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JIM ROGERS’S PICKS AND PANS
He is extremely bullish on China – so much so, he recently moved his family to Singapore.
When Jim Rogers talks, people listen. Or they should. A legendary investor and author, Rogers sat down for an interview with Barron's. The discussion visited the subjects of China, commodities, emerging markets, the U.S. credit bubble/collapse, and the U.S. dollar.
Jim Rogers has a severe case of wanderlust. The longtime investor and author, whose books include Investment Biker and Adventure Capitalist, also has a new address: Singapore. Rogers recently moved his family to the island state from New York because he wants his young daughters to learn to speak fluent Chinese, which will be crucial in this century, he says.
It fits that Rogers, a former member of the Barron's Roundtable and, with George Soros, co-founder of the Quantum Fund in the 1970s, looks far afield for investment opportunities, both long and short. He remains bullish on commodities but has sold many of his emerging-market holdings. Rogers, 65, does not run others' money these days, though an index he developed in the late 1990s, the Rogers International Commodities Index, has been licensed to some funds. Its cumulative return, from inception in 1998 through the end of March, was more than 380%, versus about 38% for the S&P 500. In a recent conversation with Barron's, Rogers had no shortage of strong opinions on topics ranging from regulation of the financial markets to China's future.
Barron's: You have set up house in Singapore. Why the big move?
Rogers: I wanted to move to a Chinese-speaking city because we have a 4-year-old daughter who speaks Chinese. I want to make sure she continues to speak Chinese. We now have another daughter, 4 weeks old, and we want both of them to grow up speaking Chinese fluently. If I am right, the best skill I can give them is to be completely fluent in Mandarin.
Why not live in China?
The pollution is so horrible and, at least in the cities where we wanted to live, we just could not bring ourselves to move there. Singapore is a terrific place. They do not speak as much Chinese here as we would like, but they speak plenty of it.
Why are you so bullish on China?
China is going to be the next great country. The 19th century was the century of the U.K. The 20th century was the century of the U.S. The 21st century is going to be the century of China. Even if I am wrong, there are 1.5 billion people who speak Chinese every day, so it is not as if our daughter is learning Danish. Even if she winds up working in a Chinese restaurant, she is going to be the maitre d' -- not the dish washer.
What else intrigues you about China?
China was in decline for 300 years and then around 1978 Deng Xiaoping said, "OK, let's find something new." He reintroduced entrepreneurship and capitalism to a country that has had a long, long history of both. In China they save and invest more than 35% of their income; in America we save less than 2%. The Chinese work from dawn to dusk. When they come to work, they do not say, "How many holidays do I get?" They want to live like we do in America and they are willing to work hard, save and invest for the future.
What about investment opportunities in China?
Perhaps the safest investment is the renminbi, the Chinese currency. I do not see how the renminbi should not go up against the dollar, anyway, for the next several decades. Commodities, of course, are a great way to invest in China. If you have nickel, they will take you to dinner, pay for dinner and pay you on time. They have to buy commodities. And there are some industries in China that are going to do well, no matter what happens to the world economy -- water treatment, for instance. China has a horrible water problem that it is doing something about.
What other industries in China look interesting?
Agriculture. Mao Zedong [who ruled China from 1949 until his death in 1976] totally ruined agriculture. China now is spending huge amounts of money trying to rebuild agriculture. The same goes for power generation. Another growing industry is tourism; the Chinese have not been able to travel for some 300 years, for a variety of reasons. But now the government is making it much easier to get passports, and they are encouraging travel.
You do not clean up the worst credit bubble in history in six months to a year.
Switching to your old home, what are your thoughts on the U.S. credit crunch?
We had the worst credit bubble ever in American history, perhaps world history. I cannot remember anytime in history when people were able to buy a house with no money down -- sometimes with no income. You do not clean out a bubble like that in six months to a year. I have been short the U.S. investment banks by using the Amex Securities Broker/Dealer Index [XBD], an exchange traded fund with exposure to many of those firms. I have also been short Citigroup [C] and Fannie Mae [FNM]. I will short some more if we get nice rallies in any of them. I am still short some of the U.S. homebuilders like Lennar [LEN].
Anything you like?
The airlines, mainly international airlines like Lufthansa [DLAKY], Austrian Airlines [AUA.Austria], SAS [SAS.Sweden], Iberia [IBLA.Spain], Japan Airlines [JALSY] and all the Chinese airlines. I fly a lot and see that the planes are filling up and that the fares are going up. I also realized that Boeing [BA] and Airbus are sold out and that you cannot get a new plane for five to seven years. Rising oil prices are a problem, but the airlines can pass on the cost increases.
You have been quoted as saying you do not think bailouts of troubled companies are a good idea. Is that still your view?
Yes, it is. If the government had not bailed out the hedge fund Long-Term Capital Management in 1998, I do not think we would have some of the problems we have now. Investment banks have been going bankrupt for hundreds of years. It is not the first time something like Bear Stearns [BSC] has happened and the world has always survived.
If you had a few investment bankers go broke in 1998 or after the dot-com bust -- or if they lost hundreds of millions of dollars -- they probably would have had a different approach to their balance sheets. But since relatively few people got hurt with Long-Term Capital Management, in a few months everybody had forgotten the lessons that should have been learned about leverage or crazy products or crazy approaches. The government has been intervening to save all its friends for a decade or so rather than letting the market work properly.
But is it not so that a Bear Stearns bankruptcy would have devastated the financial system?
If the system is so fragile that the 5th-largest investment bank can bring it all down, then you better go ahead and have the problems now. What if three or five years from now it is the largest investment bank that fails or the largest five or six banks that fail? Then there will be a disaster.
As an investor, it is crucial to figure out what is going to change.
As an investor, you often allude to the importance of understanding history.
History will teach you that, first, we have seen all of this before, whether it is bubbles or panics or collapses. And yet, somehow, the world adapts. It also shows that whatever we are seeing today is not going to be true in 10 years, as was the case with the bubble in technology stocks in the late 1990s. As an investor, it is crucial to figure out what is going to change.
Are we still in the early stages of a bull market for commodities?
I would not say it is early. The commodities bull market started in early 1999. There are going to be corrections -- and big ones -- along the way. That is true for every bull market.
But nobody has brought on any new supply of anything in the past 25 or 30 years. The last gigantic oil field was discovered in the 1960s. The number of acres devoted to wheat farming has been declining for more than 30 years. Food inventories are the lowest they have been in 60 years.
Our colleague Gene Epstein argued in a recent Barron's cover story that there is a huge speculative element pushing up commodities prices.
But where is the oil coming from that is going to drive down prices and keep them down? We are going to have corrections, as was the case in 2001 after 9/11. Is there speculation in commodities? Of course. Whenever you have a bull market, it draws money. If the fundamentals are right, investors make money and they want to make more. But people were buying commodities for 20 years in the 1980s and 1990s and nothing happened, because the fundamentals were not right yet. Now that the fundamentals are right, more money is going into commodities. It will end in a bubble and hysteria. But in 2018, or whenever this bubble finally starts to peak, if I am lucky you will call me up and I will say it is time to sell commodities.
So you expect commodities prices to keep running up.
Absolutely. Look, if somebody discovers a gigantic oil field in Chicago or Berlin, then we will maybe have to start reassessing. But remember that all the great oil fields are in decline, including those in Alaska, Mexico and the North Sea. And I am not just talking about oil. You cannot go into your garage, snap your fingers and bring a new zinc mine to market. It takes on average 10 years to bring on any new mine.
Rogers has sold his emerging market holdings, except China and Taiwan.
Why have you sold most of your emerging market holdings?
Take Africa as an example. It is a natural-resource-based economy, so a huge fortune is going to be made there in the next 10 years. Many countries will look a lot better because they do have lots of natural resources.
Having said that, right now there are probably 15,000 MBAs on airplanes flying around the world looking for emerging markets, some of which are now called frontier markets. I have been investing in these markets for many years and all of a sudden they have a name. That is why I have sold all my emerging markets except China and Taiwan.
But I hope I am smart enough that if and when there is a big correction, I will be able to buy back some of those holdings.
You have been bearish on the dollar for some time -- a good call. What do you have against the greenback?
I continue to be skeptical about the dollar, though I am not selling dollars at the moment because there are too many bears, including me. I hate to say it but the U.S. dollar is a terribly flawed currency. It seems that the people in Washington are trying to debase the currency. The Fed has been printing money.
The "including me" throw-in should be noted. One's emotions are very often, although not always, an accurate readout of the crowd's. When, e.g., a stock or commodity feels like "the sky's the limit" or "it is going to zero," chances are that the crowd is feeling that way too.
When interest rates start rising again in the U.S., won't that strengthen the dollar?
There will be rallies along the way. For every currency that has been under pressure throughout history, that is one of the tools that is used eventually. That causes a rally whenever they do it, but eventually it is just another central bank, or another government, trying to protect itself. Experience tells me that when this scenario occurs, let the rally come and sell more dollars.
U.S. foreign debt increases by $1 trillion every 15 months. Do the math.
In some ways a weaker dollar helps the U.S. economy, making exports cheaper. What is driving the dollar lower?
