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THE U.S. DOLLAR AND THE LIMITS OF IRRESPONSIBILITY
Will the U.S. dollar fall forever (vs. what?) ... until it hits zero? If so, how fast? This level-headed piece of analysis from David Merkel tries to get a grip on how much bad news is embedded in the current price of the U.S. dollar. It certainly is a good antidote to gloom and doom which, however justified it may be in the long run, is seldom a productive basis for making today's buy and sell decisions. Merkel believes that if only "a few things go less wrong" the dollar will rally from here.
Promises, promises. How many ways can the politicians dream up to spend money that they do not have? Perhaps it is easy when you are the world's reserve currency, and few argue with taking down IOUs denominated in U.S. dollars, at least for now.
But there are limits. When looking at the U.S. dollar today, the markets have kind of a benchmark that they use as their default scenario:
Of course, this is just my view, and I could be wrong. But the U.S. dollar has gotten trashed, and in order for it to get hit further, the powers that be will have to exceed the current "Limits of Irresponsibility". As for the default scenario that I have laid out above, those are key parameters that I think are baked into the current low level of the U.S. dollar. Violate those levels, get a lower dollar. Get further away from those levels, and dollar could rally.
- Fed funds will not drop below 1.5% at the bottom of this cycle.
- CPI inflation will not rise above 5% for this cycle.
- Nominal GDP growth will not drop below 4% for this cycle.
- The U.S. current account deficit will improve, albeit fitfully.
- Total Federal Debt will not grow faster than $600 billion per year. (you did not know it was growing that fast, now did you? ;) )
When I gave my talk to the Society of Actuaries, one of my recurring themes was, "It is wonderful to be the world's reserve currency." Consider especially slide 32, where the weak dollar combined with strong overseas equity markets flattens out the net foreign assets to GDP ratio at near -20%. We ship our losses overseas, and that is not counting all of the subordinated structured product that they bought ... yet.
I am not a doom-and-gloomer by nature. I try to recognize what is wrong, analyze what could be done to ameliorate the situation, and consider what could go right. I am not an optimist on the U.S. dollar, though I do not see how it falls much further from here. There is room for the U.S. dollar to rally, if only a few things go less wrong.
In the long run, though, there are imbalances that the U.S. needs to change, and the long run path of the dollar will rely on those changes. I believe that the markets embed an improvement in U.S. policies long run; if that fails, we will continue to see the dollar deteriorate.
PANIC TIME AT THE FED
Why weaken the dollar? Trade balances are determined by savings habits, not exchange rates.
Consumption plus savings equals income is an accounting identity. If the savings number is negative it becomes borrowings. The mirror of borrowings for an individual is that person's "trade deficit" with the rest of the world. He or she is exchanging an I.O.U. for a good or service getting consumed today.
If you raise the price of all consumable items, would that encourage an individual to transform from a borrower to a saver? One might posit a model where if the price of consumption today goes up versus consumption in the future, while real income is somehow maintained, then future consumption would be substituted for present-day consumption, ego savings would go up -- possibly from negative to positive.
Sum up the above identity over 300 million people and you have the U.S. economy. The identity is no less valid. What is usually referred to as the U.S. trade deficit is the mirror image of aggregate U.S. borrowings. Due to the vagaries and complexity of the modern economic system, this deficit is a political issue. Producers who compete for customers with the rest of the world think their competitors must be unfairly subsidized -- or something for darn sure unfair, anyway -- not realizing that as long as there exists a domestic savings deficit there is necessarily a trade deficit, and they just happened to get caught in the backwash. (Do we hear U.S. rhodium producers complaining about competing imports? No. There are no U.S. rhodium producers. It is only when domestic and imported goods and services are substitutes for one another that the complaints start.)
So -- the $64 thousand question -- will driving down the value of the dollar increase savings and reduce the U.S. trade deficit? There is no empirical evidence to support such a contention, so one might ask why the question is even coming up. But this snake oil is being administered yet again, so we trudge onwards.
Does driving down the dollar increase current prices relative to future prices? No reason to think so whatsoever. Does it raise individual incomes, thus -- on the theory that higher incomes lead to higher savings rates -- helping the trade deficit by reducing borrowings that way? No. Quite the opposite, particularly if wage increases lag price increases.
The major idea behind devaluing the dollar is that it will cause a substitution of domestically produced goods for imported goods. Is this valid? To the degree there is some lag in the domestic price level increase that follows the dollar devalution (dollars created to buy foreign currency for the purpose of depreciating the dollar are, in the end, the same as dollars created, e.g., to fund domestic spending), perhaps temporarily. But let us follow this through. If the savings rate is unchanged, who is going to fund the domestic goods purchase? We are back to the original situation. A foreign party has to fund the domestic-to-domestic purchase, which will be counterbalanced by an import purchase. Back to ground zero.
