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GREENSPAN’S LAST BUBBLE HAS POPPED: GOLD
And now back to the deflationists ....
Gary North is back arguing the case for deflation, this time with the backing of a sharp $100+ correction in gold. Gold and commodities in general were certainly due for a correction after the recent froth. Whether it is any more than that we are dubious. But the tape will do what it will do. No matter how compelling your theory is, be prepared to be humbled by the market.
North's case for deflation has been based on his assessment that the Fed has been deflating. Simple enough. He has argued that if you look at the correct measure of money supply -- not M3 -- you would reach a similar conclusion. "I realize that you have read article after article about Federal Reserve inflation," he writes. "All of them were wrong -- not a little wrong or sort of wrong, but completely wrong."
So, yee of little faith, now do you believe him?
"Greenspan gaveth, and Bernanke hath taken away." Put a different way: "Ludwig von Mises was right. The Federal Reserve System is wrong." (This rule is always correct -- as Mises used to say, with "apodictic certainty.")
I knew gold's decline was near. Also silver's. How did I know? Because I understand Mises's theory of the business cycle. The central bank inflates. This creates a boom. This creates sectoral bubbles. Then the central bank ceases to inflate. The bubbles will pop. The economy will go into a recession
On Monday, March 17, I posted this article on my website: "How to Short Gold and Still Keep Your Gold Coins." I had asked a specialist in commodity futures to write it the previous Friday. He sent it to me on Saturday. I scheduled it for automatic posting at 12:01 Monday morning. That article must have seemed strange all day Monday. Gold was at $1,005. In the aftermarket, it rose to $1,029. Then it fell back.
Why did I have this article written? Because I have believed for months that the Federal Reserve's policy of monetary deflation would at last break the commodities market, which I believed had all the characteristics of a bubble. This was the last remaining Greenspan bubble.
On Friday, March 14, I wrote this article: "In December, I Predicted Disinflation. Now It's Happening. Is Your Portfolio Hedged?" It was posted on Saturday. I reported on the most recent figure for the Consumer Price Index for February: 0% price inflation. I wrote this: "There are good reasons to invest in gold and silver. Inflation hedging in 2008 is not one of them." ...
On that same day, March 15, I posted this article: "What Is This Gold Chart Signaling?" I wrote:
The general commodities boom is adding fuel to the fire. Of course, this can reverse along with commodities in general. Recessions push down commodities prices. I have discussed this before.
When you buy coins, buy for the long haul. If you are buying bullion stored offshore, you should be prepared to sell half your holdings -- not all at once -- if gold moves down. Pick a price move and stick with it, such as $50. Sell 10% of your holdings for every $50 move down. If you are in a gold ETF, the same rule applies.
These articles, posted on Saturday, were the background material for the article on Monday on how to short gold. On Monday, the base metals fell sharply: copper, zinc, lead, and aluminum. I wrote an article predicting that gold would be next. I posted in on Tuesday. It was titled, "What Base Metals Are Saying About Gold." I wrote:
Hold gold bullion coins. These are for hedging against disaster. They are held to pass down to children. Don't buy them as a hedge against inflation in 2008. There is neither monetary inflation nor price inflation today. The CPI in February was flat: 0%.
In a recession, short-term credit is king. This is why the T-bill rate fell on March 17 to 1.11%.
If you are not sure which way gold is going, but you want to hold your physical position, you can short gold. What you lose in one account, you will make in the other. This is a break-even strategy.
Do not sell yet, but get ready emotionally to sell. If gold falls to $949, sell 10% of your bullion position, or short enough bullion to protect 10% of your investment. Sell 10% on $50 moves downward: daily closing prices.
Consider this: events that would push gold up to $2,000 would collapse the stock market. But a recession could drive down both gold and stocks. It is safer to sell gold and use the money to short stocks. I do not see the stock market rising and gold falling for months on end.
By that point, I was convinced that the bull market in commodities had ended. Gold would soon follow. So, I wrote a long essay that explained in detail why I thought that it was time to sell gold or short it. It was posted on Wednesday, March 18. I opened it to the general public, so that everyone could see the logic of my warning. I titled it: "Every Investment Strategy Needs an Exit Strategy, Even Gold. Do You Have One?" I made it clear in that article that I was using Mises' theory of the business cycle to make my prediction. ...
On that day, gold, silver, and platinum fell like stones. Gold was down almost $50. It breached the $949 figure. So, I took my own advice. I sold a chunk of my gold. I did not sell all of it. But I decided that it was time to begin taking profits. I report all this to let you know that what I am going to tell you here, I told my site's members before it happened. I saw this one coming.
I define deflation as "a decline in the money supply." Deflation produces price deflation. Precious metals' prices do not normally rise in a deflation. When they do, it is because they are in a bubble. Deflation will pop the bubble. Deflation has now popped the bubble.
I have repeatedly warned my readers that the Federal Reserve was deflating. I have warned for a year that under Bernanke, FED policy had changed, that he was determined to whip inflation, and that the FED was barely inflating -- in the range of 1% a year. If you have read my reports, you knew about this shift long ago.
I kept saying that all forecasts based on the useless and misleading M3 figure would turn out to be wrong. M3 has always vastly overrated the rate of monetary inflation. The FED was correct in scrapping it in 2006. So, to make my position crystal clear one last time, I posted this article on February 18: "What the Federal Reserve Is Doing to Solve the Credit Crunch. This Is Getting Little Publicity." I began the article with these words: "The Federal Reserve is deflating." Then I offered evidence. I opened this article to the general public.
I realize that you have read article after article about Federal Reserve inflation. All of them were wrong – not a little wrong or sort of wrong, but completely wrong. We now see the effects of deflation: a CPI of 0% and a falling gold market. Housing is falling. This has not happened since the Great Depression. The T-bill interest rate fell to 0.61% on Wednesday, March 18. I have not seen T-bill rates under 1% in my adult lifetime. We are seeing a frantic dash to liquidity. This is a deflationary mentality. In the Great Depression, T-bill rates fell below 1%.
One might ask at what point or whether people will start treating gold as money. We will refer to our blog entry which kicked off the year, here, which cited an article titled "Can we Have Inflation and Deflation All at the Same Time?" It today's confusing times it is worth revisiting that article periodically because -- contra North -- it is conceivable that gold could rise, as denominated in Federal Reserve Note "dollars", even as the liquidity scramble intensifies. It really depends on the degree to which confidence in the whole financial system falters. It comes down to which dollars where are you using as your measuring stick. It you sell gold to buy dollars which you store in a bank or brokerage and suddenly those dollars disappear, it was obviously a bad trade.
Will the FED inflate? Of course the FED will inflate. But it is not inflating now. This is why gold is falling now, and why real estate is falling now.
Will gold come back? Yes. The question is: How far will it fall? The other question is: Will you sell gold now and buy back more later? I do not mean sell all of it. I mean sell some of it and sell more of it as the price falls. Then buy gold when you think inflation has returned. Sell gold mining shares first. Then sell bullion. Then sell a few coins. Sell the coins last, and maybe not at all. You can short gold to protect the value of your coins. The money you lose in holding the coins is offset by the profit you make by shorting.
The FED has been in deflation mode ever since last August. We are now seeing the results. The equity markets are falling. Treasury bonds have risen. It is going to take a complete reversal of FED policy to re-inflate this economy. The solvency of major firms and investment banks is at risk. Mere fiat money at (say) 6% per annum will not save them. The capital markets are unraveling too fast.
I do not recommend getting rid of all your gold because there are still offsetting factors, such as war with Iran, a falling dollar, a major terrorist attack, a major purchase of gold by a central bank.
There is another factor: the bullion banks. They have borrowed gold from the central banks for an annual interest payment of 1% per annum. They have used the money from the sale of this borrowed gold to buy bonds. Rising gold prices threaten them with bankruptcy. They do not have enough money to buy back the gold and return it to the central banks.
In a deflation, gold falls and bond prices rise. This two-fold action will save the bullion banks. These banks are where the elite invest their money. They will be able to unwind their positions. They can sell their bonds and re-buy gold if the want to. If I were them, I would want to.
What is happening is a dream come true for the bullion bankers who borrowed gold to get money to invest in bonds. If they start buying gold to repay the central banks, this will put a floor under gold. That is why I think gold will not collapse in price to $100 or anything like that. But I think it will fall enough for the carry trade in gold to be unwound quietly.
That is why I recommend selling 10% of your gold in response to $50 downward moves. I do not know where the bottom is.
This recession is going to be a bad one. You need to protect your investments against deflation. I still recommend foreign currencies. I have for years.
AS BANKS SEIZE MORE PROPERTIES, THEY ARE STARTING TO CUT DEALS
Banks holding defaulted mortgages are starting to emerge from a state of denial. They are taking their medicine and selling foreclosed homes at a loss, but at least recovering some value on their loan. This would seem to be a favorable development. Most of us have had the experience of waiting for a battered stock to recover so that we could get out at break even, only to see it tank further. We learn the value of having stop-losses. Likewise, banks are finding they are best off cutting their losses early.
