in house prices and the Dow Jones on the evening news.
Polls show that the economy is voters' biggest concern, so politicians are itching to enact a "stimulus plan". Such a plan will stimulate little besides political careers and consumer price inflation. The brilliant government ideas do not end with cash handouts, of course. A potential freeze in adjustable rate mortgages would also have consequences. It may soften the freefall in housing prices. But it would also scare off the timid bankers still bold enough to grant non-conforming mortgages. Any hopes of a recovery would be pushed years into the future.
The government is skating on thin ice in its proposals for outright property confiscation. By nullifying the legal contracts between borrower and lender, such a bailout would take property from fixed income investors who were expecting rising ARM payments to compensate for the extra risk in making the original loan. Fixed income investors -- many of them foreigners -- would lose a big chunk of interest payments. This would diminish the confidence foreigners have about their capital being safe in U.S. dollar assets. The Fed's rate cutting activity does not help either.
This type of political initiative strikes at the very heart of capitalism. It undermines the foundations of the U.S. as the safest, most attractive destination for international capital. As my friend and colleague Dan Denning often writes, to have a healthy, advancing capitalist system, it's important to have the freedom to succeed and the freedom to fail. Risk is being socialized in the U.S., and foreign investors will notice.
In 2008, it will be hard to convince foreign creditors to hold their existing dollar assets, let alone buy more. The stock market is adjusting to this changing reality. A healthy dose of fear has returned. Investors are finally bothering to glance at the fundamentals in their stock portfolios and eliminating the garbage.
Computer hardware retailers will be at the top of the list of garbage stocks in 2008. The industry has a history of short booms and long busts that add up to a sea of red ink. A small company called Systemax may be the worst among this motley crew. I first wrote about Systemax in the February 2007 issue of Strategic Investment, describing it as a business that "requires constant reinvestment of capital into new inventory -- inventory that grows more obsolete with each passing day."
In the frenzied stock market environment of early 2007, I was amazed at how speculators bid up the stock of this second-rate company to a multiple of 70 to 80 times sustainable free cash flow. Systemax is barely profitable in the best of times. To top it off, reading Systemax's financial statement footnotes and customer satisfaction ratings should convince investors that management has been using manufacturer rebates to artificially inflate sales and profits for years. ...
Systemax is the type of idea I am looking for in Strategic Short Report. Traders are fleeing from stocks like Systemax -- stocks that had been held up by momentum and hype. It is a good time to be selling short and buying put options on the worst of the garbage stocks.
OK, we'll bite. A look at SYX's price chart indicates that after oscillating around 20 for the last 5 months of 2007, that down from a 52 week high of 31, the stock has tumbled to between 13 and 14 this week. The stock fell two points or so alone since this analysis panning SYS (i.e., praising its virtues as a short) was released. The trailing P/E of under 10 looks cheap, but Amoss's view is that the earnings benefit from suspect accounting, and that they are low quality earnings because of how little is in the form of discretionary cash flow. Also, selling computer hardware is a lousy business period, so it does not deserve a high mulitple. SYX as a short idea is not suicidal on the face of it, but neither does it speak so loudly for itself that further research is not necessitated.
LEARNING TO BE A VALUE INVESTOR
An offbeat introduction to the concept of value investing:
Marty Whitman of the Third Avenue Value Fund is one of my favorite investors. With any luck, he will be one of my wife's, as well. My wife, like Marty, loves to buy things cheap. And she is not afraid to haggle.
It is not uncommon for me to sit on a mall bench with a book while she peruses store to store, negotiating a discount. "You'll be so proud," she says on a routine stop to my home base. "Neiman Marcus has a stunning Monique Lhuillier dress for half price, and I convinced the lady to take off another 10%."
I, of course, say to myself (and let me stress myself) that 50% off at Neiman Marcus is still 50% more than at most places. But my thought more often than not remains, well, just a thought. "What's the intrinsic value?" I ask.
My wife tilts her head, raises those eyebrows and without hesitation assures me it is more than the price. "And furthermore," in a tone that assures me the discussion ends here, "it's Saturday. Leave the finance downtown."
I chuckle. So goes the wonderful cadence of marriage.
My obsession with intrinsic value got her thinking. The other night, she opened up her brokerage statement. A few minutes later, she says, "Why does my broker have me in Apple? I thought you said Apple was too expensive."
"Maybe he likes iPods," I muse. She fails to find the humor.
"Seriously, Apple's price-to-earnings ratio is well above 30. That's expensive, right?"
"You should see the price-to-book," I quip, trying to focus on the latest episode of The Wire. She grabs the remote and pushes pause. We walk to the bookcase. 30 minutes later, I find my wife 10 pages deep into Christopher Browne's latest work, The Little Book of Value Investing.
It has been three days now. Last night, she started reading an advance copy of Chris Mayer's latest book, Invest Like a Dealmaker. So the first thing this morning -- and I mean first thing -- she asks, "How do you compare EBITDAs around various industries?" Not your typical teeth-brushing conversation, but nonetheless, I am very proud.
She has what it takes. She focuses on what she may lose well before she considers what she may gain. She sees the business, not the stock. ... So this morning, I sent her a recent letter from Third Avenue Management. I highlighted the following:
"Throughout Third Avenue's more than two decades of existence, we have experienced several bear markets, yet the macro market environment has never influenced the process by which we select investments. To repeat, Third Avenue invests for the long term.