So the whole idea of fixing anything via dollar devalution is very bit as flawed in theory as it has proved in practice. Steve Hanke makes the same point.
U.S. Treasury Secretary Henry Paulson's blundering is becoming more breathtaking with each passing week. At the end of March he rolled out a grand plan to crown the Federal Reserve as the nation's new financial stabilizer. The Fed a stabilizer? That is who created the financial mess we are in.
Our sentiments exactly. We would go on to say that the Fed's very existence created the mess we are in, but alternative political institutions could have done the botch job equally well.
If this was not bad enough, Secretary Paulson then donned his cheerleader's uniform and encouraged Beijing to let the Chinese yuan appreciate against the greenback. All the while favoring in this fashion a debasement of the U.S. currency, Paulson proclaimed that we should remain calm and confident because the economic fundamentals are sound. He reminds me of the stockbroker who performed a valuable service to his partners by always being wrong.
During the Greenspan-Bernanke era the Fed has embraced the view that stability in the economy and stability in prices are mutually consistent. As long as inflation remains at or below its target level, the Fed's modus operandi is to panic at the sight of real or perceived economic trouble and provide emergency relief. It does this by pushing interest rates below where the market would have set them. With interest rates artificially low, consumers reduce savings in favor of consumption, and entrepreneurs increase their rates of investment spending.
And then you have an imbalance between savings and investment. You have an economy on an unsustainable growth path. This, in a nutshell, is the lesson of the Austrian critique of central banking developed in the 1920s and 1930s. Austrian economists warned that price level stability might be inconsistent with economic stability. They placed great stress on the fact that the price level, as typically measured, extends only to goods and services. Asset prices are excluded. (The Fed's core measure for consumer prices, of course, does not even include all goods and services.) The Austrians concluded that monetary stability should include a dimension extending to asset prices and that changes in relative prices of various groups of goods, services and assets are of utmost importance. For the Austrians a stable economy might be consistent with a monetary policy that had prices gently falling.
The current U.S. financial crisis follows the classic Fed pattern. In 2002 then governor Bernanke set off a warning siren that deflation was threatening the U.S. economy. He convinced his Fed colleagues of the danger. As former chairman Greenspan put it, "We face new challenges in maintaining price stability, specifically to prevent inflation from falling too low." (Given the U.S. economy's productivity boom, the Austrians viewed the prospects of some deflation as just what the doctor ordered.)
In the face of possible deflation, the Fed panicked. By July 2003 the Fed funds rate was at a record low of 1%, where it stayed for a year. This set off the mother of all modern liquidity cycles, and, as members of the Austrian school anticipated, the credit boom ended badly.
Those darn Austrians ... always right in practice, but their formal body of theory is so deficient in equations that it must be wrong.
True to form, the Fed has panicked again, pushing interest rates down and flooding the economy with liquidity. A broad measure of the money supply (MZM) reported by the Federal Reserve Bank of St. Louis increased at an astounding annual rate of 37.7% from the end of January until March 24. With this money supply surge and February's price gains (from February 2007) of 4% for consumer goods, 6.4% for producer goods and 13.6% for imported goods, it's no surprise that inflation expectations have risen.
It is also no surprise that the dollar remains debilitated, which makes Secretary Paulson's Beijing weak-dollar message so bizarre, particularly since it is based on an incorrect premise propagated by many prominent economists. Harvard professor Martin Feldstein, for example, argues that the bilateral trade balance between the U.S. and China is determined by the yuan-dollar exchange rate. Accordingly, to reduce China's trade surplus with the U.S., he advocates an appreciating yuan.
This advice is nonsense. Trade balances are determined by national savings propensities, not exchange rates. China's savings surplus and America's savings deficiency largely determine our trade imbalance with China. The U.S. Treasury should have learned this lesson after years of forcing the Japanese to adopt an ever appreciating yen, which destabilized Japan's economy without doing a lick of good for trade balances.
Until the Fed dumps inflation targeting and the U.S. abandons its weak-dollar policy, inflation will rule the day. Retain (and add to) your gold hedges.
BILL MILLER: CREDIT PANIC ENDED WITH BEAR STEARNS
Bill Miller, semi-legendary manager of the Legg Mason Value Trust mutual fund, is nominally a value guy, but has famously made a lot of money for his fund holders by taking big positions in Amazon.com and other dot-com fair-haired boys -- which have yet to be mistaken for value stocks. He still holds large positions in Amazon.com (6.5% of assets), Yahoo (4.4%) and eBay (4.2%).