As recently as 1987 the U.S. was a creditor nation. We are now the largest debtor nation the world has ever seen. We owe trillions. That's with a "t". The real problem is that that our foreign debt is increasing at a rate of $1 trillion every 15 months. You can do the arithmetic.
We will. Thanks, Jim.
LIVING WITH VIX
In case you had not noticed, stocks are volatile. Get used to it.
Forbes columnist Laszlo Birinyi Jr. has a proprietary approach to analyzing stock market "money flows" that involves looking at large block trades executed on the uptick vs. the downtick. It is the modern-day counterpart to the ticker tape watchers of decades past. He maintains a blog, "Ticker Sense". His analysis indicates that the precipitous climb in stock market volatility, as measured by the VIX index, from all-time lows since early last year is here to stay -- and for reasons that go beyond the allegedly sudden recognition by the market that conditions are a bit on the fragile side.
Daily 200-point moves are commonplace. Markets that are up sharply in the morning are often down in the afternoon. Many market savants say that early 2008 is an aberration, that the crazy price swings will sooner or later simmer down. Higher than normal volatility will supposedly end when the credit crunch and the mortgage crisis subside. But do not bet on that.
I think volatility is here to stay, a permanent change in the system. I have written in the past about how the advent of rapid-fire electronic trading has ratcheted up volatility (see my November 26, 2007 column). The computers that pick stocks are not being unplugged, and the hedge funds that use them are not going away.
Nowadays a large number of traders are poised to make money if the market goes down, and others can make money in both bull and bear markets. These traders both create volatility and thrive on it. Until a few years ago short-selling was mostly limited to a small number of hedge funds and marketmakers. Today the activity has spread to the far corners of the investment world. Short-sellers (and arbitragers with simultaneous long and short positions) inhabit Wall Street firms, hedge funds and even mutual funds aimed at middle-class investors. There are thousands of them.
You can see the attraction to computerized trading. A Wall Street Journal story on February 26 pointed out that there were 15 days in 2007 when Citigroup traders lost at least $100 million but 55 days when they earned more than that. Traders often care little or nothing about the underlying fundamentals of stocks.
Another factor behind the increase in volatility is the Federal Reserve, whose shifts in interest rate targets are telegraphed instantly to trigger-happy traders. Up to 1994, decisions by the Fed's Open Market Committee were not revealed until 6 weeks after they were made. The Fed's moves gradually seeped into the stock market. There was a cottage industry of experts who divined what the Fed had done before the Fed disclosed what it had done. The economist Henry Kaufman made a name for himself in the 1980s interpreting clues to Federal Reserve thinking. Since 1994 the Fed has immediately released its decisions to the public. The stock market reacts quickly and sometimes violently to these revelations.
A regulatory change is also fomenting volatility. The so-called uptick rule once decreed that you could sell a stock short only after its price had risen. Last July that rule was repealed. Result: a big surge in volatility.
One way to measure volatility is by the VIX Index, a number representing the market's assumption about near-term volatility in the S&P 500 Index. It is an annualized percentage figure, calculated from the pricing of put and call options on the index and published by the Chicago Board Options Exchange. In the final six months under the uptick rule the VIX averaged a value of 13%. In that same time the S&P's average daily move in the VIX (that is, the average of the absolute value of its members' daily percentage change) was 1%.
In the seven months with no uptick rule, the VIX has averaged 23%; the S&P Index's average daily change, 1.7%. Was that all a function of the market's slide since October, when the credit crunch and the mortgage mess began to hit? Hardly. The volatility numbers were almost as high between July and October: 22% and 1.6%. Chalk it up to the law of unintended consequences.
A heretical observation: The basic economy is doing better than most reports.
Volatility makes people nervous, and when they are nervous they think about recession. Here is a heretical observation: The basic economy is doing better than most reports, and pockets of the stock market are sensing that. We keep hearing that the consumer is under pressure. Meanwhile, stock in Wal-Mart [WMT], where America shops, continues to hold firm in the $50 area. If we truly are mired in a recession, then why are Caterpillar [CAT] (up 5% this year) and IBM [IBM] (up 10%) doing so well?
Conventional wisdom suggests that during recessions investors should buy utilities, but my Con Ed position drifts lower. During the sharp declines of January the weakness in oil stocks was attributed to the economy. Now, as oil trades above $100 per barrel, oil shares should be rallying. They are not.
Ultimately, good stocks will do well. CME Group [CME, 503], parent of the Chicago Mercantile Exchange, will continue to benefit from the growth in commodity trading. Goldman Sachs [GS, 179], despite $2 billion in writedowns, still posted $1.5 billion in first-quarter earnings, better than estimates. If anyone can prosper from volatility, it is Goldman.
END OF THE CROUPIERS
The genius that consisted of leverage in a rising market is over. But you can still make money in stocks.
We recall seeing at some point in the late 1980s a calculation that the outsized returns achieved by the leveraged buyout uber-celebrities of the day, Kohlberg Kravis Roberts & Co., could have been equaled or exceeded merely by buying the S&P 500 stock index using an equivalent amount of leverage. Clearly the risk to the LBO fund investors would have been lower with the later course of action, but fund managers KKR would have had some convincing to do to in order to collect their customary fees just for doing that. Nor would they have been able to bask in the adulation bestowed on them for having gotten in early on the swapping-debt-for-equity gravy train.
"Don't confuse brains with a bull market" (Humphrey Neill) and "Financial genius is a rising stock market" (John Kenneth Galbraith) are quotes whose relevance will never fade. Apparently Einstein-level genius is being leveraged in a rising stock market. But now the market is no longer rising, nor is easy access to leverage any longer available.
(Warren Spahn's about Casey Stengel also seems strangely apropos here: "I'm probably the only guy who worked for Stengel before and after he was a genius." Spahn played for him before and after, but never during, the times Stengel was directing the New York Yankees to 10 World Series appearances and 7 championships, 1949 to 1960.)
This means the field reverts to investors plying their trade by more conventional, less risky, means -- looking for cheap stocks, whatever their approach. Forbes columnist Lisa Hess surveys the post-leveraged geniuses world and finds what she thinks are bargains, although her choices curiously focus on a pair of companies that are as leveraged as they come.
The shocking collapse of Bear Stearns marks the beginning of the end of the croupier class. Those masters of the universe who had enriched themselves through the miracle of "two and twenty" -- hedge funds charge 2% in fees yearly and rake in 20% of any profits -- have seen the apex of their glory.
As Warren Buffett characterized them: Hedge funds are not an investment class. They are a compensation scheme for managers.
We are in the midst of an extraordinary transition away from hot-money investing, which was the source of unimaginable wealth until it was not anymore, and into a more reasonable allocation of both intellectual and economic resources.
I agree with fellow columnist Laszlo Birinyi: Market volatility is here to stay. [See posting immediately above.] Or to put it another way, the abnormally low volatility of the 2002–06 era will not return. During that bull market interest rates were steadily dropping, which made the financing of stock purchases ever more affordable and the upward march of stock prices fairly steady.
The decline in interest rates did not just raise stock prices, to the benefit of all of us. It made life particularly easy for masters of the universe, who owed their fortunes to the magic of leverage. After all, if you tell us what interest rates are going to be in three months, and allow us to borrow as much as we please, we all know exactly what to do. We buy madly, via a hedge fund or via a private equity pool, and we buy on margin.
The giant sucking sound you hear is from deleveraging. As hedge funds, broker-dealers and real estate investment trusts get death sentences, the long-repressed memory of debt's downside comes back with a vengeance.
When margin clerks rule the world they show no mercy. They look at the loan you took out to buy that now tanking stock, and want you to pony up, painfully. The money lost and the tragic personal bankruptcies that inevitably follow are not easy to recover from.
The U.S. market continues to be the best relative performer of the world's bourses, with the S&P 500 down 8% this year versus Germany's DAX, down 19%, and Japan's Nikkei, down 17%. Sadly, we cannot eat relative performance.
For foreign investors the U.S. is on sale. In New York City we have what are called GOOB stores: shady venues hawking shoddy, overpriced merchandise with large and phony "Going Out of Business" window signs.
But our equity market merchandise is far from shoddy and is getting cheaper all the time. Telling the tale is the U.S. Dollar Index -- a weighted average exchange rate between the U.S. and six other currencies. Over the past two years it has fallen from a high of 90.6 to a remarkable low of 71.7 today -- a price cut of 21%. In the same time, the S&P is basically unchanged.
While I continue to believe the U.S. offers the best absolute and risk-adjusted value, the domestic stocks I recommended in my last column have mostly taken a pounding. Exception: Target, which is flat. Recent encouraging news for the retailer is that it is poised to sell half its $4 billion credit card portfolio, reducing its exposure to defaults and freeing up cash for possible stock buybacks. Stick with Target and my other picks, such as Interactive Brokers Group. They will be back.
Here is another name you should own: Freddie Mac [FRE], which along with sister government-sponsored enterprise Fannie Mae, is at the epicenter of the housing storm. Federal regulators have given Freddie and Fannie the go-ahead to load on more mortgages, which is very civic-minded -- it could help unthaw the frozen market in mortgage-backed securities -- and also more risky. Freddie's mortgage delinquency rate expanded to 0.71% of its portfolio in January from 0.43% in February of last year.