"Third Avenue has faced securities bear markets in the past and no doubt will face others in the future. Yet for long-term fundamental investors such as Third Avenue, the general market is relatively unimportant. In the long run, the performance of Third Avenue's portfolios will be driven by the merits of the investments themselves, not by general market considerations. As such, we continue to focus on finding securities that meet our 'safe and cheap' investment criteria today, allowing for potential long-term growth in the future."
We, like the better minds at Third Avenue, have no idea which way the market is heading. In the short run, we do not really care what Mr. Market thinks. We know he has been wrong before.
As investors, we are looking to buy businesses that provide a margin of safety ... Companies trading near or below their intrinsic value with established earning power. Leave the charts and quarterly earnings reports to traders. They are playing a different game.
We are looking to buy a business, not trade it. And as with any good purchase, we never want to pay too much. Here is why ...
Let us say you receive a windfall bonus of $10,000. You want to invest your newfound wealth in one of two options. Option A is a government bond yielding 5% annually. Option B is market's latest highflying growth stock promising returns of 10% or more for the next 20 years. You naturally assume 10% is better than 5%, so you pour your $10,000 into the highflier.
As it turns out, you bought your golden stock on a 52-week high. The first year is rough ... the stock loses 50% of its value over the first 12 months. But you hang on, and sure enough, the stock starts taking off. It grows at a remarkable 10% annual pace. But even at a growth rate double that of the government bond, it would still take you 17 years to overtake that bond's return! [Diagrammatic representation here.]
Now, I am sure that tech stocks, swank hedge funds and their excessive fees and other "insider" investments make great stories. They make you feel good when you proudly tell your neighbor that your broker just slipped you into some exclusive nanotechnology company that promises to turn the Earth on its axis, reverse the spin and solve the world's energy problems all at the same time.
Meanwhile, my wife, the budding value investor, plans to keep a good portion of her money in a first-class company that supplies the world with cement. She notes that shares of the business trade for a very reasonable price. She also notes a recent report suggesting that modernizing urban water, electricity and transportation systems over the next 25 years, according to Booz Allen Hamilton, would require $40 trillion -- "a figure roughly equal to the 2006 market capitalization of all shares held in all stock markets in the world." She is convinced that is going to require one massive amount of cement. I agree.
And she will make her investments just as everyone should make their investments ... with a margin of safety.
FORBES STOCK PICKERS FESS UP
Forbes financial columnists start the new year by coming clean about how their trading recommendations of the previous year performed. The first batch of columnist house cleaning was covered two weeks ago. (See here, here, and here.)
Tug of War
Columnist and fund manager David Dreman is an advocate of buying large capitalization, low P/E, high yield stocks. He is a well-known exponent of the "contrarian" approach to investing -- deliberately going against the prevailing wisdom of other investors on the theory that the crowd is likely to go overboard when stocks go out of fashion. As will be seen, in at least one case the crowd was right and he was wrong.
Last year I got the overall market call nearly dead-on. I forecast an S&P 500 total return of 5% (it did 5.5%) and a 10% correction along the way (the index was down 9.9% between October 9 and November 26). I predicted that large stocks would outperform their small- and midcapitalization brethren for the first time in seven years. The Russell 2000 index of smaller stocks underperformed the big-company S&P by 7.1 percentage points.
I did not do well with my stock picks, which included a heavy dose of financial stocks. My 24 picks, including 7 held over from 2006, fell an average 7.5%, after hypothetical trading costs. Had you put the same amounts on the same dates in the S&P (without costs), you would have had a gain of 1.2%. It was the end of a good streak for me. Over the preceding six years (through the end of 2006), my recommendations increased an average 7% annually, triple what shadow investments in the S&P 500 would have done. Put back dividends -- these are not included in the Forbes computations -- and I would have scored significantly better.
Financial stocks looked cheap, at low multiples of earnings and good dividend yields, after their initial selloffs. But the earnings estimates turned out to be far too high when the first subprime loan writeoffs came in. With financial companies' built-in leverage, those writeoffs were magnified at the bottom line.
Two of Dreman's worst suggestions were short-selling recommendations of IntercontinentalExchange (ICE) and CME Group (CME), parent of the Chicago Mercantile Exchange. Both deal with commodities futures, which were hot as a pistol in 2007. His energy stocks did well, however, benefiting from the same inflation-driven trend.
I thought that the subprime crisis would benefit the big, established banks, as well as Fannie Mae (FNM) and Freddie Mac (FRE), as it crushed speculators like New Century Financial (CYFL.PK). I was wrong. High-quality financials suffered as much as they did in the early 1990s era of bad real estate loans and the savings and loan meltdown. At that time people feared for the survival of institutions like Citicorp. But everything turned out fine. The large banks' stocks wound up doubling very quickly. Add in dividends, and they expanded 10-fold within a decade. My longtime favorite, Fannie Mae, was down 33% for the year. Consumer lender CIT Group lost 42% from when I recommended it in October.