While they say that value is where you find it, commenters on this article have taken Miller to task for such choices. One labeled Miller's style "fake-value" investing. Sour grapes, perhaps, as he did outperform the S&P 500 for 15 straight years. Lucky, perhaps, but the fact that Miller's fund was already well-known at the start of the streak rules out the result being some pick the one fund that did well out of the thousands out there and flog the results type semi-scam. Of course, there is the matter of the most recent two years, which followed the 15. And then there is the first quarter of this year.
Miller's fund took an absolute pounding in Q1 2008, with an NAV decline of about 20%. With large positions in JPMorgan Chase, Aetna, GE and Fannie Mae, he obviously got hurt by his large exposure to financial stocks. Now he says the worst of the rout in financials is over, with the bailout of Bear Stearns. He certainly hopes so. From Miller's Q1 2008 shareholder's letter:
After an awful quarter in which our fund dropped 19.7% compared to a loss of 9.4% for the benchmark S&P 500, we have begun to perform better. In the first few weeks of the quarter, the S&P 500 is up just over 5% and we are up a bit more. Our lead widens if you look back to the Monday the Bear Stearns rescue by JPMorgan was announced. While neither I nor anyone else knows if our period of underperformance is over, it ought to be, if valuation begins to matter more and momentum less in how the market behaves.
To put our results in some context, in our 26-year history, we have outperformed our benchmark 20 calendar years and underperformed 6 calendar years. Since I assumed sole management of the fund, we have outperformed 15 years and underperformed 2 (the last 2 obviously). On a rolling 12-month basis, we have outperformed 60% of the time since inception, and 68% of the time since I took over. Our relative performance this past quarter was the worst in our history, as we trailed the market by just over 1000 basis points. We have had 3 previous quarters where we trailed by over 700 basis points, 2 of which were in the 1989-1990 period which I have previously likened to this in terms of the economic and market backdrop. We have had 3 worse quarters in absolute terms: the quarter the market crashed in 1987, the 9/11 quarter, and the third quarter of 1990 ...
Thanks to Morningstar and the like, relative performance is everything. But you cannot eat relative performance.
For planning purposes, here is my forecast: I think we will do better from here on, and that by far the worst is behind us. I think the credit panic ended with the collapse of Bear Stearns, and credit spreads are already much improved since then. If spreads continue to come in, the write-offs at the big financials will end, and we may even have some write-ups in the second half instead of write-downs. Valuations are attractive, and valuation spreads are now about one standard deviation above normal, a point at which valuation-based strategies usually begin to work again, and momentum begins to fade (there is no evidence of the latter yet, as the old leaders continue to lead). Most housing stocks are up double digits this year despite dismal headlines, a sign the market had already priced in the current malaise. I think likewise we have seen the bottom in financials and consumer stocks, but not necessarily the bottom in headlines about the woes in those sectors. Although the economy is likely to struggle as it did in the early 1990s, the market can move higher, as it did back then.
Late last year Miller also predicted that Countrywide Financial was worth $40 vs. its then trading price of $14-15. Now you can buy all you want at $6. This is the danger on calling the bottom on any distressed financial stock. You could be right, or you could be out all your money. Imagine buying a volatile stock on 10% margin and you will get the idea.
The wild card is commodities. If commodities break, or even just stop their relentless rise, equity markets should do well. If they continue to move steadily higher, they have the potential to destabilize the global economy. We are already seeing unrest in many countries due to the soaring prices of rice and other grains. Oil has rallied $30 per barrel in the past 8 weeks on no fundamental news, save only the same stories about fears of supply disruptions. The typical fundamental drivers at the margin, such as global economic growth, miles driven, and seasonality, would all suggest prices similar to those that prevailed in early February. But none of that has mattered. I agree with George Soros that commodities are in a bubble, but it also appears he is right when he describes it as one that is still inflating, and we still have the summer driving and hurricane season with which to contend.
PAPERING OVER THE PROBLEM
Killing the dollar to save Bear Stearns. (Where are the public’s yachts?)
Another critique of the Bear Stearns bailout -- which it was, properly understood -- comes from "Wilson Burman" (a pen name) writing for The American Conservative. Burnam notes that the bailout is "the latest chapter in the socialization of risk and its corollary, moral hazard." He notes shortly thereafter, devastatingly, that "Creative destruction is the mantra until things threaten to get creative in the Hamptons." And, he might have added, "until creative destruction to incumbents is threatened." How does the public make out from the creative bailouts? Not well.
As the news broke on March 14 that the Federal Reserve would backstop the rescue of Bear Stearns by JPMorgan Chase, it is unlikely that many of the drivers paying record-high prices at the gas stations off the West Side Highway thought to glance toward midtown, where two sleek towers housed the beneficiaries of the Fed's largesse. But those unhappy drivers, along with every other taxpayer and consumer in the U.S., had just become partners in a deal that offers considerably greater risk than reward.