Still, their federal overseers are loosening the reins on the duo, which have been on probation after an accounting scandal. The accounting problem is history.
Her faith in the wisdom of Freddie's and Fannie's federal overseers, as well as the post(?)-scandal quality of their accounting, is touching. Jim Rogers, in the interview covered above, is looking to short more Fannie (presumably shorting Freddie would suit him just fine as well) if its price rallies from here. We are inclined to side with Rogers, just out of caution if nothing else.
Nobody knows what the true value of Freddie Mac's assets are, and they fluctuate daily. Freddie operates with a capital vs. assets and guarantees ratio that make the most aggressive of banks and insurance companies look conservative by comparison. If, e.g., the assets they hold on their own balance sheets and the mortgages they insure are overvalued by 5%, their collective net worth is zero. It is hard to see how the shareholders benefit no matter how big a bailout effort the U.S. government mounts.
What is happening is that Freddie and Fannie can increase their loan limits on what they can package into mortgage-backed securities from $417,000 to as much as $729,000 (depending on locale). These so-called jumbo mortgages are less likely to go sour than the smaller home loans.
Plus, regulators have given Freddie and Fannie more ammunition: The two mortgage financiers now can reduce the amount of capital they need to keep on hand, enabling them to expand their balance sheets. The loosening of the capital requirements should help restore liquidity to the mortgage market. In addition, the twosome intend to raise fresh capital, likely via new preferred shares.
Freddie and Fannie are in effect calls on the health of the U.S. financial system. Yes, anything is a buy if it is cheap enough, including call options on mismanaged bankrupt operations. But there is plenty of downside left in those stocks.
The housing and mortgage sectors will recover at some point. Meanwhile, Freddie is cheap at 1.1 times book.
ECONOMIC STRUCTURE AND THE “LIQUIDATIONIST THESIS”
The U.S. economy is so maladjusted that a depression-like contraction is inevitable.
What lessons do the 1930s experience hold for us today? Most public policy makers, with Ben Bernanke in the lead, believe that the U.S. government did too little back then -- standing aside while the debt liquidation and economic implosion got out of hand, driven by some ill-advised faith in the free market. Others believe that the government efforts to avoid a recession, which they theorize was unavoidable given the excesses of the "Roaring Twenties", led to a prolonging and deepening of the downturn. They think a sharp but relatively short contraction, a la the 1921 post-World War I shakeout, would have done the trick. Instead we ended up with the Great Depression.
Doug Noland, featured almost weekly in these pages these days, sides with the parties of the second part. And he sees the same mistakes being made again by those with their sticky fingers of the levers of public policy.
Between Secretary Paulson's proposal [March 31] for financial regulation overhaul; [April 2] testimony by Federal Reserve Chairman Bernanke on housing and Bear Stearns before Congress's Joint Economic Committee; the appearance [April 3] by Bernanke, New York Fed President Timothy Geithner, Treasury under-secretary Robert Steel, and SEC Chairman Christopher Cox before the Senate Banking Committee; and the later appearance before the same committee by JPMorgan's CEO Jamie Dimon and Bear Stearns' CEO Alan Schwartz -- there was ample material this week for an entire book delving into critical financial issues of our day. I will attempt a couple pages.
From a Dr. Bernanke reponse: “One of the prevailing theories at the time of the Depression was the so-called 'liquidationist thesis' -- who said basically "let's let the system return to normal. Let's liquidate banks; let's liquidate labor." This was Andrew Mellon, the Treasury Secretary. It was partly on the basis of that theory that the Federal Reserve stood by and let a third of the banks in the country fail, which [caused] the money supply to drop sharply, and caused prices to fall rather sharply, and led ultimately to the severity of the financial crisis. I think financial instability, which was not addressed by government or anyone else, was a major contributor, both to the Depression in the U.S. and abroad. I believe the difference today is that we will address financial issues and try to maintain the integrity and stability of our financial system. We will not let prices fall at 10% a year. We will act as needed to keep the economy growing and stable. So, I think there are some very significant differences between the thirties and today, and we learned a great deal from that episode.” April 2, 2008, before Congress's Joint Economic Committee.
Not surprisingly, Chairman Bernanke invokes a notable policy error -- committed in the heat of an extraordinarily difficult (post-Bubble) early-1930s period -- as justification for government measures to sustain today's U.S. bubble economy. Bernanke and the "Friedmanites" just love to pillory Andrew Mellon and the "liquidationists" (and would gladly throw in Hayek and Mises). They avoid (like the plague), however, the much more pertinent policy debate that transpired throughout the Roaring Twenties.
Mr. Mellon was among a group of elder statesman that had become increasingly concerned throughout the decade by the Wall Street speculative boom and its inevitable consequences. The son of a banker, his family's wealth was nearly lost in the Panic of 1873. Actively involved in banking and business from the age of 17, he had witnessed first hand the consequences of the recurring booms and busts that were the impetus behind the creation of the Federal Reserve in 1913. Blaming Mr. Mellon and the "liquidationists" for the Great Depression -- as opposed to the extraordinary financial excesses and failed policies of the Bubble period - does disservice to history as well as to sound analysis.
There were astute thinkers during the '20s who believed the economy was being severely distorted from a protracted inflationary period that had commenced during the (first) World War. Although it was not manifesting in consumer prices (because of new technologies, products, overheated investment, etc.), excessive money and credit were fueling dangerous inflationary bubbles in asset prices -- particularly in real estate and the stock market. The astute recognized the boom as a period of acute financial and economic instability. [Sound familiar?] Certainly, the great "Austrian" economists appreciated clearly how credit and speculative excess had come to grossly distort incomes, corporate profits, relative prices and investment. The underlying structure of both the financial and economic systems was being corrupted.
Importantly, during that fateful period a group of seasoned thinkers (businessmen, policymakers, and economists) believed adamantly that policies endeavoring to sustain the distorted pricing mechanisms and structures -- and the resulting inflated and maladjusted U.S. economy -- were both inadvisable and doomed for failure. As such, so-called "liquidation" was a central facet of the unavoidable (post-inflationary boom) adjustment period for the highly distorted financial, labor and product markets. Profligate borrowing, spending, and leveraged speculation would come to their eventual end, requiring reallocation of both financial and real resources. It was only a matter of the degree of excess and the proportional adjustment.
To further inflate an unsustainable boom with additional cheap credit guaranteed only more problematic financial fragility, economic imbalances/maladjustment and resulting onerous adjustment periods. The astute were adamantly against the (Benjamin Strong) Federal Reserve's efforts to actively manage the economy (and markets) in the latter years of the '20s, fearing that to prolong the reckless Wall Street debt and speculation orgy was to invite disaster (the "old timers" had witnessed many!). History proved them absolutely correct, yet historical revisionism to varying extents has been determined to disregard, misrepresent, and malign their views and analytical focus. Bernanke's analytical framework of the causes of the Great Depression is seriously flawed.
Many today claim the current credit bust came out of nowhere, was unforeseeable ... yada yada yada ... despite that many in fact did predict exactly what has come to pass. And as Mr. Noland points out, most (all?) mainstream Depression buffs look everywhere for an explanation except to those who actually saw it coming. And the bust predictors, distant and recent past, were largely using the same conceptual framework.
Regrettably, all the best efforts by the Federal Reserve and Washington politicians to sustain the U.S. bubble economy are doomed to failure. It is not that they are necessarily the wrong policies. More to the point, the basic premise that our economy is sound and growth sustainable is misguided. We have experienced a protracted and historic credit inflation and it will simply be impossible to keep asset prices, incomes, corporate cash flows, and spending levitated at current levels. The type and scope of credit growth required today has become infeasible. The risk intermediation requirements are too daunting. Sustaining housing inflation and consumption levels has become unachievable. And the underpinnings of our currency have turned too fragile.
I am all for long-overdue legislative reform. Who isn't? But I will say I heard nothing this week that came close to addressing the key underlying issues. We have longstanding societal biases that place too much emphasis on housing and the stock market, while we operate with ingrained policymaking biases advocating unregulated finance underpinned by aggressive activist central banking and government market intervention. In a 20-year period of momentous financial innovation, our combination of "biases" proved an overly potent mix. And it is worth noting that Wall Street security/dealer balance sheets expanded 3-fold in the 8 years since the repeal of the (Depression-era) Glass-Steagall Act.
The focus at the Fed and in Washington is to sustain housing, the stock market, and inflated asset prices generally -- to bankroll the consumption- and services-based bubble economy. Bernanke believes that if financial company failures can be averted -- and with the recapitalization of the U.S. financial sector as necessary -- sufficient "money" creation will preclude deflationary forces from gaining a foothold. He assures us the Fed will not allow double-digit price declines, despite the reality that such price moves have already engulfed real estate markets. To be sure, prolonging current financial instability increases the likelihood of significant price level instability going forward. And while the federal government "printing presses" will be working overtime going forward, it is also apparent that a key facet of Washington's strategy is to "subcontract" the task of "printing" to Fannie, Freddie, the FHLB, the banking system, and "money funds" -- sectors that today still retain the capacity to issue "money"-like debt instruments with the explicit or implied stamp of federal government (taxpayer) backing.