As the transaction volume on these sales rises we can also hope that a credible aggregate number for post-housing bubble mortgage losses will start to arise from the mists of uncertainty now enveloping that market. Once this happens, markets can start to function and the system can adjust. Until then, there will be such a huge range of uncertainly that the system will stay frozen.
We foresee a possible consequence for the banks they may regard as less than favorable. When insurance companies decided to pursue a strategy of paying off claims quickly -- even suspicious ones -- because it was cheaper to do this than defend themselves, it of course encouraged more fraudulent claims. Here, once people become aware that banks are in "let's make a deal" mode, they are more likely to jump ship on an under-water mortgage, knowing they can get a bargain on the house down the street. How much more likely? Figure on people becoming progressively more savvy regarding the calculation of when money saved exceeds transaction and other associated costs.
Last summer Wells Fargo was in a bind: A Rochester Hills, Michigan couple had taken out a $465,000 mortgage they could not pay back without selling their home. But no one was willing to pay such a high price. So the bank tried to recoup the debt in a foreclosure sale. Still no takers. In February, after watching prices in this Detroit suburb crater, the bank threw up its hands, selling the 4-bedroom brick colonial for $325,000. "There are definitely deals to be had out there," says Alex R. Inglis, 39, who just bought the home.
Banks are rediscovering that old industry saw about the first loss being the best. After months of spurning so-called short sales, in which they have to accept less than they are owed, banks in some communities are throwing in the towel and cutting deals. Realtors, investors and credit counselors in a few hard-hit areas like Phoenix, Las Vegas and Detroit say banks are not only approving more short sales but are even calling to revive old rejected offers. If the trend spreads, it could mean the crisis in housing finance could come to a peaceful conclusion without any taxpayer bailout. Goldman Sachs estimates that if prices fall another 15% this year, the number of upside-down homeowners, i.e., owing more than their house is worth, will jump from 9 million now to 15 million.
Las Vegas broker Robert Tracey says banks are not only approving more short sales but are also doing it faster -- in three weeks instead of last year's six. The National Short Sale Center, which helps short buyers negotiate with banks, says Countrywide approved the sale of a Mesa, Arizona home recently in only 25 days -- though it was taking a 27% hit. The Short Sale Center says 3/4 of its short offers are approved now, up from maybe half six months ago. Says Pam B. Canada of nonprofit NeighborWorks in Sacramento, California, "Before, people on the phone at banks did not even have the authority to negotiate. Now they are calling us with numbers."
In Port St. Lucie, Florida, a rival of San Diego and Las Vegas for title of the nation's foreclosure capital, 3-bedroom homes are down a third to $180,000 in only 18 months. Of homes sold now, 90% are short sales by defaulted homeowners or by creditors that have seized properties. "When we used to put in offers [to lenders] we would get slapped in the face," says broker Brad M. Myers. "But now they say, 'Oh, you are from Port St. Lucie? We'll send an appraiser over right away.'"
Myers says that a year ago he found someone willing to buy a vacant 3-bedroom home for $75,000. The banks, owed $180,000, demurred. So the house sat, unsold, while prices kept dropping. In December the banks gave up, selling for $67,500 -- 10% less than the first short offer. Myers figures the money lost was double if you include maintenance and taxes, another reason deals now are moving fast. "The market is working again," says Myers, juggling 70 short sales now, up from 20 in the summer.
To be sure, many agents and counselors think banks still have their heads in the sand. "They are out to get the last dime, even when people don't have a dime," says agent Heidi Mueller in San Francisco as she heads to an auction sale on the courthouse steps. Quips a frustrated Tacoma, Washington broker, when asked if banks have changed: "Well, they seem more friendly now." Jim B. Walker, a real estate agent in Roseville, California, notes grimly that 389 homeowners in nearby Elk Grove are hoping for bank approval for short sales -- even though only 14 such sales have closed so far this year.
But he pulls up a recent listing and brightens. Washington Mutual, which is owed $629,000 on a home in the community, recently listed it for $319,000. The offer has drawn ten bidders. "The tide may be turning," he says.
U.S. MORTAGE MARKET NATIONALIZED
Credit Bubble Bulletin editor Doug Nolan, a longtime Fannie Mae and Freddie Mac critic, posits that recent actions freeing them up to participate still more heavily in the mortgage market with still less required capital represents a de facto nationalization of the U.S. mortgage market. The narrowing spreads between U.S. Treasury debt and that of the Government Sponsored Enterprises would indicate that the market concurs.
"Having lived contently for years with the markets' interpretation of the (grey-area) 'implied' government backing of the GSEs, our policymakers are surely today satisfied with the inferred market acceptance of mortgage industry nationalization," Nolan writes. He further notes that the bailout of Bear Stearns is rather trivial in both its implications and consequences when compared to the "Quiet Coup" of the de facto nationalization.
And what will come of this further step-up in government involvement. "I am certainly familiar with the view that bailing out Wall Street and the speculators is medicine necessary to stabilize the system. But not only is this approach both inequitable and unethical on moral grounds, it is my view that such endeavors will prove only further destabilizing for the system overall," writes Nolan. Indeed the ultimate result will be that the day of reckoning is at best delayed, while having increased the costs to us all: "Nationalization will prove a further blow to already fragile confidence."
March 21 - Washington Post: "To Understand Wednesday's decision by federal regulators to let Fannie Mae and Freddie Mac set aside less cash to protect against losses, imagine a family that keeps its precious antique silver in a strongbox on a high shelf, beyond easy reach. The regulators have essentially authorized Fannie and Freddie to pawn some of their family silver.
"Currently, the two firms, known as government-sponsored enterprises, or GSEs, have combined reserves of $82 billion. This includes an extra amount that the regulator, the Office of Federal Housing Enterprise Oversight (OFHEO), required them to hold while they got their books in order after accounting scandals. Now it is reducing that extra cushion by $5.8 billion. The newly freed-up money will leverage the purchase and securitization of up to $200 billion in home loans. The point, however, is not to save Fannie and Freddie themselves but to use the two firms, which buy mortgages and resell bunches of them to investors in the form of bonds, to ease the difficulties of borrowers more generally. It is as if our hypothetical family pawned its silver to help the neighbors out of a financial jam ... This is risky. If all goes well, freeing up the GSEs will buoy mortgage lending, thus slowing or reversing the slide in housing prices ... But if housing continues to tank, and the GSEs rack up new multibillion-dollar losses on top of those they have already incurred in recent months, they will have that much less in reserve to fall back on. The GSEs enjoy an implicit federal guarantee, but reducing their capital for a purpose such as this, at a time such as this, goes a fair way toward making that bailout promise an explicit one."
I found OFHEO director James Lockhart's interview late Wednesday afternoon on CNBC worthy of documentation:
CNBC's Maria Bartiromo: "Some have been arguing that the blowup in Bear Stearns caused the Administration to reconsider policy responses to this crisis. The deal announced today is basically telling them that that is a fact -- that it really was Bear Stearns that pushed the government's hand. Is that true -- was it Bear?"
OFHEO Director James Lockhart: "Not really. We have been talking about this for a long time. I have been talking for many months about the need for these two companies to raise additional capital. And I have talked for over the last year that once they got remediated and fixed their books and got them on a timely basis, we would start looking at removing that 30% excess capital charge we had on."
Bartiromo: "It seems to have taken a long time. A lot of people -- from hedge fund companies to certainly the lenders -- have wanted the restrictions eased for some time. What was the biggest barrier and what went away over the last several weeks in order to push your hand?"
Lockhart: "I think the key thing was three weeks ago they did actually produce their '07 financial accounts on a timely basis. And we have gone through all the consent agreement issues and they are virtually finished on them as well. We thought it really was the appropriate time. They now have the proper systems and controls -- proper risk management. And we think it really is a time they can help the mortgage market in a big way."
Bartiromo: "We are talking about a big number, too. Some $200 billion in the market. What's the best case scenario, sir -- what would you like to see -- what specific mortgages do you want these two guys to buy?"
Lockhart: "Well, I think they should be a player in many segments of the market. I think certainly, as (Fannie CEO) Dan Mudd just said, the conventional mortgage market has really weathered this storm pretty well because Fannie and Freddie have been there for the last year. But they could do more there. They are just getting into the 'jumbo' market next month, and certainly they will need capital to do that. And there is a lot more that could be done in the subprime -- refinancing some of these people into safer mortgages. And, also, just loan modifications. So there are a lot of ways that this capital can be used to improve the mortgage market."
Bartiromo: "Are you expecting the capital at all to be earmarked for some of the passthrough CMOs -- I mean the really troublesome securities that really did in Thornburg or Carlyle Capital or Bear Stearns, among others?"
Lockhart: "Carlyle Capital was actually holding Fannie and Freddie's securities and the spreads widened dramatically -- which they have probably come back this week. But I think they will be looking at buying their own mortgage-backed securities. They may look at some other mortgage-backed securities as well. I think we need to increase the trading. And as both of them said this morning, they need to be a bid in the marketplace to buy those securities."