Headlines notwithstanding, this was not a "bailout" in the most widely understood sense of the word. Bear Stearns lasted barely a full trading day between the Fed's action and the announcement of the acquisition by JPMorgan at $2 (later raised to $10) a share. Essentially it was a government intervention. To keep Bear Stearns temporarily afloat, the Federal Reserve extended credit through JPMorgan and agreed to bear the risk of loss on Bear's collateral to the tune of $29 billion. The move stirred memories of Long Term Capital, the 1998 hedge-fund bailout that the Fed organized but did not fund, or the Resolution Trust Corporation, the government's massive publicly financed response to the Savings and Loan crisis. On the continuum of expediency, the Bear Stearns episode falls somewhere between the two.
There were some understandable reasons for the Fed to go through JPMorgan instead of lending to Bear directly. As a practical matter, Morgan is a commercial bank, so it has access to the Fed's discount window. Also, because of the established relationship between the two firms, Morgan could quickly evaluate Bear's collateral for the loan. But there was another reason. The Fed realized that a direct, overt bailout of a hugely profitable Wall Street firm was not feasible politically, particularly in an election year and during a recession. A latter-day RTC would not fly right now. But that does not mean the situation lacks serious consequences.
By dipping into the public till to help a medium-sized Wall Street firm that is not part of the commercial banking system, the Fed implicitly pledged at least partial assistance to a whole raft of firms higher up the food chain. Of course, the unstated but understood guarantee of the government-sponsored enterprises like Fannie Mae, Freddie Mac, and the 12 Federal Home Loan Banks has always existed. But now, because the government deemed Bear Stearns worthy of a backstop worth tens of billions, taxpayers stand behind firms like Goldman Sachs, Merrill Lynch, Lehman Brothers, and Morgan Stanley as well.
That is the deal the Federal Reserve has made on behalf of the public. It is the latest chapter in the socialization of risk and its corollary, moral hazard. Anyone who works long enough on Wall Street knows, at least subconsciously, that this is the way things work: if the going gets tough, a small coterie of unelected and mostly unaccountable officials in Washington will probably decide that your employer is too important to fail. In an effort to keep that from happening, wages, savings, fixed-income streams, and Social Security checks will be inflated away to "ensure the stability of the financial system." Creative destruction is the mantra until things threaten to get creative in the Hamptons.
Just because the Fed understood the implicit obstacles to funding a classic, sustaining bailout of Bear Stearns does not mean the temptation was not there. The media almost always misses an important reality: monetary policy can effect a de facto bailout, particularly for Wall Street, almost as easily as a direct handout. In the weeks leading up to the Bear Stearns debacle, the Fed was not bashful at the levers of policy. One such lever is temporary open-market operations, which the Fed uses on a daily basis to target short-term interest rates. When the Fed adds reserves to the banking system, the salutary effects of the associated liquidity spill over into other instruments, including stocks and commodities. In early February, the value of this temporary liquidity pool was $15 billion. As stress increased in the financial markets, the Fed boosted that to a high of $77 billion on March 12 -- just as trading-desk rumors about a possible bank failure peaked and two days before the intervention to support Bear Stearns.
The Fed was busy in other ways. That same week, on March 11, it announced formation of the Term Securities Lending Facility, to accept lower-quality collateral from primary dealers, of which Bear Stearns was one. This was just one new program whereby the Fed takes bad decisions off the books of Wall Street firms by accepting riskier paper for longer periods of time.
So Washington went all out trying to buttress Wall Street and particularly Bear Stearns. But there were consequences. On February 6, with the Fed's liquidity pool at that restrained level of $15 billion, oil traded at $87 a barrel. On March 12, responding to the Fed's extraordinary measures, it closed over $109. Gold, in its role as monetary watchdog, was active as well. During the first week in February, it traded at $887 an ounce. A few days after the Fed's liquidity efforts peaked, it was well over $1,000. The dollar recoiled in horror at the Fed's onslaught. The dollar index, a measure of the dollar's value against a basket of major currencies, plunged from $77 on February 7 to $71 on the day of the Bear Stearns news, tracking the Fed's work almost perfectly and anticipating further interest-rate cuts. The digits on those gas pumps off the West Side Highway flickered by faster and faster.
The overarching goal of those cuts, which began last year, has been to steepen the yield curve, which plots the yield on Treasury debt from maturities of three months to 30 years. Banks are more profitable with a steeper curve because they borrow short and lend long and pocket the difference. The Fed's strategy has shown incipient signs of working. On March 18, just a few days after the Bear Stearns news, both Goldman Sachs and Lehman Brothers announced better than expected earnings. Their stocks gained by 16 and 46% respectively. The next day, Morgan Stanley also surprised on the upside, and its stock rose by 36% over the next three days. Visa's initial public offering on March 19 was a huge success, with the stock jumping 28% on its first day.