There was a gigantic bull market in finacial stocks from 1990-91 to 2005-06, roughly speaking, fueled by the virtual nonstop credit expansion of the period. Risky sector plays like New Century may have done the best, but stodgy conservative banks did extremely well too. Virtually all financials that did not go bankrupt far outperformed the broad market. It is almost always premature to buy into a former market leading group following its first major correction after a long bull market. No one is forcing you to buy. Hold onto your wallet for a while.
For 2008 I recommend holding on to these three gold-standard financials: Fannie Mae, Wachovia (WB) and Bank of America (BAC), as well as Washington Mutual (WM) and CIT Group (CIT). As the experience of the 1990s shows, they will have substantial upside once the current fright subsides. In my last column I warned you away from such pitfalls as highly leveraged real estate investment trusts and subprime lenders. In light of their deep wounds, these may not come back for years, if ever.
The assumption here is that the highest quality financials will avoid such "deep wounds". Maybe. Maybe not. Accurately assessing the balance sheet of any company is hard enough as an outsider. The consequences for guessing wrong are typically more drastic with a financial company, due to the leverage. The conservativism of the loan loss reserves is a primary make-or-break point. If you are unclear, you do not need to make a bet. As for a repeat of the 1990s experience, count us very skeptical. Too much has changed since then, and not in a good way. "We try to look for easy problems -- you can do that in investing," says Warren Buffett. We do not see financial stocks as being "easy problems" right now.
What is in store for the market as a whole? We will likely have a lot of volatility. Over the past year the annualized volatility implied by the prices of S&P options has gone from 10.4% to 22.5%. That trend will not reverse for some time. I expect the market to likely end the year flat or down somewhat. A real bear market, which we can define as a 20% decline, is quite unlikely from here. [The market is already down around 10%.]
On the baleful side of the balance beam: Dozens of threatening forces will continue to batter investor confidence and provoke scary visions of a recession. Rising material and oil prices will divert money that could go into consumer spending or capital outlays. They will also fuel inflation. Meanwhile, shell-shocked credit markets are making liquidity ever more scarce. Want to buy some nice junk bonds to fund that leveraged buyout? Did not think so.
On the positive side: A recession is not likely. The financial panic will gradually ease as we move into 2008. Investors will crawl out of their fallout shelters. Remember that this is an election year, and the incumbent party will do what it takes to prime the pump. Increased federal spending and more Federal Reserve easing are givens. My high-quality financial stocks will soar once that becomes apparent. Just as they did in the early 1990s, banks will maintain fairly good yields on their assets while their funding costs go down. BofA earned $4.70 a share in precrisis 2006. I think it will earn $5.50 or more in postcrisis 2010.
Look for sterling growth stocks that have been knocked down and now sport affordable price/earnings multiples. Lowe's Cos. (LOW), the home-improvement retailer, goes for 10 times depressed trailing earnings and Staples (SPLS), the office supplies chain, with 15%-to-20% growth, at 15 times.
Recessions and Bears
Laszlo Birinyi monitors money flowing into and out of markets and stocks via a sophisticated analysis of block trades. He has debunked many charting and other technical approaches to trading the market. His approach is interesting and reasonably persuasive in theory. In practice, as is so often the case in trading, things do not always work out quite so nicely. But he is always worth heeding.
John Kenneth Galbraith once said, "economists predict not because they know but because they are asked." At the start of every year economists, analysts and commentators venture forth with their predictions. I ignore their pronouncements because they have little, if any, accountability. These pundits seldom have to explain why they were right or wrong.
Forbes, however, does not let me off so lightly. By the magazine's accounting, my 2007 stock picks last year lost 1.1%; equal sums invested in the S&P 500 on the same dates would have left you with a 1.8% gain. (In this calculation my picks, but not the benchmark, are debited for a hypothetical 1% trading cost.) My best recommendation was Google, up 50%, followed by Apple, up 42%. The worst was New Century Financial; the subprime lender lost its entire value and now is in Chapter 11. Next worst was New York Times, down 33%.
One theme I sounded last year was the wisdom of buying dividend-paying stocks. My report card did not include dividends, and my results obviously would have been better had it done so. Of my 21 recommendations in the year, 6 had dividend yields over 5%.
Going into 2008, I am able to contain my enthusiasm. For one thing, Wall Street is bullish, which is typical for January, regardless of the market dip lately. The pundits, who told us last year that the subprime mess was "contained," are now shrugging off the banks' rotten floorboards labeled collateralized debt obligations, along with rising unemployment, high oil costs and weak corporate earnings.
This is the season for statistical fortune-tellers. One of their favorite talking points is the presidential cycle -- supposedly, the last year of a presidency is particularly likely to be positive. Supposedly, the second year of a presidential term is particularly likely to be weak. Our experts were intoning that immutable truth in 2006. It turned out, however, that the S&P 500 was up 14% that year (not counting dividends).
Another argument is that years ending in 8 tend to do well, years ending in 5 even better. This formula works except when it does not. The market was up just 3% in 2005. In other words, this bullish case for 2008 is based on what is probably just a statistical fluke.
The bearish arguments for 2008 are not any more valid. Many bears expect a recession, which they assume is poison for market performance. Not quite. In the 11 recessions since World War II the market has averaged a 3% gain, despite the inclusion in that data set of the 23% decline in 1974. During 6 of those downturns the S&P went up. If 2008 is a recession year, it is not automatically fated to be bad for stocks.