Bartiromo: "And just the idea that they are a bid in the marketplace to buy those securities obviously was really celebrated in terms of investors and the idea that now there is a buyer there. How long do you expect this process to take? And how long do you think it will take to actually get this moving -- liquidity back into the market and a feeling of stability?
Lockhart: "Well, it may take awhile. The mortgage market is one issue, but there are some other markets out there as well. I think this is going to be a major step forward. As you said, they can do $200 billion in purchases immediately. And to the extent they are guaranteeing mortgage-backed securities -- that could almost get into the trillions. We are looking at that they would have the capacity -- between what we did today and the significant capital raising that they committed to -- they could do over $2 trillion in business this year if the market needs that money."
As long-time readers are all too familiar, I have been a persistent critic of the GSEs. These behemoths of historic credit excess -- instigators of the mortgage finance and housing bubbles -- liquidity backstops for the ballooning leveraged speculating community -- and instrumental agents for an unparalleled misallocation of financial and economic resources -- are proving themselves the Freddie Krueger of systemic distortions and policy failures.
It would be an outright crime if thinly-capitalized Fannie and Freddie were allowed to increase their Books of Business (mortgages retained on their balance sheets and MBS guaranteed in the marketplace) by $2 trillion this year -- "if the market needs that money." I was shocked when Mr. Lockhart imparted that they were now in a position to accomplish such a feat. It is certainly a terrible idea to put Fannie and Freddie guarantees on millions of new mortgages created from restructuring loans of troubled borrowers. This would amount to nothing less than a despicable transfer of massive prospective credit losses directly to the American taxpayer (current owners of this paper should not be bailed out).
I have fully expected the GSEs, at some point, to be taken over by the federal government. It may have been orchestrated subtly, but I can only presume that such a historic endeavor was accepted this week as the only means of averting financial dislocation. And for their regulator to suggest that the GSEs today have any handle whatsoever over their unfolding "risk management" challenge is wishful thinking -- at best.
As far as I am concerned, much of the U.S. mortgage market was this week essentially nationalized. I will take the dramatic narrowing in agency debt and MBS spreads as support for this view. Additional support arrived from comments from Mr. Lockhart, Mr. Paulson, and actions by the Federal Reserve. Having lived contently for years with the markets' interpretation of the (grey-area) "implied" government backing of the GSEs, our policymakers are surely today satisfied with the inferred market acceptance of mortgage industry nationalization. To be sure, the Fed's splashy "Sunday Night Special" bailout of Bear Stearns is rather trivial in both its implications and consequences when compared to Thursday's Quiet Coup.
I have my own hunches about the rise and inevitable fall of the GSEs. I have always assumed that the Greenspan Fed was pleased (relieved?) to watch Fannie and Freddie morph in the early '90s from conservative mortgage insurance providers to aggressive bank-like lending institutions and market operators. GSE credit creation (and timely market interventions) worked greatly to alleviate the forceful economic headwinds created by an impaired banking system. I also (admittedly, rather cynically) pictured President Clinton, Treasury Secretary (and former Goldman Chairman) Robert Rubin, and Budget Director (and former Fannie vice chairman and so-to-be CEO) Franklin Raines behind the closed doors of the Oval Office plotting the exploitation of the GSEs, Wall Street finance, system mortgage credit, and housing inflation for the orchestration a politically expedient economic boom. After beginning the '90s with assets of $454 billion, the GSEs ended the decade with balance sheets that had swelled more than 3-fold to $1.723 trillion.
In the latter years of the '90s, global financial crisis coupled with political foible -- not to mention Wall Street's rapidly growing power and influence -- granted the GSEs carte blanche. And then there was the market hysteria surrounding Y-2K, followed by the bursting of the technology bubble, the terrible terrorist attacks, and then the 2002 corporate bond dislocation. By the time accounting irregularities surfaced in 2004, GSE assets had almost reached $3.0 trillion.
I also have a hunch with regard to Greenspan's now infamous prodding of households into adjustable-rate mortgages. I think he recognized clearly the degree to which the impaired GSEs (and their scantily capitalized counterparties) had become acutely vulnerable to a rise in market yields. As the Maestro, his interest-rate policies (market manipulations) orchestrated a massive shift of interest-rate risk from the financial sector to the household sector. In the process, however, recklessly low interest rates spurred unprecedented mortgage lending and speculative excesses that today imperil borrower, lender, leveraged speculator and system stability alike.
Somewhere along line, I think the Fed came to appreciate the extent to which they had relegated monetary (mis-) management to the agencies (and their Wall Street enthusiasts). Meantime, some politicians belatedly came to recognize what an affront the GSEs had become to the pricing and allocation of system credit, as well as to the functioning of free markets more generally. Especially after the 2004 revelation of massive fraud and gross system inadequacies, a consensus developed in Washington that the GSEs needed both restraint and a powerful regulator (although the legislative details were much too slow to materialize). Apparently, all these justifiable concerns were chucked out the window this week in the name of "system stability".
After first reaching $2.0 trillion in 1999, Fannie and Freddie's combined Books of Business surpassed $5.0 trillion in January. This "Book" increased $638 billion, or 16%, last year, in what will surely be the greatest transfer yet of risky mortgage credit to the GSEs (only to be greatly outdone in 2008). Interestingly, OFHEO, Washington politicians, and Wall Street analysts are keen to play a dangerous game pretending that there is limited risk in guaranteeing MBS (as opposed to the obvious risk associated with mortgages retained on their balance sheet). The absurdity of Mr. Lockhart stating that the GSEs will be in a position to take on an additional $2.0 trillion of mortgage risk this year is simply incomprehensible. Keep in mind that the GSEs are on the hook for the "timely payment of principle and interest" on more than $5 trillion of American mortgages -- and counting ... Such obligations will, in the post-bubble era, prove untenable.
I remember when my old "analytical nemesis" Paul McCulley would refer to himself as a "populist" (I still prefer my "inflationist" characterization). Well, where are our "populist" statesmen today? The "average American" is getting slammed by rapid inflation in the prices for fuel, food, healthcare, education and other basis necessities. He was duped into various dangerous mortgage products to purchase homes with, in many cases, grossly inflated market values. Millions are in the process of losing virtually everything. He was also duped into various risky investment products, while the bursting of bubble markets will leave him dreadfully unprepared for retirement. Now, he is seeing the returns from his savings crushed by the melee to bailout Wall Street "money changers" and speculators. Over the coming months, millions will lose their jobs with the inevitable adjustment and realignment to cope with post-bubble realities. And now, apparently, the American taxpayer is to sit back and watch his contingent liabilities balloon (even further) with the nationalization of the U.S. mortgage market.
I understand perfectly the motivation Wall Street, the Administration and the Fed have in blindly throwing the "kitchen sink" at this unfolding crisis. These are indeed scary times bereft of solutions. I am certainly familiar with the view that bailing out Wall Street and the speculators is medicine necessary to stabilize the system. But not only is this approach both inequitable and unethical on moral grounds, it is my view that such endeavors will prove only further destabilizing for the system overall.
Many are this weekend undoubtedly relieved by the market's strong rally. The Fed and Administration finally are said to have discovered the right antidote -- crisis resolved -- buy financial stocks! I will caution, however, that U.S. and global markets this week had "dislocation" written all over them. First of all, there is the issue of a problematic dislocation in the massive "repo" market to resolve. We all should hope and pray that this is not the next "contemporary" financing market buckling under the forces of contagion. And to see commodities break down while financial stocks go into spectacular melt-up mode forebodes only greater losses for leveraged speculators in the troubled "market neutral" and "quant" arenas. The short financials and long commodities "pairs trade" was quickly added to the list of favorite trades gone sour. And those (and there were many) using March options (especially financial sector derivatives) to hedge market risk saw this strategy go up in flames as well. Speculators that were long international markets against shorts in the U.S. were similarly crushed. And speculators hedging with short positions in agency, agency MBS, and many other fixed-income derivative indices quickly found themselves on the wrong side of hasty developments.
Surely, policymakers were keen to mete out some punishment on the increasingly destabilizing "systemic risk trade" (shorting stocks, bonds, credit derivative indices, buying bearish derivative products, etc.), but the upshot was only further destabilization. News that the GSEs were back in the game in a big way added to an already highly unsettled situation for myriad sophisticated trading strategies. But before getting too excited about the spectacular short-squeeze, keep in mind that shorting has become an instrumental facet of leveraged speculator trading strategies -- and, really, "contemporary finance" more broadly speaking. And the disintegration of an ever increasing number of hedge fund and Wall Street strategies, as I have written previously, remains at the heart of deepening monetary disorder.
Not surprisingly, the Fed could not risk a Bear Stearns failure -- not with all of its derivative, "repo" and counterparty exposures. It really was not a difficult fix. Yet the rapidly lengthening line of vulnerable non-bank lenders (Thornburg, CIT Group, and Rescap come immediately to mind) and hedge funds will pose a greater challenge. There are some very substantial balance sheets at risk and significantly more "deleveraging" in the offing -- and the big banks will have no appetite.