But what about the public? So far, the results have not been as promising. Former Fed governor Lyle Gramley said, "In all past recessions, I was always quite sure that if the Fed stomped hard on the gas pedal, the economy would turn around and start to grow. But they have now stomped hard on the gas, and credit is not more available, it is less available." It is not hard to understand the sour mood. In a March CNN/Opinion Research poll, 91% of respondents said they were somewhat or very concerned about the rising rate of inflation. That exceeded the proportion of people worried about jobs, the stock market, or falling home values. They are not delusional. In late February, the government reported that wholesale prices over the previous 12 months posted their sharpest rise since 1981.
Ludwig von Mises once wrote, "No emergency can justify a return to inflation. Inflation can provide neither the weapons a nation needs to defend its independence nor the capital goods required for any project. It does not cure unsatisfactory conditions. It merely helps the rulers whose policies brought about the catastrophe to exculpate themselves." Yet the universe of "emergencies" has been expanding to include elections, natural downturns in the business cycle, inconvenient stock market weakness, and bad decisions by Wall Street firms -- with predictable results.
Inflation's defining characteristic is expediency. It obviates sacrifice and postpones pain. That makes it a natural complement to many political ventures, particularly unpopular wars. As early as 1965, Lyndon Johnson's economic advisers worried about rising inflationary pressures. As Johnson resisted calls for new taxes, the deficit for fiscal 1967 came in at $9.8 billion. By the time Congress and the White House finally agreed on a tax increase in 1968, after years of escalation in Vietnam, the deficit was $25.2 billion and inflation was rampant.
Of course, it would get far worse over the next decade. Even as the seeds of inflation planted in the mid-1960s grew, Richard Nixon put pressure on Fed Chairman Arthur Burns to goose the economy for the 1972 election. That dynamic continued and worsened during the 1970s. By the early 1980s, Ronald Reagan was dealing with the consequences of decisions made by Johnson and Nixon over a decade earlier. Part of Reagan's legacy is the latitude he gave Paul Volcker, as risky and painful as that was, to deal with those problems. [Carter deserves some credit too. Perhaps more, for he sacrificed his reelection odds.] Unless one believes the next president will want to take the hit for Bush's decisions, or that someone with Reagan's mandate and courage is about to appear, whoever is in the White House a decade from now will probably confront the economic fallout from current policies. But by that time will anyone remember how it all started? How many cursed LBJ or Nixon in 1979? The White House not only knows the answer, it is counting on the nation's forgetfulness.
Federal Reserve officials, safe in the arcana of their craft, might not have to depend on the public's short memory. The opaque nature of monetary policy could do the trick. For this article, I asked customers at a gas station in New York City one question: "What is the main reason for the high price of gas?" Five blamed either Bush or Cheney. Four blamed oil companies. Three said they did not know. Three claimed price gouging by gas stations. Two said, "Everything is going up." Two cited "inflation," with one mentioning the dollar. Two pointed to the campaign in Iraq. One said, "We are running out of oil." One blamed "big cars." One blamed "the Arabs." One apparently upscale customer driving a late-model car blamed "too much money being printed right now." When pressed further, he named Alan Greenspan.
For Ben Bernanke and the current Fed, so far it looks like mission accomplished.
CREDIT CRUNCH: WE’RE FROM THE GOVERNMENT, WE’RE HERE TO HELP
There are multiple answers to the question of what are the three most common lies told. The answer we best remember, from way back, is: (1) The check is in the mail. (2) Of course I will respect you as much tomorrow morning as I do now. (3) I am from the government and I'm here to help you. Lie #3, at the time, was kind of a non-joke joke. Today it has a more bitterly ironic edge to it. Government cannot "help" anyone without hurting someone else, but sometimes its efforts to help are so transparently destined to fail you wonder why the sponsors bother to show up.
Lenders cannot stay in business simply by making loans. They also have to charge borrowers a rate of interest that is profitable enough to even be in the lending business. Right?
"Yes, of course," is probably what you are thinking to yourself. "Who does not get that?"
Good question, but for reasons you are about to understand, I prefer not to give a direct, one- or two-word reply. The answer you deserve will take some explaining -- I promise not to make it too long.
Let us assume that you have heard of "college tuition." If so, you may also have heard that it is expensive. From this, we can infer that the people who pay college tuition (mostly parents, plus some students themselves) are not happy about just how expensive it is. They have to deplete their savings, and/or work extra jobs, and/or take out various types of loans. What is more, tuition costs go up every year. In turn, the people who pay the tuition must do even more of that same stuff which reminds them of how unhappy they are about how expensive it is.