Basically, the strategy is to substitute government-backed debt for the now discredited Wall Street-backed finance. I am the first one to admit that this desperate undertaking stopped financial implosion in its tracks. However, the problem with this whole approach -- because of our "societal," financial, and policymaking biases -- is that our credit system will just be throwing greater amounts of (government-supported) debt on top of already fragile credit structures underpinned largely by home mortgages. Wall Street-backed finance buckled specifically because this ("Ponzi Finance") debt structure was untenable the day increasing amounts of speculative credit were no longer forthcoming. The underlying inventory of houses does not have the capacity to generate debt service -- only the mortgagees taking on greater amounts of debt.
The underlying economic structure is now THE serious issue. The last thing our system needs right now is trillions more mortgage debt, although it would work somewhat to sustain consumption and our "services-based" bubble economy. The inherent problem with a finance, housing, consumption, and "services"-dictated economic structure is that it inherently generates excessive debt backed by little of real tangible value or economic wealth-creating capacity. System fragility is unavoidable. It may appear an "economic miracle," but for only as long as increasing amounts of new finance are forthcoming. At the end of the day, one is left with an extremely fragile structure both financially and economically.
Yet as long as Wall Street "alchemy" was capable of creating sufficient "money" to fuel the boom -- and the world was content in accumulating (increasingly suspect) dollar claims -- our bubble economy structure remained viable. It is, these days, increasingly not viable. The wholesale and open-ended government backing of U.S. mortgage debt -- and financial sector liabilities more generally -- will prove a decisive blow to already shaken dollar confidence. And it is today's reality that the massive scope of credit growth necessary to sustain the current bubble structure will correspond to current account deficits and dollar outflows that will prove (as we are already witnessing) only more destabilizing in markets and real economies around the world.
Government backing of our debt does not substitute for a sound economic structure. And it is the current structure that is incapable of the necessary economic output to satisfy domestic needs and to generate sufficient exports to exchange for our huge appetite for imported goods and energy resources. Today's "services"-based economy will no longer suffice. Examining today's job data, one sees that 93,000 "goods producing" jobs were lost in March after dropping 92,000 in February and 69,000 in January. At the same time, Education, Health, Leisure and Hospitality jobs increased 178,000 during the first quarter. Yet it is more obvious than ever that we need to consume less and produce much more.
Back to the "liquidationists". It is my view that our economy will require a massive reallocation of resources. We will be forced to create much less non-productive (especially mortgage and asset-based) credit in the Financial Sphere, while producing huge additional quantities of tradable goods in the Economic Sphere. In our expansive "services" sector, there will no choice but to "liquidate" labor and redirect its efforts. Throughout finance, there will be no alternative than to "liquidate" bad debt, labor and insolvent institutions -- again in the name of a necessary redirecting of resources. After an unnecessarily protracted boom, there will be scores of enterprises that will prove uneconomic in the new financial and economic backdrop. "Liquidation" will be unavoidable, policymaker hopes and dreams notwithstanding.
From this evening's vantage point, recent extraordinary government measures to "back" U.S. finance appear likely to delay the adjustment process -- what I will be referring to as a "depression." This reprieve, however, comes with a cost. It will ensure significantly greater damage to the core of our monetary system, as well as requiring a more onerous real economy "liquidation" with the inevitable onset of the more serious phase of the unfolding crisis.
CALIFORNIA HOME PRICES FALL 26% AMID FORECLOSURES
Our guess is that during the real estate bull market, foreclosed homes sold for only marginally less than non-foreclosed homes. Now they sell at 15 to 20% less. As the number of foreclosures jumps, the number of homes sold out of foreclosure also jumps, and, given the above discount, drags down the average sales price. The result was a 26% plunge in California home prices in March -- so large a number that one can only scratch one's head and wonder what it will all come to.
A glut of foreclosed homes helped prompt a 26% plunge in California home prices in March, highlighting a trend that experts said is likely to continue as low, introductory interest rates expire for people who bought near the height of the housing boom.
More than 38% of California homes sold in March had been foreclosed at some point during the previous year, DataQuick Information Systems said ... Figures for previous years were not immediately available, but company analyst John Karevoll said the March percentage for foreclosed home sales was believed to be an all-time high for the state.
The state's median home price was $358,000 last month, down from $484,000 in March 2007, when the market peaked, DataQuick said. The number of new and resale houses and condos sold during the month fell 38.3% from a year earlier to 24,565.
DataQuick said the numbers also reflect difficulty in getting financing for expensive homes. In March 2007, loans over $417,000 accounted for nearly 40% of home sales. Last month, those so-called jumbo loans accounted for less than 15% of sales.
The percentage of foreclosed homes on the market is growing as many potential sellers hang on to property and wait for prices to rebound. Foreclosed homes in California sell for about 15% less than non-foreclosed homes in the same neighborhoods, bringing all prices down, Karevoll said.
The nationwide foreclosure glut is expected to worsen in May and June as two- and three-year introductory interest rates expire on homes purchased in 2005 and 2006, said Rick Sharga, vice president of marketing at RealtyTrac, a research firm. ... Nationwide, foreclosed homes have been selling for about 20% less than similar non-foreclosed homes, Sharga said.
California housing prices may bottom out in summer or fall, around the same time that foreclosures peak, said Karevoll. Lenders appear to have loosened the spigot in recent months -- a trend that will likely continue into the fall -- though credit will not be as easy to find as it was during the market's heyday, he said.
The big uncertainty is whether the economy will sour even more, making it more difficult for people who lose their jobs to make payments, Karevoll said. "If we do have a recession in California, things will get bloody out there," he said.
The affordability of some foreclosed homes has helped some buyers. Cyndie Schubert, who earns $16.94 an hour as a parking garage attendant, said she bought a San Diego home out of foreclosure for $250,000 after two years of looking for places that were out of her reach.
The first-time homebuyer had to buy a water heater and kitchen appliances but the plumbing was new. "I walk to work, I have my white picket fence," said Schubert, who lives with her 25-year-old daughter. "It's got a little yard but that's all right."
Her mortgage payment of $1,104 eats up much of her first monthly paycheck, but it is only $300 more than what she was paying to rent an apartment in a crime-ridden neighborhood where she was raised in suburban El Cajon. She pays her other bills with her second monthly paycheck. "I got caught up on my bills, and it was time for me to do something," said Schubert. "I'm 52. It was time for me to leave (my daughter) some kind of legacy."
The foreclosure glut has hit California especially hard. The state ranks only behind Nevada -- and just ahead of Florida, Arizona and Colorado -- in the percentage of households in foreclosure, according to RealtyTrac's March rankings. California and Arizona are victims of an overheated market in the early part of the decade, when banks lent money for homes that buyers could not afford, said Sharga. Nevada and Florida had lots of speculative buyers.
Los Angeles Neighborhood Housing Services, a nonprofit group, is counseling about 2,000 financially troubled homeowners a month this year, up from about 200 a month during the same period last year, said Lori Gay, chief executive officer. The group developed a "triage system" to accommodate the flood of people seeking to avoid foreclosure, Gay said. Previously, the organization worked with people over three or four months, often in classrooms. Now it asks people to tackle questions online and aims to give them quick answers.
"We're expediting in a way that we wouldn't have to before," Gay said. "Now there's not a lot of time. They're up against the wall."
HERE IS HOW TO END THE PANIC
Steve Forbes, editor of Forbes magazine and one-time Republican presidential candidate, is rather too enamored of military adventurism and certain aspects of centralized government for our taste. But he does have a lot of good ideas, foremost among them being his consistent advocacy of a strong dollar policy and a vastly simplified income tax system. Here he sounds off on how to put an end to the current credit panic. We think the system is rotten to the core, but to begin to have a rational debate on the subject the current agony does have to be sedated, and Forbes is worth listening to from the perspective.
The Bush administration must take two steps immediately to quickly halt the unending, enervating credit crisis: shore up the anemic dollar and, for the time being, suspend "marking to market" those new financial instruments, such as packages of subprime mortgages.
The weak dollar is pummeling equities, disrupting the economy, distorting global trade and giving hundreds of billions of dollars in windfall revenues -- through skyrocketing commodity prices -- to our adversaries such as Iran and Venezuela. Not since Jimmy Carter has the U.S. had a President so oblivious to the damage done by an increasingly feeble greenback.
The Federal Reserve can rally the markets for a day or two by finding some new mechanism through which to lend more money to banks and other financial institutions. But this is the proverbial Band-Aid for a patient who is beginning to hemorrhage.
The Administration acts as if the dollar were like the sun, its rising and falling beyond any control. Countless times experience has shown that notion to be false. The U.S. Treasury Department could buy dollars in the currency exchange markets. Our allies would gladly cooperate with such an operation; their exports are being hurt more and more. The Fed could mop up some of the excess liquidity it has created since 2004, even as it makes targeted loans to beleaguered banks and financial houses.
The other measure: The Treasury Department and the Fed should get together with the SEC, the Comptroller of the Currency and other bank regulators and announce that financial institutions for the next 12 months will no longer write down the value of exotic financial instruments (primarily packages of subprime mortgages). Instead, writedowns will occur only when there have been actual losses on those assets. If a mortgage defaults, a bank will then -- and only then -- recognize the loss.