The S&P 500 is down a modest 7% from the much changed financial and economic world of one year ago. While having little impact on the unfolding credit crisis (or home prices), policymakers have thus far largely succeeded in sustaining inflated U.S. stock prices. But, in reality, the profound deterioration in the U.S. and global credit backdrop has greatly altered prospects for the vast majority of companies, industries, and the U.S. and global economies more generally. Despite any number of policy actions and all the good intentions imaginable, there is absolutely no way that the U.S financial system will now be capable of sustaining either the (pre-bust) quantity of credit or the uniform flow of finance that levitated bubble economy asset prices, household incomes, corporate cash-flows, "investment" spending or consumption. Huge sections of the credit infrastructures (notably throughout Wall Street-backed finance) are inoperable and disCredited. Prominent monetary processes have been broken and the resulting flow of finance radically revamped.
Prospective credit and financial flows will prove insufficient for scores of companies, as well as for state and local governments and various entities all along the economic food chain. Enormous numbers of business downsizings and failures -- many by companies that thrived during the Bubble Era -- will lead to huge losses of jobs and incomes (many at the "upper end" where the greatest excesses transpired). I simply see no way around it -- nationalization of U.S. mortgages notwithstanding. It is fundamental to my analytical framework that efforts to subvert the unavoidable adjustment process only extend the misallocation of finance and real resources, while adding greatly to the future burden of the financial institutions today aggressively intermediating very risky pre-adjustment credit (certainly including the banking system and GSEs). And I certainly do not believe this week's rally in the dollar should be viewed as a vote of confidence for the direction of U.S. policymaking. Nationalization will prove a further blow to already fragile confidence.
THE FINANCIAL MARKET OF 2013
Martin Hutchinson thinks that the ongoing financial crisis will be long and deep enough such that "the risk-tolerant, even risk-seeking culture prevalent on Wall Street for the last generation will be gone." To our minds, this cannot come too soon. Hutchinson then speculates on what a post-restructured Wall Street will actually look like. For example, any institution that is "too big to fail" would also be too big to recklessly speculate. Financial innovation would come from a variety of smaller institutions, which in general would have to live by the value they actually add rather than depend on their access to suckers with capital to burn. The financial sector will deflate back to its historical proportion of the economy. Lots of interesting ideas.
The Bear Stearns bailout was not quite unprecedented; Continental Illinois Bank in 1984 and Citicorp in 1991 were both beneficiaries of Fed-orchestrated rescue operations. And notoriously, the hedge fund Long Term Capital Management was not allowed to fail in 1998. However since the mortgage crisis is by no means over, and further financial difficulties seem likely to appear as the U.S. recession deepens, it raises the interesting question of what kind of U.S. financial system we can expect to see in 2013, after the storm has passed.
Economically, we can expect to be climbing out of the current unpleasantness by 2013 -- it may be prolonged, but probably not quite that prolonged. This is not Japan, and given the choice of a short sharp shock or 15 years of stagnation, most U.S. voters would choose the short sharp shock. In any case, capital spending has been depressed since 2001 and corporate balance sheets have markedly improved; thus we are to some extent already 7 years into the process of recovering from the dot-com bubble. Nevertheless, the financial system in 2013 will have a memory of a debt crisis, followed by a sharp decline in housing prices, followed by inflation, followed by a decline in stock prices. It will not have been a pleasant five years, and financial market participants, both institutional and individual will have been scarred by the experience.
Financial market structure in 2013 will probably be very different from today. How different depends on the degree of pain suffered by market participants in the intervening five years, and the actions taken by the authorities in their attempts to clean up the mess and return markets to an even keel. Those matters are intrinsically unknowable. While one can forecast with some assurance the general shape of an economic downturn, one cannot be sure of its depth, nor of the order in which traumas occur, nor of the political position, economic resources and sheer basic competence of the authorities attempting to deal with problems.
It is just possible that the impending downturn will be relatively mild, in which case the financial market structure and ethos will be only modestly changed, as it was by the 2001-02 downturn. That outcome is however fairly unlikely given the apparent scale of impending losses. In what follows I have assumed that serious and repeated losses will have provided Teaching Moments for market participants and regulators, and will have pushed the market structure beyond the "tipping point" at which fundamental change occurs and a new equilibrium structure shakes itself out.
In that event, of a recession and financial crisis that takes Wall Street beyond the "tipping point" at which a new structure appears, the risk-tolerant, even risk-seeking culture prevalent on Wall Street for the last generation will be gone. In addition, government will have stepped in with new regulations, some of which like the Glass-Steagall Act of 1933 that separated banking and investment banking, will decades later prove to have been counterproductive.
In all probability the most structurally significant of those regulations will involve the "too big to fail" doctrine that has repeatedly brought the Fed to rescue of ailing behemoth banks and investment banks. If an institution is too big to fail, so that taxpayers are ultimately at risk for its actions, then well designed legislation would also prevent it from taking excessive risks. The ludicrous structure of the -- hopefully now moribund -- Basel II bank capital regulations allowed large banks to take more risks than small ones, while relying on their own dodgy risk management systems to monitor the mess. The huge checks that taxpayers will be forced to write in the downturn will bring huge political demands for legislation forcing "too big to fail" banks and brokers to act in a highly conservative manner in order to preserve their "too big to fail" status.
Under this new legislation, banks and brokers with more than a certain volume of deposits, capital or total assets will be compelled to register as "mega-institutions". They will benefit from an automatic Fed bailout, but in return will be compelled to submit to very strict capital ratios and restrictions on the businesses they will be permitted to carry out. In particular, they will be permitted to carry out new businesses to a total principal amount of only 10% of their assets, until those businesses have been registered with and approved by the Fed for mega-institution activity. Thus credit derivatives, for example, would not have been a permissible business for mega-institutions except in small amounts until the Fed on behalf of the public was completely satisfied their risk management problems had been solved.
With these restrictions, the mega-institutions would be neither risk-seeking nor innovative. They would be conservative in outlook, and their management would be paid respectably but not lavishly, perhaps somewhat above the level of Federal civil servants of equivalent responsibility. Fannie Mae and Freddie Mac, which by 2013 will probably have received at least one taxpayer bailout, will be registered as mega-institutions, and compelled to follow the stringent capital regulations for "too big to fail" banks. (If this put them out of business, tough; the home mortgage market would be the better if it lacked their quasi-public participation). In that event they would probably pay their top brass like the GS-15 civil servants they truly are.
Given the draconian restrictions on mega-institutions, new financial innovations would have to come from somewhere else, as would the risk-seeking that has been so successful in the last couple of decades. In the latter area, current structures would probably survive, to a limited extent, in hedge funds and private equity funds. These would have difficulty raising large amounts of capital, since the mega-institutions would not be allowed to invest in them, and would be very limited in their lending. Moreover fiduciaries such as pension funds will by 2013 have discovered the hard way the legal dangers of subjecting beneficiaries' money to the risks of hedge fund investment and the Pharaonic remuneration standards of hedge fund managers.
As at present, hedge funds and private equity funds would be short-term in their orientation, and would continue to supply capital to the riskier areas of arbitrage and venture capital and psychic and occasionally financial satisfaction to the greedier "bankers". Their area of productive operation might theoretically be increased by removing the competition from the mega-institutions, but their profitability would alas be severely affected by this elimination of a class of enormously rich suckers.
There would then remain a need for intelligence, to carry out true financial innovation, profit from new product areas while their volume is still relatively small and their margins high and advise on merger and acquisition transactions and on financial reorganizations generally. This business would be increased by the elimination of many large "profit center" finance departments in major corporations. The losses and indeed bankruptcies due to ill-judged speculation by profit center finance departments will have demonstrated to even the doziest Boards of Directors that at best such departments are an expensive, poor quality and unnecessary duplications of Wall Street, while at worst they are an invitation to ignore the firm's core business and "make the numbers" through value-subtracting speculation. Eddie Lampert, he of the attempt to turn Sears Roebuck into a hedge fund, will no longer be a revered name by this point.
This intelligence will be provided by much smaller houses, generally private partnerships, living on their wits rather than their capital, which will navigate between the hedge funds and mega-institutions to make money for themselves and provide service to their corporate and wealthy individual clientele (private banking is an intellectual-value-added business only at the very top of the wealth spectrum.) They will perform the functions of the pre-1986 London merchant banks or some of the pre-1975 Wall Street investment banks, and will operate in the same way, living primarily on the fees they earn. By removing the temptation to "principal investing" inherent in the current behemoths, these institutions will eliminate a huge conflict of interest and allow for the reduction in the share of national income devoted to financial services. Naturally, to deal effectively with giant corporations and the very rich they will have to have what the 1960s Bank of England Governor Rowland, Lord Cromer called "prestige and standing." As their market develops they will quickly discover that they will not get this by operating hedge funds, or by risking scarce capital in speculation.