"Even more of that same stuff" does, of course, include various types of loans -- and as borrowers they must pay a rate of interest that is profitable enough to keep the lender in business.
Well, in September 2007, the representatives of the American people said: We're From the Government, We're Here to Help. Specifically, Congress passed (and the President signed) a bill that basically mandated a 50% reduction in the interest rate lenders could charge for federally-insured student loans. In case you are wondering, federally-insured student loans amount to some 70% of the $100 billion borrowed for that purpose each year.
So, recalling the first paragraph of this article, what do you suppose happened to the lenders who had been in the business of making student loans?
If you say, "The business of making student loans is drying up because lenders are pulling out in droves," then you get a Gold Star, dear reader. Congress passed a law that forbade lenders from charging a profitable rate of interest on student loans. And so, "A third of the nation's top 100 lenders to students in 2007 have temporarily suspended new loan origination or exited the business altogether," according to The Wall Street Journal.
Naturally, the same bunch that said We're From the Government, We're Here to Help, are back to say and do more of the same. Congress is patching together something to fix the system it broke. You can look it up, but what you will find is a ton of articles about how the "Credit Crunch Affects Higher Education." That premise is rubbish. Most news stories say little or nothing about the real cause of the problem. Many lenders did go too far and did create a credit crunch, most conspicuously in the housing market. But that is not what happened in the market for student loans.
The trashing of the debt markets has involved no shortage of greed, but let us not neglect the role played by raw stupidity. It is a distinction with a difference, as every independent thinker knows.
In some way Congress could help here more than they realize. If they permanently impair the market in student loans, higher education might fall enough in price that students could afford it without loans. What a concept!
THE COLLAPSE OF AMERICA’S SERVICE ECONOMY
Peter Schiff, author of Crash Proof: How to Profit from the Coming Economic Collapse, sees support for his thesis summarized by the title of his book in recent business bankruptcy and consolidation news.
Recent high profile bankruptcies of mainstay American retailers, such as The Sharper Image and Linens ‘n Things, as well as the proposed mergers between Blockbuster/Circuit City and Delta/Northwest, and the admissions from the nation's leading student lenders that their business models are no longer viable, mark the beginning of a long overdue overhaul of the American economy. In short, the economy will be getting smaller and more expensive.
The success of all of these seemingly disparate sectors depends, to a large extent, on the ability of Americans to continue to borrow cheaply and easily. Now that home equity extractions and zero interest credit card rollovers can no longer be used to fund electronics purchases, vacations or tuition, those corresponding sectors are suffering. The foundation of our bloated service sector economy, supported by overseas savings and production, is now giving way.
This diminished capacity will result in a wave of bankruptcies and consolidations to restore profitability in what will become a much smaller service sector. The days of cheap consumer goods at Wal-Mart and cheap airfares at Jet Blue are coming to an end. It is all part of the process of an unprecedented decline in America's standard of living, which is the inevitable result of years of living beyond our means.
For retailers, the business model of selling cheap foreign imported goods to overleveraged Americans was doomed from the start. It is fitting that just prior to the collapse, Wall Street private equity firms decided to jump aboard a sinking ship (Linens ‘n Things was purchased by the Apollo Group for $1.3 billion back in 2006). No doubt the added debt subsequently piled on to the firm by the profit-squeezing buyout boys hastened the company's demise. As revenues decline and debt servicing costs rise for many retailers (who have been similarly hog-tied by private equity firms), look for additional blow-ups down the road.
As the dollar continues its historic decline, imported goods will become too costly for many Americans. In addition, more of those products still made (or more likely grown) here will be exported to wealthier foreign consumers whose appreciated currencies increase their purchasing power. As a result, fewer products will be available to fill our shelves and those that remain will carry much higher price tags.
In addition, as defaults on credit and store charge cards continue to increase, the market for such debt will soon disappear. As a result, the credit crunch will spread from subprime mortgages to all forms of consumer credit. Therefore, not only will Americans be staring at higher prices, but they will have to pay in cash.
Similarly, the coming airline consolidation will usher in a harsher era for the American airline industry. In truth, given the rising costs of building, flying and servicing aircraft, U.S. carriers currently supply more planes and passenger miles than American consumers can afford to utilize. While this may seem illogical in a time when domestic flights are usually fully booked, it is important to realize that these crowded planes do not translate into profit at current ticket prices. While mergers may help the airlines hold down costs for a bit, the only lasting pathway to profit is fewer flights and significantly higher ticket prices. Of course, this will mean that Americans of modest means will travel less by air. Unfortunately, that fact is simply an inevitable consequence of a sagging currency and diminishing national wealth.