It is preposterous to try to guess what these new instruments are worth in a time of panic. Such assets are being marked down to increasingly arbitrary low levels. But when a bank books such a loss, it must replenish depleted capital, even though cash flows for most financial firms are still positive. Worse, when forced by panicky regulators and lawsuit-fearing accountants to write down the value of these securities, institutions will dump assets in a market where there are temporarily few or no buyers. The result is a spiraling disaster. So let us have a time-out on markdowns until we actually have real experience in what kind of losses are actually going to occur.
These two steps would quickly end the panic. Until that happens, expect more trouble.
In theory marking to market imposes a worthwhile accounting integrity and financial discipline. In practice, it only gets enforced rigorously during a financial panic -- when it does not make since if, as Forbes asserts, cash flows are still positive. Cash flow is the lifeblood of all businesses. The "true" value of an asset is the estimated discounted value of future cash flows produced by the asset. If the market value deviates in an obvious matter from the true value due to the market itself being messed up, then those market values cease to be a useful benchmark for anything.
THE CASE FOR GOLD
U.S. real short term interest rates are negative. This has historically been associated with strong moves up in the price of gold. However, the recent correction in gold was not driven by a move up in real interest rates. It apparently was driven by a lessening of panic in the credit markets. Adrian Ash argues that this is temporary, and that we have not seen the end of the gold bull market.
You can link the historic surge in gold prices starting mid-August 2007 to many apparently disparate things. Pick the correct link and you might be able to tell whether it is worth you buying or holding gold today.
One such link is the price of money, as decided by the U.S. Federal Reserve. Gold's stellar 58% gain in the seven months starting August 18 began with the Fed's first change to U.S. interest rates in 18 months. Last August's 0.25% cut to the Fed's "discount rate" -- the interest rate it charges commercial banks to borrow short-term funds -- was the Fed's first interest rate cut since July 2003. By the end of March 2008, it became a 3.0% cut to the bank's key fed funds target. And gold's initial jump turned into a pole vault ...
The real cost of borrowing dollars -- or, rather, the real returns paid to anyone saving money today -- clearly impacts the demand for investment gold. You can measure this real rate of interest quite simply. Just subtract the rate of consumer price inflation (CPI) from the fed funds interest rate, as in the chart above. Then compare this changing value to the price of gold and you will see that when the real returns paid to cash sink below zero, investors and savers tend to pay more -- or demand more -- for gold.
That is what investors and savers did in the 1970s. It is what they then did NOT do again until real U.S. interest rates sank toward and below zero during the first six years of this decade. Why choose gold when real interest rates sink? Because if central bankers, driven by a fear of "deflation" in asset prices and consumer spending, try to stop the public from hoarding cash, then people will seek out reliable stores of value instead, led by hard assets.
Unlike real estate, however, gold bullion remains a highly liquid, easily priced asset that can store huge quantities of wealth in a very small space. And gold, as the action since August's first Fed cut reminds us, has acted as a reliable store of wealth for more than 5,000 years. In times of monetary destruction, or so history says, it is human nature to seek an escape from fast-shrinking currencies [see graph].
Another important connection -- also related to the Fed's new rate-cutting cycle -- sits in the currency markets. In particular, look at the euro/dollar exchange rate. Because as the dollar sank versus the euro in the back half of 2007, daily movements in the U.S. dollar gold price were more strongly linked to the euro than they were to crude oil, the broad commodity markets, and even the price of silver -- gold's poor cousin in the precious metals market.
This "correlation coefficient" would stand at zero if gold's daily movements bore no relationship whatsoever to the euro. It would be negative if gold rose when the euro slipped back ... The correlation would stand at 1.00 if they always moved together in lock step.
And as of last month, gold and the euro were more tightly connected (with a correlation of 0.62) than gold and crude oil (0.45) or gold and the broad Goldman Sachs Commodities Index (0.29). What does this tell us? First, the gold price is behaving much more like a currency than it is acting like a raw material. This is unsurprising given what little use gold has as anything other than a store of value.
Barely 15% of last year's total gold fabrication worldwide ended up in either electronics as gold bonding wire, coating for space shuttle windows, or in people's teeth as dental fillings. But that lack of apparent practical use -- which actually grew by 49 tonnes from 1998, to total 411 tonnes in 2007 -- does not mean gold is useless.
You would hardly say the European single currency holds zero value, correct? But you try fueling a jet engine or building a highway with euros today ... That is why smart institutions such as the Royal Bank of Canada trade gold alongside the euro on their currency desks, rather than handing it to their commodity teams. If you think the long-term decline of the dollar is only set to grow worse, you might want to consider joining them [see graph]. ...
[T]he gold price in euros has risen by more than 160% from its lows of 1999, even as the European currency has surged against the dollar. The upshot? Do not be misled by that strengthening correlation between gold and the euro. You would still have better rewarded a bearish view of the greenback in gold than in the European single currency or any other major world money. And while the euro has risen 48% against the dollar since March 2003, gold outpaced that gain by a further 97% on top.
But just before you open a new Internet window and type "Buy gold" into Google today, hang fire for a moment. Because yes, the dollar's 12% loss versus the euro has somehow created a 28% gain for European gold investors since last August. And yes, again, the Fed's new rate-cutting campaign still has no firm end -- let alone a reverse -- in sight.
But if everything's lined up for a fresh surge in world gold prices, why did the market pull back so sharply in the middle of March? Plunging 15% from its new all-time record above $1,030 per ounce, the gold market now stands some $100 lower. The euro, in contrast, has risen since then. So too has the oil price. The latest cut to Fed interest rates lopped another 0.75% off the gross returns paid to dollars, as well. So why the big swoon?
"This sharp reversal in price cannot be explained by a stronger U.S. dollar," notes the team at Virtual Metals in London, writing in the April edition of Metals Monthly on behalf of Fortis Bank. "Gold's decline measured in euros has been larger than in dollars. "Nor can [the drop] be explained by a reduction in inflationary expectations, as this hasn't happened," they go on. "Instead, it seems to be narrowly based on improving sentiment in the credit markets ..."
This chart "shows a close relationship since October 2007 between the gold price and the benchmark Markit CDX investment grade index, which measures the risk of credit-swap defaults," explain Matt Turner, Gary Mead, and Jessica Cross at Virtual Metals. In plain English, the Markit CDX measures the cost of buying insurance against nonpayment by 100 big corporate borrowers in the United States. And "As the Bear Stearns panic subsided, the index fell sharply, and so did gold."
Meaning? Gold did not only surge on the Fed's rate-cutting frenzy to mid-March. It also gained as institutional investors ran for cover amid the world-banking crisis -- a crisis yet to end. No one's to create at will, gold is also no one's liability -- not if it is owned outright, rather than as a mere credit on a gold dealer's ledger. Incredibly, London professionals have told BullionVault that around 97% of the world's gold dealing takes place on this kind of "unallocated" basis, attaching a real risk of default to the vast bulk of day-to-day gold trading.
Perhaps that concern explains why, alongside gold futures and exchange-traded gold trust funds, the latest GFMS analysis notes "healthy growth" in physical gold bullion investments, "mainly in allocated accounts." This market in late 2007 "was dominated by institutional and high-net worth investors," the group's Gold Survey 2008 goes on. "Many of the latter bought gold as a safe haven, soon after the subprime credit crisis erupted." Demand from smaller retail investors, in contrast, "grew over the year (and notably in the last couple of months), but its contribution to total investment remained marginal overall."
In short, the mass of private investors and savers still have yet to buy gold, or even consider it. So if you were concerned that gold might be reaching some kind of bubble, you might want to consider the absence of "last fools" to date.
You might also want to note that, so far, the threat of U.S. corporations defaulting on their debt obligations has been more imagined than real. Just what happens to the price of insuring corporate risk -- and the resulting dash into gold -- when debt defaults really do start to turn higher?
THE HIGH PRICE OF PRICE TO EARNINGS
Much of what passes for investment analysis these days concerns whether a company's price-to-earnings ratio "should be" higher or lower. So if an analyst predicts earnings of $X per share for a company and decides that a "fair" multiple is Y, and the stock price is some fraction of $X*Y, then it is a "buy". (During a bull market, "fair" multiples miraculously climb while required discounts to value to make a stock a buy fall.) Now analysts as a group have never been and are still not very good at predicting earnings, so the exercise is basically academic anyway. But an inquiry into what multiple of current or expected prospective earnings constitutes under/overvaluation is a useful one. Jonas Elmerraji has written an introduction to the subject.
You cannot open a newspaper these days without hearing about the state of our economy. Bear market this ... Recession that. And left and right analysts and investors are falling all over themselves to find that "cheap" stock -- and throwing around price to earnings (P/E) ratios to make their cases. But just because a stock looks cheap does not mean that it is worth throwing money at ...
The price-to-earnings ratio is one of the most well-known -- and maybe misunderstood -- metrics that investors can use to look at how much a company is worth. The P/E ratio is calculated by taking a company's market capitalization and dividing that by its net income. Basically, it is a multiple that tells you how much investors are paying for that company's net income.
But remember, P/E ratios vary from industry to industry -- while American Express's P/E is somewhere around 13 right now, it does not make sense to say that it is any cheaper (or more undervalued) than Apple, which has a higher P/E of 33. They are in different industries, so you can expect very different P/Es.