Finally, there will be the "minnows", those banks and brokerage houses not large enough to be "mega-institutions" but still providing banking and/or brokerage services to a limited clientele, generally regionally. They will not be permitted to grow beyond a certain point without registering as "mega-institutions" but will otherwise operate with fewer restrictions and more generous capital ratios than the mega-institution fraternity. Since regulation will have eliminated much of the economies of scale from growing "too big to fail" these entities will be highly competitive in their limited markets, surviving by means of lower capital costs, lower top management salaries and better customer service. Indeed, since securitization will have fallen largely out of favor, they may find a profitable new line of business in home mortgage lending, which they will perform more efficiently than the Wall Street machine. (Research has shown that the move from direct home mortgage lending to securitization between 1970-75 and 2000-05 added about 50 basis points per annum -- 0.50% -- to the cost of every home mortgage in the U.S. -- the new market was pure rent seeking.)
The new Wall Street will be less exciting for the greedy, but provide a better service for customers, while shrinking the financial services sector back towards its historic level and eliminating most rent seeking behavior. As such, its emergence will be one of the few unequivocal benefits of the miserable recession ahead.
All in all, it starts to sound outright attractive when compared to all the post-1970s craziness that infected markets across the board. Getting there from here without the government stepping in and doing monumentally dumb things might be hard.
HOW TO COPE WITH ECONOMIC TIMES THAT TRY THE SOUL
Our current financial crisis as seen through the eyes of Thomas Paine.
A little philosophy -- and promotion -- from the good folks at Elliott Wave International.
These are the times that try men's souls, wrote Thomas Paine in 1776, referring to the North American colonists' revolt from British rule. And now, referring to the U.S. economy, we can equally say that these are the economic times that try the national soul. Whereas last year and in years earlier, we here at Elliott Wave International warned about the tough times to come in the economy, today's news stories are full of woe:
These are indeed the times that try the souls of men and women who must cut back on their spending in order to pay their bills. Thanks to the credit crunch and lower home prices, people can no longer cover the difference between their income and their outgo by refinancing their home or taking out more equity as a line of credit.
- Home prices down 11.4% in January, the steepest drop since the Standard & Poor's Case-Shiller index began tracking home prices. (Reuters)
- Retail sales grew at their slowest pace since 2003 last week at a 1% growth rate, according to the International Council of Shopping Centers and UBS Securities LLC. (Bloomberg)
- The Consumer Confidence Index, which has been falling since July, dropped to a five-year low in March. The Conference Board reports that consumers are worried about tight credit, fewer jobs and higher prices. (Reuters)
Some of Paine's famous words from The Crisis, a series of essays he wrote after the Declaration of Independence was signed, can even apply to the difficulties now being faced by U.S. consumers. Here is the beginning of the essay he published on December 23, 1776. General George Washington thought so highly of it that he ordered it to be read to his troops huddling at Valley Forge.
THESE are the times that try men's souls. The summer soldier and the sunshine patriot will, in this crisis, shrink from the service of their country; but he that stands by it now, deserves the love and thanks of man and woman. Tyranny, like hell, is not easily conquered; yet we have this consolation with us, that the harder the conflict, the more glorious the triumph. What we obtain too cheap, we esteem too lightly: it is dearness only that gives every thing its value ...
So many more people who bought a home in the past few years may read those last words in a new context, knowing that they obtained their new homes too cheap with subprime loans and esteemed them too lightly. In fact, as pocketbook issues now begin to hit everyone's pocketbook, the recession out there in the U.S. economy becomes my recession or your recession when someone we know loses their home or their job.
So, we come to a question for those who want to preserve the wealth they have: Where do you put your money during a recession? In gold? That is the most common response. In stocks? Seems iffy right now. In T-notes? So boring.
Bob Prechter and one of our analysts did the research to see which of these three investments have fared the best in economic expansions and recessions since World War II. The stock market was the winner during expansions, with gold coming in second. No surprise that T-notes came in last, since they are designed to provide low risk and therefore provide lower returns. But there is a surprise when it comes to which is the best investment historically during recessions ...
ON SHOES DROPPING, AND OTHER THINGS TO WAIT FOR
A lot of financial footwear is falling from the sky.
More reportage from Elliott Wave International.
"Waiting for the other shoe to drop" basically means that you expect a final bad thing to happen that you cannot control, in relation to previous other bad things that you could not control. It is an American phrase of mid-20th century origin, and recounts how an apartment dweller feels when sleeping beneath an inconsiderate neighbor who goes to bed late, but not before dropping the first shoe (or boot) onto the floor with a thud -- and then takes his sweet time as the now-awake person below waits for that other shoe to drop.
The things is, one piece of footwear after another has thudded to the floor since at least August of last year. A lot of people have been deprived of any financial piece and quiet, and in fact a growing number are now suffering deprivations of a more serious kind.
These "shoes" and others like them have either thudded quietly, or promise to make a thud that no one will miss. And it is true that for most of us, there is indeed little or nothing we can do about most of the bad news. Yet what you can do is look after your own financial future; people who expect politicians and policymakers to play that role are even more likely to be part of the bad news they hope to avoid.
- According to a USA Today/Gallup poll, half the respondents say they fear that the current economic downturn "could become a depression."
- A BBC article headline, "Tent City Highlights U.S. Home Crisis," suggests that a vivid symbol of the depression era has in fact already appeared in a small but growing group outside of Los Angeles.
- A group of angry homeowners whose properties are in foreclosure forced their way into the lobby of Bear Stearns's mid-town Manhattan headquarters this week, to protest the investment bank's $29 billion bailout by the Federal Reserve, because they and millions of other families in foreclosure have received no such consideration.
- Jefferson County in Alabama could file for bankruptcy due to sewer and school system debt obligations that amount to $4.6 billion; it could prove to be the largest municipal default in U.S. history.
DEFLATION’S EFFECT ON REAL ESTATE, BONDS, AND THE DOLLAR
Bob Prechter has persistently promulgated the theory that the persistent inflationary times since the Great Depression of the 1930s would culminate in a severe deflationary credit crunch -- possibly more severe than the 1930s. Here he gives a short introduction to this fundamental idea, and some investment advice for navigating the deflation. The later can be summarized: (a) hold no-default-risk bonds during the deflation, and (b) own gold once the deflation stops. The main difference between this advice and those who advocate owning gold now is that Prechtor thinks a deflation is inevitable, while many (most?) seem to think the central banks can stop the credit contraction and take things directly to high or hyperinflation.
They say that generals tend to fight the last battle. And the generals at the Federal Reserve are no different. They constantly say they are battling inflation. But the head of the Fed's Joint Chiefs of Staff, Ben Bernanke, has lately been worrying about deflation and doing his darnedest to head it off. He has even let worries about a credit crunch outflank concerns about inflation.
Long before Bernanke came on the job, though, Bob Prechter was thinking and writing about deflation. In this excerpt from Prechter's Perspective [reissued 2004] -- the useful and interesting book of questions and answers taken from his interviews with the media over the years -- Bob explains how a deflationary depression will affect real estate, credit, and the U.S. dollar.
Q: It seems there has to be some fundamental change in our current monetary stability to produce such an extended decline that we would be facing deflation.
Bob Prechter: The most widely held belief with regard to the future course of national financial affairs is that inflation will accelerate, or, at minimum, continue. I think the case for an impending deflation is overwhelming. The next monetary trend should be a period of severe deflation, just as occurred in 1835-42 and the 1930s ...
Q: So some day, people will want inflation?
Bob Prechter: Take, for example, the real estate crunch of 1990. Some people suffering from that minor deflation were already prescribing "cures." The Wall Street Journal ran two guest editorials on the desirability of government policies that would regenerate the multi-decade phenomenon of real estate values rising faster than the CPI. The essential message was, "Bring back the real estate bubble," delivered under the illusion that the bubble period was normal life and should last forever. Well, the incredible thing is, the bubble reflated! Now, we are right back where we were in 1989 except that the distortions are even greater. A perpetual credit-fueled bubble is not possible, either mathematically or psychologically, but people will certainly want it to continue. The same desire will extend to the stock market as it falls, and the economy.
Q: In the 1970s, when the economy and the stock market sputtered, real estate did reasonably well.
Bob Prechter: As big as the disaster in stocks is likely to be over the next five to 10 years, it will almost certainly be matched by the upcoming disaster in real estate-related investments. The 1970s were inflationary: the next period of difficulty should be deflationary.
Q: Are there manifestations of euphoria in real estate?
Bob Prechter: In the past five years, people have been erecting "McMansions" all over the place -- million dollar homes crowded in like condos. It is all financed with credit, and that game is ending. The trap is set.
Q: Credit will contract?
Bob Prechter: Yes, from long-term bonds all the way down to the broader measures of the money supply ...
Q: At what point might the economy deteriorate so substantially that its condition and trend are no longer bullish for bonds, but bearish?
Bob Prechter: When it reaches depression, and a depression is exactly what is on the agenda if the stock market fails to the extent that the Wave Principle suggests. The only way for a bond investor to survive a depression is to hold bonds issued by a strong borrower. Weak borrowers, such as most corporations and municipalities, will default. As investors come to the realization that default is a risk, rates on weak debt will rise as its prices fall.