Although many Americans have come to regard affordable air travel as a birth right, from a global perspective it remains the province of the wealthy. The massive borrowing that has financed the American economy for generations, combined with an evaporating industrial base and a lack of domestic savings have combined to lower American's wealth in comparison to the rest of the world. Consequently, as more materials, technicians and jet fuel go to service the burgeoning Asian air travel industry, the higher the costs will become for American travelers. As with other hallmarks of a diminished standard of living, Americans now have to confront the reality of staying closer to home.
The same mathematics will come into play for our ridiculously expensive higher education system, which can not exist without a well-lubricated loan infrastructure. Limit the ability of students to take on heavy loans, and college education becomes untouchable for anyone but the wealthiest Americans. If loans dry up, universities will be forced to slash their bureaucracies and substantially reduce tuitions. Ironically the silver lining here is that with low tuitions students will no longer need the loans that kept tuitions so high in the first place.
For a more in depth analysis of our financial problems and the inherent dangers they pose for the U.S. economy and U.S. dollar denominated investments, read my new book Crash Proof: How to Profit from the Coming Economic Collapse.
Earnings Speak Clearly
John Browne, senior market advisor to Peter Schiff's firm Euro Pacific Capital, analyzes the first quarter earnings reports and sees "very interesting, and troubling, economic messages" within. Those companies who depend on the U.S. consumer, like retailers, have already suffered heavily. The financial companies continue to suffer from large loan writeoffs. He advises against any bottom fishing in the sectors, as he thinks the pain has just begun.
Last week, as the corporate "earnings season" got underway and some 30% of S&P 500 firms reported their results from the first quarter of 2008, investors seized on any shred of positive news in the first wave of reports and sent share prices surging. Looking beyond this first blush euphoria, the reports do contain some very interesting, and troubling, economic messages.
First, U.S. companies that have significant overseas markets for their products, such as Caterpillar, have shown a surge in sales. This is in line with our forecast of one of the few positive effects of U.S dollar weakness. It can be expected to continue in the short-term and even increase, if the Fed continues to lower U.S. dollar interest rates.
Second, for companies that have little international distribution but instead rely on sales to other U.S. corporations, major sales downturns have not been a major factor; at least, not yet.
Third, on the other hand, those companies whose profits depend on selling directly to the U.S. consumer, such as retailers and airlines, have suffered a serious erosion of their sales and earnings.
The forces behind these numbers are fairly easy to discern, and support the economic hypothesis that we have long predicted. The current economic downturn (which I expect to lead to severe recession) is being driven by a downturn in consumer demand, the effects of which are first seen in the retail sector. It is only when the retailers subsequently cut back on their purchases that wholesalers experience a downturn.
In addition, it appears that the rising inflation burden (as indicated by the relative difference between the Producer Price Index, increasing at over 7%, and the relatively milder level of the Consumer Price Index) is not yet being passed on to consumers, and is instead being absorbed by retail companies. Failure to raise prices in line with rising costs will likely lead to even further downward pressure on retail sector corporate earnings in the second quarter of 2008. Despite the seemingly "bargain basement" allure, investors should resist the temptation of buying these stocks at their current levels.
The fourth message from recent earnings announcements is that financial companies are still experiencing pressure from write-downs. I expect these pressures to continue as the current economic retraction deepens in the months ahead. Indeed, as I write, National City Bank has announced staggering quarterly losses and has expressed the need for a further $7 billion equity infusion.
The biggest surprise of the week just passed may be that while some financial firms, like Citigroup, posted losses, their stock prices subsequently rallied. The reason, of course, being that some investors and analysts had feared losses could have been much steeper, and the earnings reports sparked a sense of relief, even of hope, that the worst was now over.
This leads to another phenomenon that is characteristic of Wall Street's bias. In times of expected economic contraction, analysts almost compete to lower their forecasts of estimates of corporate earnings. Often they become overly pessimistic, only to raise the morale of their investors when the earnings, although badly down, are "ahead of estimates" and therefore "good", justifying new investment and "bottom fishing". We have seen this recently, particularly in the important financial sector, which is often seen as a market leader.
Despite the recent rallies, investors should not lose sight of the over-arching bearish trend in U.S. stocks. U.S. stock markets have posted losses in five of the past seven months. But that is only half the story. These losses have been compounded by the falling U.S. dollar. U.S. investors who remained locked into U.S. stock investments have to add these two downward impacts together, plus inflation, before they see a real return!
As I have said before, I feel that unstoppable economic forces now threaten deep and long lasting recession. Although the natural economic cleansing brought on by recession is clearly in the long-term interests of our economy, I doubt that our politicians will agree. The political cost of recession can all too easily result in politicians becoming un-elected.