With that little nugget in mind, it is easy to fall into the trap of thinking that P/E ratios are the end-all be-all for stock valuation. Granted, it is a valuable tool for measuring value, but there are also some things you should keep in mind about a company's P/E. ...
When P/Es are low (compared to the industry or a historical P/E), investors are prone to think that it is a sign that they have got a bargain on their hands. But why might that number be low? For one, you might see a company's P/E ratio drop when investors do not think that its stock is worth what it used to be. That is what happened to OFSI, a banking company that is banking on some "substantial" losses this year. OFSI's P/E is sitting around 2, while others in their industry are sitting pretty with double-digit P/E numbers.
Another concern with the price to earnings ratio is the fact that "earnings" does not always mean "how much money we made" ... Companies report income according to Generally Accepted Accounting Principles (GAAP). Because non-cash items can affect a company's earnings in a big way, the P/E is not always an accurate read on valuation. ...
Under perfect certainty, a company's value would be the discounted value of its future cash flows -- not earnings. No more, no less. In real life, you have to account for the uncertainty of future cash flows and attach an approriate risk-adjusted discount rate to the cash flows, but the principle is the same. In particular, you can spend cash flow but not earnings.
Some cash outlays grow in a fairly predictable manner. How much receiveables and inventories are needed to support an additional dollar of sales tends not to vary much over time for a company with good controls. Other uses of cash such as spending on physical plant can vary widely from year to year. Thus companies like to smooth that spending/cash drain by depreciating it gradually for earnings reporting purposes. (Tax rules generally force that treatment as well.) But make no mistake, that cash was spent today. And companies whose earnings are offset by lesser cash drains invariably are assigned -- justifiably -- higher earnings multiples by the market.
Another way of thinking about the issue is to imagine you are buying the whole company. Do you care what GAAP reported earnings are. No you do not. You care about how much cash you can take out over time vs. how much cash you have to put down to buy the sucker. A rational approach to investing is to maintain that way of thinking when buying small company pieces, i.e., shares of stock.
Now, don't get me wrong ... I am definitely not saying that you should toss the price-to-earnings ratio. Like I said before, the P/E ratio is one of the most valuable tools investors have for determining a company's value.
What I am saying is that the P/E ratio should be used in concert with other metrics to get a better picture of how much a company's worth. Using other fundamentals like dividend yield (if the company pays a dividend), enterprise value, PE-to-growth ratio, and price-to-cash flow can help you get the whole picture on a stock's prospects. ...
You do not have to be Warren Buffet to learn how to value companies effectively. What you do need is a solid understanding of how valuation ratios like P/E work, shortcomings and all.
THE AUTOMOTIVE ENERGY REVOLUTION
Whether one believes in the "Peak Oil" thesis totally or takes it with a substantial grain of salt, it seems -- which always does until it no longer does -- that the cheap oil of the 1980s and 1990s is not coming back. Byron King looks at what this means for the automobile industry.
Every automobile on the roads of the world reflects a long and complex chain of industrial production and energy usage. Yet we live in a world where many of the highest quality resources and energy supplies have already been exploited. And lower quality resources are more expensive to extract and exploit, if they are even available. So the world's automobile industry is in the midst of a revolution in both resource availability and energy consumption.
Today the automobile business is vast. It is a global industry that has evolved by leaps and bounds in the 100 years since Henry Ford made his famous remark in 1908 about building "a car for the great multitude." The worldwide customer base includes at least a billion people -- spread over six continents -- who have income sufficient to buy a car or small truck. According to figures assembled at the MIT Sloan Automotive Laboratory, there are about 700 million automobiles and light trucks in the world. About 30% of those vehicles are in North America.
Every car requires steel, aluminum, copper and lead. Each car requires rubber, plastic, and myriad of other petroleum and natural gas by-products. And there is much else in the long industrial ladder of automobile production. Just think in terms of the energy that goes into processing materials, fabricating parts, building components, assembling a finished product, and all the transportation along the way. In addition to the basic energy and material resources that go into manufacturing an automobile, the sheer number of vehicles reflects a lot of fuel tanks to fill with gasoline and diesel. And this does not even touch on the energy and resources that go into building road systems.
The oil shocks of the 1970s -- in both price and availability -- spurred improvements in auto energy efficiency within the U.S. as well as worldwide. In the U.S., the increase in fuel efficiency was related to rising costs for gasoline, as well as government mandates for higher fuel efficiency dating from the late 1970s. On average over the past 25 years, the typical power train of gasoline-fueled automobiles in the U.S. has improved in efficiency by about 1% per year according to data gathered by MIT. While discrete, 1% improvements may not appear to be much, the compound improvement in the typical U.S. automotive engine over 25 years has been about 30%.
There has been even more progress in the fuel efficiency of diesel engines over the past 25 years. Diesel power trains are no longer the sooty, "knock-knock" devices that they were back in the days of disco. Most cars sold today in the European Union, for example, are powered with clean-burning, fuel efficient, smoothly running diesel engines. In fact, the demand for diesel fuel in Europe is such that EU refineries routinely ship surplus gasoline to sell into the North American market. And in North America the relatively low prices for gasoline throughout the 1980s and 1990s discouraged the use of diesel engines.
So there have been significant improvements in automobile power train efficiencies over the past couple of decades. But have these improvements translated into any overall reduction in demand for fuel? No. In 2007 motor fuel consumption in the U.S. was high as it has ever been. (Although according to the American Petroleum Institute, demand for motor fuel may be at a plateau due to price increases at the pump in 2006 and 2007.) In the past 25 years we have seen more people driving more cars for more miles. But compounding the fuel issue, the cars that people are buying and driving tend to weigh more and offer higher performance.
As I have said over and over again, we live in a world of peaking oil output, and of energy and resource scarcity. So the trend lines for fuel usage by automobiles simply cannot continue for much longer. The first, most obvious sign is the rising price for oil and by extension for fuel at the pump. Something has got to give, and the energy markets are sending signals of long-term high prices for motor fuel. Where do we go from here?
Well first, people and policy makers have to realize that there is an energy problem. Everyone has to realize that this is something permanent, going forward. "Peak Oil" will not pass if we ignore it long enough. And no one can solve the problem just by bellyaching about the rising price for gasoline.
It helps to view the age of the automobile -- and its future -- as a systemic whole. And some social critics are out in front of the broad discussion, with a sharp focus on the automobile and what it has brought us as a society. James Kunstler, for example, author of highly regarded books such as The Geography of Nowhere and The Long Emergency, believes that the car-dependent suburban build-out of the U.S. may be "the greatest misallocation of resources in all of human history." That is, in an era of expensive energy and scarce resources, a car-dependent culture has no real future and is in fact a hindrance to progress in other directions. That is quite a viewpoint, well-presented by Kunstler in his writing. It is depressing, but it sure gets your attention.
And criticism of the automobile culture is not confined just to social commentators like Kunstler. Another remarkable indictment comes from no less an automotive insider than Prof. John Heywood, the director of the MIT Sloan Automotive Laboratory. He has stated that "cars may prove to be the worst commodity of all." According to Prof. Heywood, cars are "responsible for a steady degradation of the ecosystem, from greenhouse emissions to biodiversity loss. What is worse, even if we improve vehicle efficiency, turn to fuel hybrids or make rapid advances in hydrogen-based fuel technologies, the scale for slowing down the degradation may run to the decades. Turning the curve won't be easy."
You can agree or disagree with the broad themes of Jim Kunstler or John Heywood. But there is no argument with one of Prof. Heywood's points. Wherever we are going, it will not be easy to "turn the curve." Looking forward, the oil just is not there to fuel cars in the future in the way that we did it in the past. So a lot of people are going to have to do things differently.
Worldwide, the automobile industry has seen the handwriting on the wall. Fuel is expensive, and is getting more so with each passing year. So the industry has invested tens of billions of dollars in improving engine and power train efficiency. In addition, auto designers are coming up with new ways to eliminate weight and drag. (At higher speeds, up to 70% of the energy used to turn the wheels on a car goes just to push the air out of the way of the chassis.) The auto industry is looking towards different sorts of fuels, and moving towards what is called fuel-flexibility.
Hopefully this will lead us to a great new investment in the car of the future.
ONE OF THE LAST WAYS TO PROFIT WHILE THE PUNDITS SLINK AWAY UNSCATHED
Patrick Cox notes with irony that all the bubble-enablers are now bearly suffering even a cross word for having been totally wrong. But the job of financial reporters is really just to feed the public what it wants to hear -- at least on the way up. While stocks are going up and the public is long stocks, it wants to hear that prices will continue to rise. When prices are declining the public wants to know who is to blame for their losses.
Cox thinks one can profit by betting against the mainstream pundits. In particular, the screaming housing disaster headlines mean it is getting close to buy time for real estate. He does add a major qualification to the recommendation: Buy where the income produced by the property alone is greater than the carrying costs. Forget entirely about capital gains in this calculation. This is sound advice. We wonder how many such opportunities are out there. And, by the way, one should include a "margin of safety" in one's expected rental income projections. Just like housing prices no longer "always go up," rental rates can fall when the income level of a region falls.
In general market news, the Fed continues to grow the money supply to lessen the impact of the subprime mortgage fiasco. For those of us who predicted this entire dreary affair, from housing bubble to credit bust, it is extremely frustrating. It is not even fun to gloat anymore.