Q: What happens to the dollar?
Bob Prechter: During the deflation, the dollar's domestic purchasing value should rise, as debt instruments denominated in dollars are defaulted upon. As dollars disappear, the value of the remaining dollars will rise. The same thing has been going on with the Japanese yen in terms of how much you can buy for it in Japan. But how the yen or dollar will perform against other currencies, I could not say. We will have to follow the wave counts.
Q: After the initial deflationary hit, what will turn currency values back down?
Bob Prechter: It will be the pressure on national governments to create paper money to pay off their debts. Which ones will be destroyed depends upon what course each government chooses when faced with bankruptcy. I am not optimistic that most will take the honest course. Whether or not all paper currencies eventually go to zero, it will be wise to own gold after the deflation.
Q: So, in the very long run, the dollar is in trouble?
Bob Prechter: I think so. Did you know that Roman inflation persisted, in recurring waves, for over 400 years before the monetary rot was thorough enough to allow invading armies to successfully sack the city? We have had nearly 70 years of dollar inflation in the United States. Can you imagine what another 300 years of persistent dollar inflation would do to the political fabric of the United States?
Q: Is there an alternative?
Bob Prechter: The only way to guarantee that politicians will never again inflate is to introduce private money and ban legal tender laws.
Q: Private money? Do you mean gold coins issued by a private mint?
Bob Prechter: Not a private mint. By anyone who wants to issue it! The marketplace will choose the soundest forms of money, and competition will insure that the science of money is advanced. Compare the old telephone monopoly to cell phones and the Internet, and you will get an idea of what would happen.
IRRATIONAL BEHAVIOR, IN THEORY AND PRACTICE
But why study theory when “practice” is all around?
Just in case you needed more persuading that the rational economic man/woman, beloved in academic economic and finance theory, is more fiction than fact, a couple new books are out that purport to show just how irrational people are. But, as the author of this article points out in so many words, this is more of the classic "Yes it works in practice, but does it work in theory?" calling card of academia.
The important bottom line is, do not expect the future to be a linear projection of the past in financial markets. Human behavior is too subject to swings in the herd's mood. And the herd is hardly a model of emotional moderation.
Irrational behavior is popular these days, in both theory and practice.
The "theory" part consists of the steady stream of academic research and now best-selling books, mostly by economists of the behavioral finance school. One such book last year The Black Swan: The Impact of the Highly Improbable. It showed how most people (including most Ivory Tower types) go much too far in assuming that past events and trends will follow a linear path into the future, when in fact the future is more often shaped decisively by events that are dismissed or never anticipated because "that can't-won't-shouldn't happen."
Even more recently, Predictably Irrational (by an M.I.T. professor) just hit the best-seller's list. The title is by no means misleading: there seem to be countless ways in which people make predictably irrational choices, from health to career to how to select a mate and beyond. One example in the book involves placebos and the power of suggestion. The researchers "zapped volunteers with a little painful electricity, then offered fake pain pills costing either 10 cents or $2.50 (all reduced the pain, but the more expensive ones had a far greater effect)."
Alas, research that involves volunteers in a lab setting is still just "theory" that fails to record and verify the actual "practice" of predictably irrational behavior. In fact, it is not clear to me why researchers would even bother with lab studies -- there is no shortage of conspicuous irrationality in the real world of finance and consumption. The history of stock markets amounts in large part to how investors buy the highs and sell the lows. For more than a year, the news headlines have been full of problems that started when lenders did dumb lending to borrowers who did dumb borrowing.
And on the horizon are big problems with the way most of us do most of our consuming, namely credit cards. It seems credit card debt is "securitized" -- and has been rated AAA -- in the same way as mortgage debt. And as the number of bankruptcies skyrockets, credit card companies have started setting aside billions for the anticipated loan losses. Yes, that is exactly the type of story we were reading around this time last year regarding mortgage lenders.
Obviously it is good to shed light on irrational choices, especially in the hope that people will see the behavior for what it is and make fewer bad choices. Maybe, maybe not. What I know for certain is that Elliott wave analysis -- and many methods of technical analysis generally -- assume that the future is non-linear, and expect investors to drive trends that take irrational turns. This has been true for decades. Put bluntly, it is good to see that some academic research is catching up, but "catching up" is precisely what it amounts to.
A STEADY HAND AT THE CORPORATE HELM IS VALUABLE
Forbes columnist and value style money manager John Rogers expounds on the value of long-serving company managements.
Term limits were all the rage for elected officials a few years ago. The idea of capping how long someone can stay in power was to diminish the cronyism and corruption that extended tenures supposedly promote. But in this political year we are hearing the opposite argument: that experience is valuable.
There is something to that notion. In Chicago, where I have lived all my life, I have seen firsthand the benefits of allowing officeholders to stay for a long time. Richard M. Daley, mayor since 1989, has been able to look far into the future and take on projects that someone limited to a couple of terms could not have. On his watch we have witnessed improvements in our public transportation, the building of the wonderful Millennium Park and robust environmental efforts. Officials on the mayor's staff have been able to amass tremendous experience and knowledge, enabling them to serve Chicago better. ...
This is tangential to Rogers's main point, but Daley can "think ahead" because he is virtually assured of being reelected. Monarchs used to have the luxury of thinking in those terms as well. When you have to worry about whether you will still be on the job in four years the incentives change, and the short term starts to dominate. This is an argument in favor of extented tenure in upper management, but of course it must be tempered with accountability for results as well.
The corporate realm should pay heed. Many company boards set arbitrary limits on how long directors can serve, occasionally by tenure but more commonly by age. Why toss out people who have spent accomplishment-filled lifetimes in the business world because they hit a certain birthday?
A related trend is the eagerness to fire chief executives over short-term issues, like temporary earnings dips. The root of this is Wall Street's fixation on today's stock price. When trouble brews, as it inevitably will, ousting a seasoned business leader shows awful timing, especially when no clear successor is on deck.
As long as the manager's tenure is truly marked by accomplishment, firing a CEO because of age seems shortsited in the extreme. And as long as a decline in earnings is due to factors legitimately outside of management's control, then ousting a seasoned leader for that reason is also awfully stupid. As Warren Buffett has mentioned when discussing management compensation, the manager should be paid (or not) based on his or her performance vis a vis what he or she can actually affect. Similar logic applies to hiring and firing issues.
At Ariel we love companies with managers who have been in place for long stretches. They remember what works and what does not during rough patches. They strategize intelligently because they know their markets and rivals well.
For the 440 companies that have been in the S&P 500 for a decade, the average chief executive tenure is 4.3 years and the average stock return is 12.2% annually. Of that group, 42 companies have had one chief executive in place for the whole 10 years. These stocks gained 18% annually. True, this performance difference does not establish a predictive value for long tenures; to a large degree it reflects the fact that a chief executive will not be shown the door when the stock is doing well. What is also true is that performance is not a random event. Some bosses can keep delivering it.
Within our own portfolio is a company whose leader has been granted a lot of flexibility, which he has used to great effect in 22 years at the controls. Toolmaker Black & Decker (65, BDK) brought in Nolan Archibald in 1985 to combat foreign competitors making inroads in the U.S. The turnaround required patience. From 1986 through 1990 Black & Decker's stock fell 50%. Archibald took the hard steps, closing plants, reworking the management structure and debuting many innovative products, like cordless power tools. Since the beginning of 1991 the stock is up 9-fold.
Lately Wall Street has been worrying that the housing crisis will hurt Black & Decker. But Archibald has proved that he has what it takes to guide his company through the down segment of a business cycle. Black & Decker trades at a 35% discount to my estimate of its $100 intrinsic worth.
Which is a pretty decent discount, if Rogers's calculation is accurate. He goes on to discuss the merits of carpet maker Interface (15, IFSIA) and cruise line operator Carnival (38, CCL), both with long-serving board chairmen. Both companies face issues, but a management team and board that have seen it all before are compensating plusses. Rogers assesses that Carnival is trading at a 40% discount to private market value.
FIXED INCOME CANADIAN ENERGY PLAYS
Canadian oil and gas trusts are interesting income/natural resource plays that can bring the buyer tax accounting headaches. The group also got hit in late 2006 when the Canadian federal government, in what amounted to the proverbial bolt from the blue, suddenly announced a change in the trusts' tax status, effective in 2011. No one will be surprised that the change involves more taxes for the trusts. They will be taxed like normal corporations, rather than have their distributions to trust unit holders be largely tax exempt, similarly to U.S. real estate investment trusts.
Have these various issues been adequately discounted, from the perspective of a would-be U.S. unit buyer, in the units' prices? Forbes fixed income analyst/columnist Richard Lehmann seems to think so. Not discussed is the danger of oil and gas prices taking a major tumble from here. Right now it seems unlikely, but such events usually seem unlikely until they happen.
Canadian oil and gas trusts are a favorite of mine, thanks to their capital gains potential (something most income vehicles cannot aspire to) and healthy dividends. I last recommended them to you in 2006, when energy prices were softening. A lot has changed since then. Oil prices are at record levels, and natural gas is way up, too.