Birinyi likes American Express (AXP), "which like all financials has been beaten down by the subprime issue, even though the firm has zilch to do with housing." [The desire to "call the bottom" on financial stocks seems to be catching.] He recommends holding Apple (AAPL), Polo Ralph Lauren, Google (GOOG), as well as smokeless tobacco purveyor UST (UST) and railroad titan Burlington Northern Santa Fe (BNI).
Bearish commentators say defensive stocks like health care, consumer staples (soap, food, tobacco) and utilities are places to wait out the storm. Do not count on that wisdom. Data to support the durability of sectors like those are fairly recent -- first gathered in the late 1980s. Since then there have been only two recessions. Result: not enough data points to form a solid conclusion.
My researchers took the data back to 1962 (covering six recessions) and found that building-material stocks do the best. One possible reason is that investors are anticipating a post-recession uptick in housing construction. Health care, staples and utilities are in the middle of the pack. No sector consistently got murdered. Telecom, the worst, had an average decline of 7% in the six recessions since 1962.
These ending paragraphs are typical of Birinyi: He looks a little deeper at what passes for conventional wisdom on Wall Street, and finds it wanting. It would have been good if he had supported his other recommendations with commentary on money flows, or some other hint of his particular take on the picks.
Fund manager and newsletter writer Jim Oberweis loves small growth stocks, and does not hesitate to pay up for them -- a very different approach than that of a typical value buyer.
Value stocks could not outperform growth stocks forever, and they sure did not last year, especially in my specialty, stocks of smaller companies. After dominating this end of the market for seven years, value fell well behind. In 2007 the Russell 2000 Growth Index gained 7.1% as the Russell 2000 Value lost 9.8%. The reversal in the growth/value horse race was remarkable given the declining investor appetite for risk (thank you, subprime crisis) -- usually a death sentence for growth stocks.
When investor "appetite for risk" for risk goes down that means, loosely speaking, that the discount rate they apply to earnings goes up. The discounted value of the distant future earnings of growth stocks usually get hit harder than that of the higher current earnings of more mature stocks. Usually but not always.
But growth got so far behind that even after a relatively good 2007 it is still cheap. Stick with it. Consider the price/earnings ratios for companies with the highest growth rates. We look at those with 30% or more growth in the latest quarter. That is, the top 6% of small-cap companies in terms of recent earnings growth. The average P/E based on forward estimates for these supergrowth stocks over the last five years has been about 30. Right now it is 27, or about 10% below the average. This is down from over 40 in October of last year, which is among the fastest and biggest drops in the average P/E that we have seen.
Small tech stocks have had a rough start in 2008, but I think they are destined to rebound sometime this year. Certainly their prices may get worse before they get better. Yet nobody can call the bottom. Right now is a great buying opportunity.
Foreign investors likely will be the first to awaken to it. The weak American dollar gives them enormous purchasing power and a ready appetite for U.S. equities. Furthermore, a low dollar increases the competitiveness of U.S. companies with foreign customers. That is great news for high-growth tech companies with global distribution potential, as well as pharma and medical product firms. I predict we will see 10% to 30% gains for small growth stocks over the last 11 months of 2008.
The wild card for the rest of 2008 will be Asia. It is clear that we are in the early innings of a long-term global capital shift from Europe and America to Asia. It is also clear that some large Asian stocks, particularly those of the best-known Chinese companies open to outside investors, carry preposterous valuations. Do not be surprised if some of these stocks tank even as the companies do well.
Oberweis's favorites for 2008 include two "small-scale China plays", both with ADRs, Home Inns & Hotels Management (HMIN) and digital TV equipment provider China Digital TV Holding (STV), which sell at 28 and 26 times his 2008 earnings estimates. He considers the current level of pessimism about th U.S. economy and corporate earnings "unmerited". Favorite U.S. high-growth stocks are Priceline.com (PCLN), Synchronoss Technologies (SNCR), Omrix Biopharmaceuticals (OMRI), and Obagi Medical Products (OMPI).
Last year, all the turbulence aside, was a good one for this column. ... In 2007 I recommended 15 stocks and my group returned 10.6% versus 2.1% for the S&P 500. One advantage I had: My investment style stresses growth stocks, in favor last year. My best performer was Focus Media (FMCN), which tripled. Focus dominates the market for flat-panel display advertising in high-traffic hotels and office buildings in China. In the last 12 months revenues were up 129% to $390 million. Focus trades today at 29 times my forward earnings estimate, a bargain given this company's rapid growth rate. Hold on to your shares.
My worst performer was armored-vehicle maker Force Protection (FRPT). Navistar International arose out of nowhere as a successful competitor for Force Protection's military contracts, and Navistar has the staying power to survive any Iraq troop pullback. Sell Force Protection shares. Also sell the rest and start anew, except for two other 2007 keepers: touchpad maker Synaptics (SYNA) and robotic tumor-blaster maker Accuray (ARAY), which have dipped to very enticing levels.