Reality is an educational process, and there are lots of lessons to be learned from the last few years of financial folly. One is how useless most of the mainstream media's stable of clueless financial writers are. Of course, we already knew that. Once again, the columnists who got it entirely wrong are skating blithely away from the mess they have enabled.
In a more perfect world, those who encouraged the public to believe the general housing market could rise at bubble rates forever would be laughed out of the financial publishing business. This, unfortunately, is not how it works. Nor has it ever.
My first taste of this reality came with the banking and S&L crisis in the late '80s. Writing regular columns for USA Today, I warned that policies were setting up a disaster. When the disaster happened, however, the financial columnists who had completely missed the boat were never called to the floor. Most were given raises.
The same thing will happen now. Most media will learn nothing. They will be on board for the next bubble, as well. Of course, the media are no different from the general public, so perhaps I should not be so hard on journalists. The cycle of boom and bust seems to be in our genes. As long as financial records have been kept, all the way back to the Phoenicians, a significant percentage of the population has bought high and sold low.
Regardless, Fed policies aimed at preventing failures in the financial sector will continue to drive the dollar down compared with other currencies. This ain't rocket science. With the growth in dollars outpacing U.S. economic growth, supply and demand in the currency markets will make dollars cheaper. If I were giving shorter-term market advice, I would be looking hard at sectors that profit from inexpensive dollars. Exports and domestic tourism are going to get boosts as currencies such as the euro gain purchasing power in the U.S.
Also, this is, obviously, the time to think about housing. Sellers are worried, if not desperate. I do not do timing here, but we are surely closer to the bottom than to the next top. Ironically, old-school value-based real estate investment is going gangbusters. It did so during the entire run-up and continues to do so during the collapse. You know what I am talking about. You borrow the money to buy a property in a stable growing area, where profits from rental incomes are greater than the costs of ownership. Then you let renters pay for your asset until you want to cash out. Such purchases provide, by the way, one of the only real tax shelters left today.
Even in the current credit crunch, someone with good credit can borrow on property that generates more money than it costs. Do not look at the price appreciation of a property when judging real estate as an investment. Look at the return on the cash you put in.
My philosophy is that you should never buy a house or other consumer durable expecting the price to rise. If it does, that is fine, but the investment should make sense even if prices fall. If you can buy a house without having paid for it yourself, your return on actual "cash out" investment can be unbelievable.
Nowadays, the same crowd that rushed to buy when prices were high is rushing out. Many are convinced that with prices low, it is time to sell. This is an old, sad story, but I suggest you take them up on their offer.
HEDGE FUNDS: NERDS AND BARBARIANS
Hedge funds have taken a lot of justifiably bad press lately, but not all hedge funds are created and run equal. As with mutual funds, they invest using all manner of styles. Some take things to leveraged extremes not available to mutual funds, but others invest using a hard-to-criticize conservative style. In the end, the term "hedge fund" refers to a legal setup. Thinking of them as an asset class makes no sense.
Commentator David Merkel breaks down the hedge fund universe between those which seek yield, the "nerds", and those who swing for the fences, the "barbarians". Nerds do not like volatility, while barbarians love it. Because of the current high volatility the nerds are hurting, but Merkel thinks it is time to start thinking about favoring the nerds.
There have been a lot of bits and bytes spilled recently over whether hedge funds like volatility or not. ... Here is the truth -- the answer is not a simple yes or no. Hedge funds are limited partnerships that do a wide variety of things in the markets. Some aim for easily modeled consistent gains through arbitrage. Others aim for maximum advantage, no matter what. I call the first group the "nerds" and the second group the "barbarians." Neither of these terms are meant to be insulting -- I consider myself to be a nerdy barbarian.
Nerds are yield-seekers. They are attempting to achieve high smooth yields well in excess of the nominal risk-free rate on a constant basis. They tend to get funded by fund-of-funds who attempt to diversify nerds, and maybe a barbarian or two, who have clients looking for smooth yields in excess of their hurdle rates.
When volatility rises, nerds get hurt. In the same way that junk bond investors get hurt in volatile times, so do hedge fund nerds. Almost all simple arbitrages rely on calm markets, where there is enough liquidity to finance every project imaginable, and a few that are not imaginable. Volatility alerts investors to the concept that maybe there will not be enough cash flow to complete the transaction at a positive net present value.
Barbarians are another matter. They swing for the fences, and are looking for maximum advantage. They look to earn the returns from big bets that could be right or wrong. They like increased volatility, because it enables them to take positions when they are despised or enraptured. They play for the mean reversion, something that the nerds cannot do.
To make matters more complex, some hedge fund groups blend the two attitudes. Good idea, if you can maintain your competitive advantages.
To close this, there is no simple answer to whether hedge funds like volatility or not. Some benefit, some get hurt. In my opinion, because of hedge fund-of-funds, which like nerds, volatility tends to hurt hedge funds in aggregate, but not by much.
With credit spreads wide, and disarray among the nerds, it is probably time to favor high yield investing and nerds in hedge funds. Do not jump in with both feet though, I would only allocate 50% of a full position at present. There is a lot more volatility to be worked out of the system.
SHORT SALE IDEA: TUPPERWARE BRANDS IS OVERVALUED
The sterotypical short sale candidate is some hyped-up borderline fraud -- or at least something hyped up. But just as a conservative value buyer might initiate a purchase a blue chip that he or she figures is 20% undervalued or so, a "value shorter" might look to sell a quality company that has just drifted into mild overvaluation territory. The virtue is that hype stocks may collapse in the long run but you have to survive the short run to reap the benefits. No price is too high for pie in the sky. Whereas with a "value short", such as the Tupperware Brands sale recommended here, if you are wrong your downside is limited. The stock may go up, but if you have done your homework there is no real risk of it going through the roof.
Tupperware (TUP) may not produce the most exciting products on the market but its stock has performed extremely well. In stark contrast to the broad market, TUP is up more than 20% year to date, with much of that gain coming after posting strong 4th quarter 2007 results. Revenue jumped 19% and net income was up almost 38%. As a result, stock investors pushed TUP up in a big way -- up more than 40% since the results were made public on January 29th. We offer congratulations to Tupperware shareholders but the stock is now overvalued and will not remain at such price levels for long.
The business has performed well of late and TUP has made significant gains internationally, as evidenced by the Q4 results; however, one has to suspect that much of that strength has been priced-in to the stock through its recent out-performance. This rapid price appreciation puts TUP's valuation metrics outside of its normal levels. As an example, price-to-cash flow is currently 10.6x, while TUP has historically traded in the range of 7.1x to 10x. Likewise, price-to-sales is normally .73x to 1.09x and it is currently slightly out of range at 1.14x. These numbers are not massively out of line but are symptomatic of an overvalued stock, which -- in this market -- makes it an excellent "source of funds" as TUP's recent capital gains are at risk.
Long-time TUP shareholders will surely recall the stock's plummet from $55 a share in December of 1996 down to $11 in September of 1998. There is no evidence to suggest that a decline of that magnitude is in order, but it is worth noting that it has happened before. We have a long-term price target in the neighborhood of $32-$38. [The stock was around $40 when this was published.] Therefore, we recently downgraded TUP to a Sell rating in our 4/5/2008 report. ... [W]e have a very solid track record with this stock and rated it a Buy when it was trading in the low 20's earlier [last] year.
SHOULD SHORT-SELLING BE LIMITED?
Companies whose stocks get heavily shorted love to accuse the "market manipulators" of hurting the company -- not just the stock price, but the business as well. A hypothetical scenario is the stock price goes down enough to spook the company's lenders, who pull the plug, and then the company cannot keep going. The sudden collapse of Bear Stearns last month has engendered accusations against parties unknown of such a scheme. Now the S.E.C. may be looking into the matter.
I criticized Barack Obama's call to go after market manipulators like those rumored to have brought down Bear Stearns last month. My contention was that stricter enforcement could have a chilling effect on the dispersal of good information. But regulators seem to be taking the issue seriously. In congressional testimony earlier this month, S.E.C. boss Chris Cox strongly implied that the agency was looking into the Bear matter.
And Knowledge@Wharton now points us to some recent research which argues that bear raids" can cause real economic, not just financial, harm.
Itay Goldstein of Wharton and Alexander Guembel of Oxford look at a hypothetical situation where a company is looking to invest in a project with an outcome that is unknown. In a world where investors have special information about the potential payoff from the project, then if we see the stock price rise after the announcement, we have a good idea that the outlook is good. On the other hand, a price decline means that the project is probably a bad idea.
But in the real world, there are investors who don't have any special knowledge about such projects. If they chose to buy the stock on this non-information and the project turns out to be a bust, then investors lose out.
However, if investors start shorting the stock on no information and the stock declines, the company may read this as a sign that they should not take on the project, even though it would ultimately have been profitable.
"On average, this is the wrong decision and will in itself reduce the value of the firm," the authors write. "This enables the speculator to cover his short position at a lower cost and make a profit. Due to the nature of this strategy, we refer to it as manipulation."
Of course, it's important that no one know what the speculator is up to, Goldstein says. "If everyone in the market knows that this hedge fund is trying to manipulate [the stock], then it will have no effect." It is essential, he adds, that the market's other players think the manipulator bases his decisions on insight even if he does not.