Is this the time to sell these Canadian royalty trusts? Quite the contrary. They are still good, despite the risk of higher taxes and the difficulties of replacing reserves. Trust shares are oversold and are a buy now.
Some exaggerated fears surround the trusts. One is the fear that conventional oil production in western Canada has peaked. So growth potential looks stunted, a condition made worse by rising energy production costs. The industry consolidation that has ensued, as smaller trusts have been bought up, is no succor to investors, because the takeover premiums are not very big. Reason? The Canadian government has put size limits on trust mergers.
Another downside is that Ottawa plans to yank the trusts' tax-free status in 2011, a nasty provision known to trust investors as the Halloween Surprise, since it was announced October 31, 2006. The news that trusts will be paying corporate taxes sent their prices skidding 20% overnight, and they have not climbed back since. Even oil at $100 per barrel has not helped. Oil-rich Alberta is making matters worse by raising the royalty it gets from the oil that is extracted.
Investors get favorable tax treatment but not a tax holiday. Suppose a U.S. investor held a trust that distributed $1.68 for each unit last year. The whole payout gets hit by a 15% Canadian withholding tax, 25 cents per unit, before it arrives in the U.S. account. Surprisingly, even though the trust never paid corporate tax back home, the $1.68 is considered a qualified dividend and taxed at the 15% capital gains rate because most income trusts count as qualified foreign corporations under IRS rules, says Jerry Beneke, who advises energy trusts at KPMG in Calgary.
The tax paid to Canada can then be credited against U.S. income tax. If the trusts are taxed by Canada at the corporate level and earnings do not continue to grow, dividends will shrink. Even more reason for caution: Both the qualified dividend and the trusts' corporate tax exemption expire on December 31, 2010.
Investors seem to be as much put off by the confusion as by the tax burden. There is a decent chance that the tax change slated to begin in three years will be scotched. Even if the tax does hit then, most trusts have built up pools of deductible items that will postpone corporate tax payments for at least four more years, longer still for trusts that are boosting their reserves.
Production from oil sands is just beginning in Canada, where reserves are huge. Oil sands production requires natural gas to heat and liquefy the gunk. Natural gas is not that expensive for trusts, which have plenty of it. Oil sands effectively represent a conversion of natural gas into oil.
Income investors should value these trusts much as they would convertible securities, but in this case convertibles paying double-digit current yields. Over five years you will have recovered two-thirds of your investment through dividends (barring any dividend cuts, which I think are unlikely), and you will still be holding a resource-rich trust with many good years ahead.
The king of oil and gas trusts in size and potential is Penn West Energy Trust (nyse: PWE - news - people ) (28, PWE ). It produces 200,000 barrels of oil equivalent a day and has 11 years of proven and probable reserves. Penn West also holds significant oil sands properties, which at this point aren't counted in its reserves. The trust's $4.08 dividend consumes 76% of cash flow from operations, which means there's a bit of money left over to rebuild reserves, and furnishes a yield of 14.7%. Another big trust is Enerplus Resources (43, ERF ). It produces 100,000 equivalent barrels a day. The dividend yields 11.7%, which represents 74% of cash flow. Enerplus has proven reserves of 15 years. Both these trusts have grown through recent acquisitions and will be leaders in oil sands development. Their cash flows don't yet fully reflect current oil prices because they sell a good deal of their production forward, meaning they contract now for delivery later. Locking in advanced orders has the virtue of granting them stability, even though the income takes a while to catch up when prices are rising on the spot market. When's the best time to buy? Over a number of months. Energy price flux does affect shares. Smooth out the cost.
PAVING YOUR WAY TO PROFITS
Chris Mayer revisits the infrastructure theme, this time making the fundamental macro-case for road and bridge construction companies.
America's roads and bridges are breaking down. Who is going to fix them? China's roads and bridges are inadequate. Who is going to build more of them? All forward-looking investors should investigate the answers to these questions. As the world modernizes and expands its highway system, somebody ought to make a buck or two.
In America, our road system strained to keep demand, which means that lots of folks are spending dozens of hours hanging out for nothing. Who has not sat in snarls of traffic for hours somewhere in America's tangled network of roads? Who has not avoided certain roads at certain times because they just know it will take twice as long to get where they are going?
Most Americans squander countless hours of their lives idling in a car. It is a mean reality. And it is also a hidden tax on economic productivity. Every year, gridlock costs the U.S. economy some $78 billion. It eats away 4.2 billion hours in travel delays and sucks out 2.9 billion gallons of wasted fuel, according to the Texas Transportation Institute.
The future does not look much better -- unless you are an investor. In which case, there are ways to cash in on the coming rebuilding of America's roads. In markets, crisis and opportunity are often dance partners, like Fred Astaire and Ginger Rogers. Where there is one, the other is often nearby. It is an idea embedded in the masthead of my investment letter, Capital & Crisis. So wherever there is the whiff of crisis, we look to see if there is an opportunity for our capital. (There is not always one. Fred sometimes made films without Ginger.)
That is why we are taking a hard look at America's crumbling infrastructure, as well as China's and India's inadequate infrastructure. Somebody is going to be doing a lot of road-building during the next couple of decades. We would like to know who. But first, a little background ...
Since 1982, America has added very few new roads relative to the growth of road miles traveled. Quite simply, the supply of "road space" has not kept up with demand. The end result is predictable and unavoidable: Mounting hours of delay. The average American spends 40 hours per year in gridlock.
Currently, the amount of money we invest in our roads is not enough to offset the beating they take. The U.S. Department of Transportation (DOT) estimates that over 160,000 miles of federal highway has pavement deemed "unacceptable". Over 153,000 bridges are structurally deficient or functionally obsolete, says the DOT. Poor infrastructure actually leads to the deaths of thousands of Americans every year. On this last point, last summer's bridge collapse in Minnesota provided a tragic and shocking wake-up call.
Incredibly, the need for miles of highway will double over the next 30 years. If the demographers are right, the U.S. should add another 100 million people over that time frame. If we add capacity at a rate no faster than what we have done in the past, the average American could spend up to 160 hours each year in traffic. That is about four workweeks! Despite the acute need for highway miles in America, the need for highways around the world is many times greater. In fact, it is downright staggering to think about. The U.S., Europe, India and China combined planned to build nearly 70,000 miles of highways before 2020. But China and India will add 98% of that total.
Well, I can imagine a lot of things. But let us focus on just one: Road-building construction. It should prove a steady market in the U.S. Overseas, it is a growth industry.
Therefore, the road-building industry could still be a great place to park some cash, because of the action abroad ... Overseas, the road story dovetails nicely with the commodity boom. I remember reading Jim Rogers's comment on this fact in his book Investment Biker. He talks about coming to a wonderful paved road in Niger, when all the other roads were in shambles. The reason: There was a uranium mine nearby. "In Third-World countries -- in fact, everywhere -- there is no better way to develop an infrastructure. If there are profits, somebody will put down roads and telephone lines."
In the great quest for more oil, gas, uranium and metals of all kinds, the infrastructure behind all that stuff is a powerful investment theme. Infrastructure follows beehives of economic activity.
I am giving this sector a good scrubbing now, but I thought I would let you know it is one of the areas I am looking at. Most of the companies I am looking at have significant overseas operations. These businesses are growing at healthy rates. Watch this space and I will report back soon.
SMALL STOCKS | THE HARDY BOYS
Small growth stock aficionado, money manager, newsletter writer, and Forbes columnist Jim Oberweis thinks now is "the best time in years" to be buying small growth stocks. Buying while everyone is so pessimistic might sound like reasonable contrarian advice, but Oberweis recommends buying companies that have actually resisted the bear market's claws ... whose stock prices have held up relatively well.
It has been a long while since investors have felt so gloomy and stock index declines have been so steep. Investment firms Goldman Sachs, Merrill Lynch, Morgan Stanley and Lehman Brothers have announced layoffs. With all the bad news, giving up on the market is easy. Do not be fooled. This is the best time in years to be scooping up small growth stocks.
The last time we encountered such problems was in 2001-02, with the dot-com bust. The investment industry shrank, confidence sagged and layoffs hit. As things turned out, the latter half of 2002 was great for buying stocks. Ditto 1998, when the Asian flu roiled global equity markets; financial firms panicked then, too, and slashed head count. Shortly after, the market took off. Lesson: Big market declines and legions of jobless Wall Streeters bring cheap stocks and good buying opportunities.
While buying bloodied shares is tempting, I recommend the opposite. Go for stocks that have held up well during the downturn. The economy will take time to recover, and hardy companies that can grow despite economic headwinds should continue to be well appreciated on Wall Street. Here are four.
After losing money for most of the past two years, software maker Phoenix Technologies (16, PTEC) has new management that has restored the company. Phoenix boosted revenue by 79% in the most recent quarter and posted a solid profit. In the early 1980s Phoenix pioneered the design of the basic input-output system (BIOs) that boots up a computer. Phoenix is the leader in the modern version of BIOs with a 50% market share. The company debuted two exciting products late last year: FailSafe, a theft-loss-protection service that remotely disables lost or stolen notebook PCs, and HyperSpace, which eliminates the long wait when Windows is loading in laptops. Phoenix trades for 25 times my 2008 earnings estimate.