More Baskets For Your Eggs
ETF specialist/newsletter writer Jim Lowell shares his 2007 highs and lows, as well as his look ahead:
With exchange-traded funds, you can take a steep route and reach splendid heights, but at risk of a severe fall. For such daredevils there are ETFs that hold just one position (gold), or just stocks in a narrow sector like green technology. For a safer route you can opt for a widely diversified fund, like the iShares Dow Jones Total Market (IYY). This fund holds thousands of stocks that are in the Dow Jones U.S. Total Market Index.
To say the least, 2007 was not an easy time for netting and holding on to gains. In a rocky year my 14 picks, which included two ETFs that short stock indexes (the Dow Jones industrial average and the Russell 2000), were down an average 3.4%. That was after subtracting a hypothetical trading cost of 1%. These picks, which began in the May 21 issue when I started my column, narrowly beat the market. ... My best pick last year was iShares Comex Gold Trust (IAU), up 9%; the worst, iShares FTSE/Xinhua China 25 (FXI), off 17%.
For the record, my two investment advisory newsletters fared well in 2007. My Fidelity Investor newsletter, which offers advice for investing in the galactic array of Fidelity mutual funds, has four model portfolios, which each beat the S&P 500 last year. My newly launched Forbes ETF Advisor delivered a 9.1% return. This year appears to be every bit as treacherous as 2007. With diversification as the watchword, keep all of my 2007 picks -- then add four more ETFs to the mix.
He likes the iShares tips Bond (TIP), which owns Treasury-Inflation Protected Securities. It is a somewhat safer alternative than the inflation and market hedges of gold and the short-selling ETFs. Also, the iShares Global Healthcare (IXJ), the PowerShares Dynamic Food & Beverage (PBJ), and the iShares NYSE Composite Index (NYC). The later is a basket of stocks that mimics the 2,300-name New York Stock Exchange Composite Index. It gives you a fairly broad exposure to the U.S. market, with some large foreign issues thrown in via ADRs. "The index has a noticeable dollop of financial-industry stocks. Financials are in the doghouse now, but they will have their day." [Another financial stocks bottom fisher.]
BERKSHIRE HATHAWAY ANNUAL MEETING 2007 NOTES (PART 2)
In about three months thousands of investors will make a pilgrimage to Berkshire Hathaway's 2008 annual meeting in Omaha, Nebraska in order to imbibe firsthand the truly exceptional wisdom of Warren Buffett and Charlie Munger. Below is a subset of some notes from the question and answer session following the 2007 annual meeting. The session covered a huge number of issues relevant to today's and any day's finacial arena. Original notes were recorded on May 7, 2007 by two gentlemen named Alex Dumortier and Jim Gillies -- who deserve thanks for the manifestly thorough job they did.
Part 1 was published in last week's Financial Digest.
Q: Your silver bullion investment -- why did you sell when you did? Did you sell to an exchange traded fund for cash plus a non-cash consideration?
Warren Buffett: Whoever we sold it to was a lot smarter than I was. I bought it too early, I sold it too early -- other than that it was a perfect trade. That was entirely my fault -- Charlie had nothing to do with that trade.
Charlie Munger: I think we have demonstrated how much we know about silver.
On how things would be different if Berkshire was only managing a small amount of capital:
Q: You have repeated several times that you could earn annualized returns of 50% a year if you were managing small amounts of money -- how would you accomplish this? Buy-and-hold investing or through Ben Graham "cigar butts", arbitrage, etc.?
WB: If I were working with a small sum, I'd be doing very different things than the things I'm doing now. Your universe expands -- you have many, many options, if you are investing that small amount. You can earn very high returns with very small amounts of money. Not anybody can do it, but if you know something about value investing, you can do very well. If we were deploying $1million, we would earn very high returns on capital. If Charlie and I were working with $500,000 to $1 million, we would find small things and they would not all be stocks.
CM:There is no point in thinking about that now ...
On the subprime market fiasco:
Q: What is your opinion on the subprime market?
CM: What we had was a combination of sin and folly. The accountants allowed the institutions to show profits on loans that no one in their right mind would have allowed to show a profit until the loan matured to a better condition. The minute you pay people high commissions to make loans to the "undeserving poor", or the "overstretched rich," you are in trouble. ...
WB: You have loans where some people were not even making the first two or three payments -- that should not happen. We saw a preview of this with the manufactured home industry years ago. Securitization has fed the problem. Discipline goes out the window. ...
On managed futures funds and other "alternative" investments:
Q: What do you think about managed futures funds?
WB: I would say that most logical structure is the one at Berkshire, where we can do anything that makes sense and are free to avoid anything not making sense. Any entity dedicated to a particular segment is at a disadvantage to one with no restrictions provided they are managed by right person. We do everything at Berkshire. It is a mistake to shrink the universe of possibilities (ours is shrunk by our size). There is no particular form that produces investment results (not hedge funds, private equite, mutual funds, etc.), otherwise it would suffice to call yourself by the name of that form. What really makes the difference is when the person in charge knows what he is doing,
CM: Averaged out, I expect that the return in a managed futures fund would be somewhere between lousy and negative.
WB: I agree -- people find out what sells. People will sell it until it stops selling.
On appropriately measuring risk:
Q: On the use of Beta ... Why would a rational investor substitute volatility (the opinion of the market) for their own intellect? Could you expand on your thoughts?