This is very academic hypothetical argument, but it is getting at a real phenomenon. One could, of course, argue the reverse as well: If investors/whoever pump up a stock, the company may read this as a sign that they should take on the project, even though it would ulimately be unprofitable -- in the sense of being value destroying, with a return less than the company's cost of capital. Of course, this is what happens all the time during a loose credit-inspired mania. That is what the Austrian economists have been saying all along. We expect S.E.C. investigations on this matter to commence tomorrow.
The authors argue that regulations aimed at stifling incentives for manipulation through short-selling can improve market efficiency. The S.E.C. already has some restrictions against selling short, but Goldestin and Guembel's analysis implies that further tightening may be needed.
In effect the authors are arguing that incentives that stifle irrational stock pricing leads to more efficiency. This is, of course, a "Good Thing" (a term that saw heavy use in 1066 and All That long before Martha Stewart popularized it). Good luck with all that.
THE DEGRADATION OF ACCOUNTING
Some problems with “mark to market” accounting.
Steve Forbes noted in an article flagged above that "mark to market" accounting imposes perhaps unnecessary contraints on a financial system's ability to equilibrate if enforced too rigorously during times of stress. But that is valid only if it allows otherwise viable institutions to carry on where they might otherwise have been prematurely foreclosed upon. In other words, looking the other way is justified if there is good and sound reason to believe the distressed assets will recover in price. But if the value is permanently impaired, then the bullet must be bitten. Finessing the timing of the recognition will be of no avail.
Martin Hutchinson notes that the same mark to market concept has been shamelessly abused in another context: By marking values of illiquid assets up and generating earnings -- and executive bonuses -- off the markup. As a bull market gets long in the tooth, one can expect to see lower quality companies getting their day in the sun. Shoddy accounting accompanies shoddy businesses. But in the case of the mother of all bull markets just past, the shoddy accounting became widespread to an unprecendented extent.
Fair value accounting, by which debt and equity securities on a company's balance sheet are "marked to market" -- written up or down to their market price -- has been hyped by accountants and regulators as the epitome of modern financial reporting, enabling investors to gain a completely true picture of their investment's financial position. Indeed, Gerald White of the Chartered Financial Analyst Institute ... believes it should be applied to all items on the balance sheet, not just financial instruments. There is just one problem: In the turbulence of the last nine months it has completely failed to work, and has indeed shown itself to be pro-cyclical, encouraging economically foolish behavior in both up and down cycles.
As someone who only thinks about accounting once a decade or so, I was not really aware that much had changed from my business school days in the early 1970s. At that time, the values of assets on the balance sheet did not move much. Everything the company owned was dumped on the balance sheet at cost price and stayed there for decades while the world turned. The only exception was when the company held bonds or shares that had declined catastrophically in value (the occasional wobble was ignored) in which case they were declared "impaired" and their value written down. The fun for analysts was in finding companies whose downtown real estate was still held on the books at its value of 1926, when it had been bought, since there just could be a little teensy-weensy asset profit that might be unlocked from the company if one could figure out how.
This attitude to values was maintained through the inflation-accounting period of the late 1970s and early 1980s. Assets were assumed to be held for the long term, so buildings were written up by the movement in the consumer price index between the asset's purchase date and the balance sheet date. U.S. and British accounts differed in their approach to inflation accounting, which may have been one reason why it was abandoned fairly quickly once inflation returned to single digits, but neither system attempted to "mark to market."
The "mark to market" approach had been used since 1940 by U.S. investment banks, holders of large numbers of tradable securities, who needed to convince their regulators that their capital was adequate. It was not, however, used by British merchant banks, equally holders of substantial amounts of tradable securities. Only a small portion of merchant bank assets was held in a "trading account". The remainder was held on a "back book" investment account and valued at cost. In this way, merchant banks were able to manage earnings very effectively; generally they built up large "hidden reserves" in good years which were amortized into earnings in years of unexpected dearth, so that the overall picture was smoothened. The result was to increase the confidence of the market in each merchant bank. People assumed that 200-year-old institutions had accumulated enough "hidden reserves" and undervalued real estate to smooth out any problems that might arise.
Mark to market accounting spread beyond the traditional investment banks around the late 1980s. Its great advantage, to executives who were for the first time paid a large portion of their remuneration based on profits, was that values could be marked up as well as down. No longer did you have to sell that illiquid investment in order to realize a profit on it and be paid a bonus. You could now recognize its increase in value on an annual basis. Conventional book value accounting was derided as being old-fashioned, and the original acquisition cost of a position scorned as being hopelessly irrelevant to an up-to-the-minute valuation.
Of course, since the asset was not actually sold, we all had to take the management's word about what it (both the asset and management) was worth.
The new accounting standard FAS157, propounded in September 2006 and coming into effect for fiscal years beginning in 2008, codifies this trend but does not materially alter it. Its most startling feature for a layman is that it allows companies to mark-to-market assets for which there is no market. Financial assets are divided into three "levels" according to their degree of marketability. Level 1 assets are those for which a ready market exists, Level 2 assets are those for which a market exists for comparable securities and Level 3 assets are those for which no market exists, which are to be valued by use of mathematical models.
In the use of this new standard by the investment banks, two problems have appeared. First the "Level 3" designation has given rise to all kinds of model-building creativity, by which "market" values can be artificially increased. Such is the ethical standard of Wall Street that this was done in a number of investment banks during the bull market years before 2007, with the resulting increases in value being taken into earnings and large bonuses paid to executives in actual cash based on the imaginary increases in value. This technique was particularly useful for private equity holdings, where the normal procedure of holding the position until it could be realized and booking the profit only then proved irredeemably boring to the impatient titans of Wall Street finance.
The second problem that has now emerged runs in the opposite direction. "Level 2" valuation techniques allow the institution to ignore prices received in a "distress sale". However, in a bear market almost all sales are distress sales. The asset holder is distressed that his asset has declined in value and is only selling it because he needs the cash. Since the values of ABX indices on subprime mortgages have declined to a modest fraction of par, holders of this rubbish have decided that they do not represent the true market. Consequently, in their view, there is no true market, consequently the assets are "Level 3"
It is notable for example that Goldman Sachs's Level 3 assets increased in the last quarter from $54.7 billion to $82.3 billion. Since it seems most unlikely that Goldman, a smart operator if ever there was one, has been deliberately loading up on $26.6 billion worth of illiquid rubbish, the change must result largely from strategic reclassification from Level 2 to Level 3. Indeed, Goldman's Level 3 asset backed securities doubled during the quarter to $25 billion, presumably for precisely the reason that Goldman found unattractive the market prices prevailing for those securities.
At $82.3 billion, Goldman Sachs "Level 3" assets are more than twice its capital. This is not therefore a peripheral problem, which can be allowed to remain hidden within the arcana of accounting conferences. The reality is that, as was demonstrated in the true recessions of 1973-74 and 1980-82 but not in the mere dips of 1990-92 and 2001-02, the value of highly illiquid "Level 3" assets taken on at the peak of a bull market is pretty well a big fat zero.
Since the Michigan Consumer Sentiment Index is now at its lowest level in 26 years, it is beginning to become clear even to investment bankers that the U.S. and probably the world are in the early stages of a "proper" recession of the 1973-74 and 1980-82 pattern, albeit a recession with a considerable inflation problem attached. In that event, the "Level 3" assets on the balance sheets of Goldman Sachs and other financial institutions are worth only a small fraction of their nominal book value, and the institutions themselves will eventually be demonstrated to be insolvent. So much for the supposed greater transparency of "fair value accounting."
The shaky state of the world's major financial institutions is a matter of history. Their shareholders and creditors have been deluded by the fictions of fair value accounting and the excitement and profitability of a prolonged asset bubble. Repeated bankruptcies are probably the only fair way out. In practice however most such institutions will be deemed "too big to fail" and the cost of their rescue will fall on the world's long suffering taxpayers.
At that point, the taxpayers should have something to say about the accounting practices that made financial institution balance sheets and income statements so illusory. Fair value accounting must go, and be replaced by the much sounder principle that pertained previously, that assets can and should be written down, but must never be written up until they are sold. If banks and investment banks wish to make a memorandum account of the fair value of their investment positions, they should certainly be free to do so but increases in that fair value should not be brought through the income statement until they are sold, and bonuses should not be paid on the basis of such increases.
Accounting was invented in 15th century Florence. (Well, actually in Dubrovnik, a dependency of Florence at that time.) Another Florentine of that period, Niccolo Macchiavelli, would instantly have recognized the attractions of fair value accounting, enabling investment bankers to maximize their short term returns, while leaving the long term problems of an illiquid and clogged balance sheet to be sorted out by regulators at the expense of the public.
In the long run, institutions that are "too big to fail" are also too big to take large risks at public expense, and both their operations and their accounting should be scaled back to the most conservative basis. Their place will be taken by smaller institutions, not subject to bailouts by the general public, who will remain relatively unrestricted and will be able to assume risks in order to innovate, albeit only on a modest scale as befitting their smaller balance sheet.
In other words, the structure of finance, like the principles of accounting, needs to revert at least 40 years; probably, in the United States, 80 years.
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