Most small growth stock buyers do not hesitate to pay up for favored stocks if they think the growth will keep on coming. After all, if they were hesitant they would probably be labeled "growth at a reasonable price" (GARP) buyers or something like that. Small growth buyers are willing to pay multiples of much greater than 25 as well, as we will soon see. The trick with the approach is to avoid the devastating price collapses that come when companies do not deliver as promised. In keeping with the "Hardy Boys" theme, Phoenix's stock is up nicely for the year so far.
Ctrip.com International Ltd. (55, CTRP ) is the dominant online travel provider in China. I have followed and invested in this company for years and continue to be amazed at its prowess. Chinese have more disposable income these days, so they are traveling more. The Beijing Olympics will spur bookings. In China only 3% of travel industry revenue is generated online, leaving a wide-open space for growth. Analysts expect online's share to quadruple by 2012. Ctrip has fostered strong brand loyalty, with 80% of sales from repeat customers. It carries a lofty valuation of 45 times my estimate of 2008 earnings, but its growth is so impressive that the high multiple is eminently worthwhile.
Ctrip.com's stock price is more or less flat for the year so far.
Sapient (7, SAPE ) reported fourth-quarter results way better than analyst expectations, with revenue up 35%. The company provides marketing and technology consulting services, and thus has benefited handsomely from the continued shift to advertising dollars online and away from traditional outlets. The company ... has extensive operations in Europe, but 60% of its employees are in India, providing around-the-clock project management. Their comparatively low salaries translate into reduced fees for clients. Valuation of the stock is still very reasonable, reflecting concerns that advertising budgets will shrivel, even in the robust online world. This phenomenon has indeed begun to affect almighty Google. Still, online is where the future lies, and Sapient is well placed for the eventual upturn. Excluding acquisition charges, this fine company trades for only 13 times my 2008 earnings estimate.
Sapient's stock is actually down from around 8 1/2 at year's start, but the multiple is obviously pretty reasonable if Oberweis's estimate is close to the mark.
Energy producer Carrizo Oil & Gas (60, CRZO) is thriving from higher demand and prices for natural gas. In the latest quarter revenues generated by the Houston company rose 65% to $40 million. One advantage is its extensive presence in the Barnett Shale region, which covers a significant swatch of the Dallas-Fort Worth metroplex. The Barnett Shale is a U.S. onshore gas field currently swirling with activity, in part because modern drilling techniques have recently increased the ability to tap such fields. Production there will continue expanding. Another plus is Carrizo's stake in the Huntington Field in the North Sea, discovered last year; it stands to yield lots and lots of oil. Carrizo trades for 34 times my 2008 earnings estimate.
Small growth buyers are not generally big natural resource stock fans, but sometimes they will venture into that territory. A value buyer would want to know a reasonable value to put on Carrizo's proved, probable, and -- it looks in this case -- possible reserves, and then try to buy them at a discount. They would also want to know that management did not intend to reinvest the revenue stream in value-destroying projects. Most growth stories have an envisioned future where the company's growth tails off and it slides into a mature, cash flow generating, comfortable middle age. Oil and gas companies, on the other hand, are destined to go out of business unless they keep reinvesting in and reinventing themselves.
Soldiering through an economic slump takes considerable intestinal fortitude, not to mention patience. Small growth stocks tend to spring up rapidly once the bad days are over. Invest now. These will be much more expensive in a year or two.
BLACK SWANS EVERYWHERE
A "black swan" event, a term made popular by Nassim Nicholas Taleb by dint of the title of his popular book, The Black Swan: The Impact of the Highly Improbable, is an event so rare that no one really expects it, but whose consequences are severe enough that everyone should be prepared in the event it does happen. It has now become a term of derision of sorts because so many "highly improbable" events, as assessed and asserted by the ultra-leverage-loving financial engineers such as hedge funds, are happening in a very short term. Obviously, their probablility assessments were wrong.
Peak oil alarmist James Howard Kunstler, author of such books as The End of Suburbia and The Long Emergency, shares his bleak but colorful assessment of all the finacial markets and economy, following the black swan event of the near "meltdown" of the financial markets around Easter.
After a one-day reprieve from total meltdown in the financial markets, news media cheerleaders for the most reckless gang of bankers in world history declared the crisis over on Good Friday (with the markets safely closed). Whew, that is a relief. Problem solved. And just in time for baseball season, too, so none of the Banker Boyz have to sell their sky box leases.
What is meant by "meltdown," by the way, since the word is used so promiscuously by myself and others. I would define it as the shock of recognition that many big institutions are worse than flat broke and are therefore powerless to conduct normal operations. By "worse than flat broke" I mean they are so deep in hock that all the accountants who ever lived, in the life of this universe and several others like it, using the fastest parallel processing computers ever built, could not keep up with their compounding accelerating losses (now approaching the speed of light).
The current vacation from reality on Wall Street may last a few more days, or even a couple weeks, but it seems as though a whole flock of black swan events is circling the sky over Financial-land and is about to blot out the sun. By black swan, I refer to the concept popularized by Nassim Nicholas Taleb in his recent book of that name, namely unexpected events of great power that tend to change the course of history.
For the moment, with the crisis "contained," and the Boyz getting ready to air out their Hampton villas for the coming season, we are once again primed to be blindsided by potent random events that nobody saw coming. The trouble is, there are enough potent potential fiascos already visible on the horizon.
The mortgage fiasco is still just gathering steam as it moves from the non-payment stage to the default and repossession level on the grand scale. Even the political wish to bail out feckless mortgage holders will stumble on the mammoth clerical task of administrating the process, especially since we have barely begun to sort out who actually holds the mortgages after they have been minced into a fine mirepoix of securities off-loaded onto countless dupe "investors" ranging from municipal funds in obscure corners of foreign nations to countless public employee retirement plans.
No matter how the authorities try to "nationalize" the sucking chest wound of bad mortgages, the body of finance will flat-line -- and the American public will get stuck with the bill from the intensive care unit. Those who, for some weird reason, continue to pay their way and meet their obligations, will be none too pleased to pay for misdeeds of the deadbeats and their banker-lenders. This portends a taxpayer rebellion, which may translate into a voter rebellion.
It is too bad the current presidential candidates have been unable to address the unfolding economic nightmare. Their collective silence on the matter suggests that they do not have a clue what to say about it. As the nightmare plays out and black swans flock in to blot out the sun, and the hedge funds come a tumbling down, and more big banks blunder into black holes, and businesses big and small across the land shutter up their operations, and the unemployment rolls swell, and families are thrown out of their houses even when bailouts are supposed to be saving them (but the bureaucracy cannot get the paperwork done in time) -- well now, they are going to be one pissed off bunch of people. What will they do at the conventions? Our outside the conventions?
In the deeper background of all this is the all-important oil story that nobody in politics or the media wants to pay attention to. Notice that in the fervid unloading of assets this past week, as investors dumped their positions in the commodities markets, the price of oil remained stubbornly above $100-a-barrel when it was all over on Thursday afternoon [March 20]. Well, maybe they will ratchet down a little further this week, but the trend line will prove to continue remorselessly upward in the months ahead.
Peak oil is for real. The supply cannot keep up with global demand, even if it dips in the USA. And more portentous sub-plots develop in the story every month. Export rates are falling at a steeper rate than depletion rates. The exporting nations are not only buying more cars and running more air-conditioners, they also need to use more energy to lift the oil they have got out of the ground.
Another sub-plot is the fact that the equipment used world-wide to drill for oil and recover oil and move oil around the planet -- all that equipment is now so old and rusty that it can barely do the job, and it is going to start failing altogether unless investments are made to replace it, which nobody is making.
By the way, Americans blame the familiar private oil companies for all the trouble with oil in their lives -- Exxon-Mobil, Shell, et al -- but they do not seem to know that oil nationalism is in the driver's seat now. The old private "majors" are only producing 5% of the world's oil. The rest is coming from the national companies -- Aramco, Petrobras, Pemex, et blah blah -- and the very operations of the oil markets are entering a phase of radical instability as they move away from auctioning their stuff on the futures markets and start making long-term favored customer contracts instead.
The bottom line is that high prices for oil is hardly the only thing America has to worry about. Pretty soon the U.S. will have to worry about getting the oil at any price -- meaning, we are in for shortages and supply disruptions sooner rather than later.
Also unbeknownst to most of America, the financial markets reflect all this instability around the basic resource of oil because industrial economies like ours are set up in such a way that they cannot run without cheap and reliable supplies of the stuff. So the least little twitter in the reality-based world of peak oil means that everything to do with money and capital investment will naturally go crazy, since our expectations for increased wealth -- i.e. "growth" -- are predicated on the activities driven by oil.
It will be interesting to see what new machinations are unveiled this week. Whatever else this catastrophe is, it is a good show from the cheap seats.
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