WB: Volatility does not measure risk. The problem is that the people who have written and taught about risk do not know how to measure risk. Beta is nice because it is mathematical, it is easy to calculate and it is wrong -- past volatility does not determine the risk of investing. In early 1980s, farmland that had gone for 2,000 an acre, went for $600 an acre. Beta shot up. I was apparently buying a riskier asset at $600 than at $2,000. Real estate is not frequently traded. Stocks give you the ability to measure this volatility nonsense
Because people who teach finance use the mathematics that they have learned, they translate volatility into all types of measures of risks -- it is nonsense. Risk comes from the nature of certain types of business, and from not knowing what you are doing. If you understand the economics of the business that you are engaged in and you trust the people you are partnering with, you are not running significant risk.
I don't think I can recall a loss on marketable securities with Charlie, even though we have bought securities with very high betas. Volatility as risk has been very useful for those who teach, never useful for us.
CM: We would argue that it is at least 50% twaddle, though these people have very high IQs. One of the reasons we have done well is that we recognized early on that very smart people will do very dumb things and we tried to figure out why (and who, in order to avoid them).
On evaluating the quality of company managements:
Q: You spend a lot of time evaluating the quality of the management of the companies you invest in. What do you suggest I focus on to determine the quality and integrity of management?
WB: We spent many, many years without meeting managements at all, without having an entrée. The $5 billion in stocks in the first quarter -- never met the management nor talked to them. We read a lot -- we read a lot of annual reports, we read about the industry and about a company's competitors. Obviously, when you are buying the entire business that is a different matter because you are getting in bed with them.
You can learn a lot by reading the annual letters. When they are clearly the product of Investor Relations and outside consultants, that tells you something about the person at the top. If they are not willing to take that time, once a year, to communicate with shareholders, I have got questions about that. I want to hear directly from somebody who considers me a partner.
The other day, I read the annual report for a large oil company, and I could not find their find their extraction cost, which is the most important figure for an oil company. They spent a lot of money this slick press release. That is a dishonest reporting; that makes a difference to us.
We have bought into good businesses run by people we did not particularly like. We bought because we doubted they could screw it up.
CM: There are two things we look for: good business and good management. It is a rare person that can take over a textile business -- totally doomed -- which is what Warren did in his youthful folly and turn it into Berkshire. You should not be looking for more Warrens.
WB: If you gave me first draft pick of all CEOs in America, and dropped them into a lousy business, I would not do it. A good CEO is dependent on too many external factors.
How far is there to go in the current lean period in the stock market?:
Q: If you were writing a follow-up to the prescient 1999 Fortune article you wrote in which Buffett divides the stock market history for the years 1965 through 1998 into two 17-year periods -- the first "lean", the second "fat", halfway through third 17 period, how will things turn out? What would you be writing?
WB: There is nothing magic about given spans of time. There was something very different between the first and the second 17-year periods. That first 17-year period was very different. I would say what I said earlier -- if I had long bonds or long-term equities, I would own equities, but not have high expectations. In 1999, people were extrapolating the previous 17 years, and expectations were bound to be disappointed -- simply had an unrealistic view. Today, I would not have high expectations, but I would have better expectations than for bonds.
If I had to own the long bond or equities, I would prefer to own equities and I would expect to earn something beyond 4 3/4%. How much beyond, I don't know, but something more than that. If I were writing something now, I would not have high expectations for equities, I would have modest expectations for equities.
CM: Since that article was written, equities have been decent. Warren is probably right now to have modest expectations.
WB: I can't say something important/intelligent every week. Every now and then, things really get out of whack. I closed the partnership in 1969. I did an interview in 1973 and then in 1981 and 1982. I wrote that article in 1999. If everything is overpriced, you should probably sell. The gradations in between are tough, but you don't have to have an opinion every day.
On learning who to trust and who not to trust:
Q: I have made a few mistakes in business by trusting the wrong people. How can I learn who to trust and who not to trust? They don't teach that in business school!
WB: That's a good question. ... We have good luck buying businesses and putting trust in people. People give themselves away fairly often. The very things they talk about, what they regard as important and not important, etc. are a lot of clues about their subsequent behavior. ...
CM: We are deeply suspicious when we hear something that sounds too good to be true.
WB: You can look at? Anything implicit in their comments or what they laugh about -- it ain't that easy. We get suspicious very quickly, we may rule out about 90% of people and we may be wrong 90% of the time, but the important thing is who we rule in. I may rule out some of the wrong people, but the people I rule in I feel very good about.
What expected rates of return do Buffett and Munger demand from their investments?:
Q: Superior business may not require that much of a margin of safety -- does that imply market rate of returns from the truly great business? How do you come up with your discount rate?
WB: Charlie reminds me I have never prepared a spreadsheet, but in my mind I do. We want a significantly higher cash return for a business, than for a government bond. ... If T-Bonds are 3%, then it does not interest us to buy a business that will return 4%-5% -- we would rather wait. We don't have a hurdle rate -- we have never used the term. I don't call Charlie up and say: "What's our hurdle rate today?"
CM: Hurdle rates -- just because you can measure something, does not mean it is right. There are no substitutes for thinking about a whole lot of investment options. Hurdle rates -- not that we do not have one in a sense -- do not work as well as a system of comparing things. If I have something that guarantees a return -- opportunity cost is paramount -- you want to make your decisions based on that. One of the things we use are comparisons. If I have something available that will earn 8% for sure and you show me a business that may return 7%, you don't have to think about it.
WB: In that example, we would not even be interested in a business that returns 8.5%.
How often do you review each position in portfolio?:
WB: When I had more ideas than money, I was thinking about existing positions more in order to put [the] money to work in [my] best ideas. Now that I have more money than ideas, I am really re-examining things less frequently. We still think about the businesses -- whether owned or stocks, we keep getting incremental bits of information. It is a continuous process, but without the idea of doing daily activity. If we needed money for a big deal -- $20 to $40 billion, and needed to sell $10 billion in equities to raise money, we would use the incrementally collected information.
Q: Ethanol thoughts?
CM: The idea of running automobiles on corn is one of the dumbest I have ever seen. You want a social safety net. The most basic safety net is food and now you are going to raise the cost of food? I love Nebraska, but this is not my home state's finest moment.
What are you doing to protect our company's portfolio against the perils of inflation?:
WB: We would not necessarily look at metals investing as any protection against inflation. The best protection against inflation is your own earnings power. The second best hedge is to own a wonderful business, not a metals business, not a raw materials business, but a wonderful business. If you own a business like Coca-Cola or See's Candy with a product that people are going to continue to give up a portion of their income for and that requires very little in the way of capital expenditures, you will do well. Berkshire won't do as well in high-inflation times as in low-inflation times, but we will do fine.
Why are they investing in the railroad industry (hardly a classic "Buffett business")?:
Q: What can you tell us about your views on the future profitability of the railroad industry and what might make that more exciting than what it has done over the past?
WB: I do not think it will be exciting, but I think their competitive position has improved somewhat. ... [H]igher diesel fuel prices are about four times as much a drag on trucking. Railroads were a terrible business 25-30 years ago, but a better business now. It will never be sensational, but we expect a decent return on capital. It can be a lot better than in the past.
How will the Berkshire company portfolio fare going forward?:
Q: Assuming a necessary margin of safety and proper changes in discount rates, do you think things will be stable, with our modest expectations, tight credit spreads, current account deficits, etc.?
WB: We think we are in a pretty good group of businesses given the world we face. We do not try to buy our businesses in terms of world trends. We do think about international competition, we do not want to buy a business that has a very high labor component, that can be shipped in from a low-cost country. You do not want to have something whose competitive position will erode over time. The variables you named do not bother us -- we will play the hand we have with the people we have. We have a lot of things going for us. They are not likely to produce huge returns, but we think we will do OK.
On the future of the U.S. dollar and its impact on Berkshire:
Q: In the last three years, the dollar declined by 25%-30%. I want to understand how it will impact Berkshire and the threat it poses.
WB: We think the dollar, over time, is likely to decline against most major currencies. We originally backed that opinion up with a transaction in foreign currencies that reached $21-$22 billion, but the carry on that transaction (the differential between interest rates) grew quite expensive, so we now prefer to focus on foreign businesses or businesses that have substantial foreign currency earnings. The United States is following policies that are likely to lead to further decreases in the dollar. We own one currency trade now -- it would surprise you -- we will tell you next year. ... Look to oil, the price of oil has gone up very little if you are European. We will need to think of currencies more in the future than most Americans have in the past.
What is the proper way a board of directors should function?:
Q: I am hoping that you can tell about interactions with board of directors, types of ideas exchanged. What is your model for the way in which a board of directors is supposed to function with management?
WB: Most shareholders have a distorted view of the way in which corporations have functioned over time. Most of the time, directors were sort of like potted plants. Management had an agenda and they did not really want the input of the board. If you have spent 25 or 30 years getting to the top of a company, you want to be the boss.
There are three roles for the board. Overwhelmingly, the job of the board of directors is to get a good CEO. The second thing is that if you have the right CEO, you want to be careful that there is not overreaching, because the CEO's interests may be different from those of the shareholders. The third thing concerns acquisitions. When significant deals come along, you need a balanced discussion of the economics of the transaction. The problem is that over the years, CEOs have only brought deals to the boards once they are basically done.
CM: I would say that on average, big deals have not been favorable for shareholders. That is the way to bet.
WB: I have seldom -- in fact, I don't think I ever -- have heard a discussion of what you are giving away in an acquisition relative to what you are getting. I hear discussions about dilution, etc. ... When I gave away 2% of Berkshire Hathaway to acquire Dexter shoes, it was the dumbest deal in history. I was not giving away 2% of Berkshire Hathaway then, I was giving away 2% of Berkshire Hathaway now. You all would be 2% -- more than 2%, actually -- but, you would all be a full 2% richer than you are today if I had not done that deal. ...
WB: I have been on some terrific boards. I was on one for Daily Documents. Everyone understood the business, everyone was making decisions in the best interests of the business, everyone was thinking like owners -- in fact, the directors all had a significant percentage of their net worth in the company.
What do they think of commodities?:
Q: There is an increasing exposure in your portfolio to commodities. What is your long-term view on commodities?
WB: We have no opinion on commodities. If we are in an oil stock, we think it is because we think it offers a lot of value at that price, not because we think oil is going up. If we thought that, we could just buy oil.
We like businesses that have low capital expenditures, because those are the only kind of businesses that have a chance of earning a decent return on capital. A business that requires significant capital expenditures year after year simply is not going to earn good returns; the world just does not work that way.
We have very little opinion about any commodity general. We think POSCO is the best steel company in the world; we bought it at four to five times earnings, it is the lowest cost producer, and we made 20% on the Korean won appreciating into the bargain.
CM: We are interested in businesses, not commodities, by and large over time.
On (former Buffett-favored business) newspapers:
Q: Dow Jones, Murdoch, what advice to give to long-suffering New York Times shareholders?
WB: I think the long-suffering shareholder has probably made a mistake -- we have said for a good many years that newspapers were overpriced as valuation was based on [looking through a] rear-view mirror, not [a] window. ... The position of newspapers today still reflects past inertia and momentum. I don't care how smart you are, the forces you are going against are inexorable. Not much any genius can do about that. [We] used to sell 300,000 sets of World Book per year, they now sell about 22,000 sets -- not through any fault of World Book. ... Buffalo News earnings are about 40% off the peak, and we have tremendous penetration and great management.
Shorting the Subprime Market
When some of the most intelligent and powerful minds in the financial world are all doing one thing, it can be very difficult for anyone to do anything else. With fortunes at stake, both personal and financial, going against the trend can sometimes lead to losses totaling in the billions.
If the winds are all blowing in one direction, it takes a brave and confident person to stand against those gusts and forge ahead into a new path. This is what two traders at Goldman Sachs did last year, and their bet paid off. These two traders, with a stronger stomach and a greater appetite for risk than most, went against the common thought on Wall Street and are now being lauded as financial heroes for their efforts.
In early 2006, like almost every other investment bank in the world, Goldman Sachs was exposed greatly to the booming subprime mortgage market. Goldman was doing a lot of business with the mortgage-backed securities that wound up exploding a year later, crippling many of Goldman's immediate rivals. So why did Goldman not suffer the same fate as Merrill Lynch, Bear Stearns or any of the other once-giant investment banks? The answer is quite simple: they took a huge risk.
Euros, Gold and the Fincial Times’s Person of the Year
[F]or all the good he has done defending the value of euros, Jean-Claude Trichet -- head of the European Central Bank -- may seem a weird choice for 2007 Person of the Year. But for saying one thing and doing another ... and for helping the forces of inflation to mass, even as he claimed to stand firm against them ... he has corralled the spirit of our financial age better than even Ben Bernanke at the U.S. Federal Reserve.
Jean-Claude Trichet, we salute you. Truly, you are the man of the moment!
From Too Big to Fail to Too Big to Care
Alan Greenspan's confirmation hearing was in July 1987. ... Toward the end of the hearing, Sen. William Proxmire declaimed the trend: "It seems to me that banking in this country, and finance in this country, is likely to move very sharply ... in the direction of concentration ... I think most senators, if they thought very long about it, might be very concerned too. And I think the American people would be concerned too."
A coincidental development was the socialization of risk, unwritten (at least in legislation), but gradually understood by all: the "too big to fail" doctrine. The government bailout of Continental Illinois in 1984 made it plain that the federal government would not allow one of the largest banks in the country to suffer insolvency.
In the same year that Continental Illinois was born again, 1986, Henry Kaufman, then the managing director and chief economist at Salomon Brothers, wrote an important book, Interest Rates, the Markets, & the New Financial World. As is often the case with books published well ahead of their time, nobody read it. Kaufman saw that banks would augment their balance sheets and profits by securitizing mortgages, consumer credit and commercial property. Financial derivatives were young. He expected these markets to explode. ...
[Said Kaufman:] "Institutions with aggressive [derivative] models will get the business and garner the profits. Senior managers will find it more difficult to resist increasing pressures to compete using riskier models, especially if doing so would cause the earnings and stock process to lag behind those of institutions deploying riskier models. Ongoing financial intermediation and balance sheet leveraging also will continue to support riskier modeling on the near horizon." ...
In the end, both Proxmire and Kaufman tacitly conceded defeat to the monster they saw so clearly and that may devour us all. Proxmire concluded: "This nomination should result in a slam-bang debate in committee and the floor. It won't, and it is startling, given what you have told us."
At the end of his 2007 speech, Kaufman noted that decisive changes in economic thought occur only after collapse: "In light of this pattern, it seems unlikely that a new economic philosopher will come forth with an integrated economic and financial approach anytime soon. Today's most influential economists have strong vested interests in preserving the integrity and reputation of their views ... especially for those who have reached a leadership role. A lifetime of research and writing is at stake."
The Fed Follows the Market -- Not the Reverse
[After the Fed's formal announcement of the rate cut, the] Dow Industrials immediately shot up some 200 points ... and then gave it all back by the closing bell. The reversal does not always happen that quickly, but being born yesterday is the only decent excuse for being "surprised" by the market's up-quickly-then-quickly-back-down price action. The same thing has happened more than once since the Fed began cutting rates last year. The Federal Reserve cannot change the dominant trend of the stock market.
What is more, the notion that interest rates "follow the Fed" is an even bigger myth. See for yourself. ... The mythology of the Fed will not die easily; if facts were relevant, the myth would have evaporated long ago.
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