It is therefore highly likely that the Fed, under heavy political pressure from the Treasury Department, will continue to adopt a weak dollar policy. Unfortunately, the hapless U.S. Dollar still has a long way to fall. I continue to point to the attraction of the shares of sound, high earning companies traded overseas in sound currencies such as the Swiss Franc.
SHORTING HOMEBUILDERS A SURE THING
No matter how bad the news is about a company, at some point its stock has fallen sufficiently that the news has been adequately discounted. Or, as Jim Rockford said to a hood who was intending to bump him off while at the same time telling him to shut up: "For your information, you can only kill somebody once!" Acklowedging all this, shorting home builders is a tempting way to play the ongoing bust in real estate, as far as they have already fallen. The author of this short sale recommendation article argues they have further to fall.
It does not happen often that the market conditions present a "sure" money maker, but homebuilders are now as sure a short as they can ever be. Here are 7 reasons why:
When a high stock price is combined with weak and further deteriorating fundamentals - the stock price will follow the fundamentals.
- Unsold inventory of homes is rising with no signs of improvement, exacerbated by stricter lending criteria by mortgage lenders and rising foreclosures that compete with new construction for a few available qualified buyers.
- Weak economy, rising unemployment, spent out consumers squeezed hard by high gas prices, higher down payment requirements and still too high property prices place many potential buyers out of the real estate market.
- Home sales continue to deteriorate. As reported yesterday by the National Association of Realtors, home resales fell 2% in February and inventory of unsold homes have risen 1% representing a 9.9 month supply at the pace of sales in March.
- Many of the builders have loans that will mature and be due for refinancing over the next two years and some of them may not be able to "roll" them.
- On top of all that, homebuilders are finding themselves between the rock and hard place of inflation. Rising cost of labor and building materials against collapsing revenues spells trouble for profit margins. What profit margins?
- Despite all of the above, homebuilder stocks have risen year to date as much as 60% from the bottom in January, making their valuations based on the current and next year estimates astronomically expensive ...
- The insiders are actively selling their stocks at fraction of the value of 2006 and 2007 - taking advantage of the bounce from the low? Who knows the state of the business better than insiders? Do insiders know that the glut of unsold homes and tighter credit standards are not helping buyers and hurting sellers?
The easiest way to take advantage of this rare situation, is to short U.S. Home Construction iShares (ITB) ($20.70) or short individual builders such as Ryland Group (RYL) ($34.00), Pulte Homes (PHM ($14.06) and others.
In my long and hard earned experience, real estate cycles NEVER turn quickly. They are always long, they last for decades and this is one of the worst kind.
I am shorting builders. You place your bets.
Notwithstanding the above points, all the bad news could be priced into the stocks. But a 60% price jump in three months would alleviate a lot of those concerns (for short sellers).
YOUR PAIN, THEIR GAIN
Crumbling home prices and $100 oil helped Wall Street’s highest earners pull in $19 billion last year.
The hedge and private equity fund managers who bet against subprime borrowers or who went long energy equities did pretty well last year. Not a surprise.
Problems paying the mortgage, filling the gas tank and feeding the family have eroded living standards for millions of Americans during the past several months. Not so for people who manage big piles of money -- many of them made a fortune betting correctly on the housing debacle and rising commodity prices last year.
Our second annual look at the pay of folks who run hedge and private equity funds shows that the top 20 took home a collective $18.7 billion last year, 43% more than in 2006. To even make the list you needed minimum earnings of $350 million, which is $90 million higher than the year before. No chief executive of a traditional Wall Street investment bank even came close.
As Babe Ruth once said when someone remarked that he earned more than the President: "I had a better year than he did."
Our top-ranked earner, hedge fund manager John Paulson ($3.3 billion), reaped much of his bounty from shorting the ABX Index, which tracks the strength of the subprime mortgage market. Paulson earned an estimated $2.3 billion from his share of fees charged to investors and $1 billion from the appreciation of his own capital invested in Paulson & Co. funds.
As can be seen in this chart, the ABX index fell from over 50 to under 20 between July and November last year. There is no ETF or other simple tool to make a bet on that index directly. Paulson must have used a sophisticated package of positions in order to replicate the short position in the index.
Fund manager Philip Falcone, who ranked third with $1.7 billion, posted triple-digit returns by shorting subprime credit, resulting in $11 billion of growth for his two Harbinger Capital funds, excluding assets raised from new investors. John Burbank, who runs San Francisco hedge fund Passport Capital, made $370 million last year, also in large part by shorting home mortgage companies and mortgage-related debt [see story immediately below].
Some members of our list, like Texans T. Boone Pickens ($1.2 billion) and John Arnold ($700 million), made their fortunes the old-fashioned way: betting on energy. Pickens' $2.7 billion BP Capital Equity Fund grew by 24% after fees, while his $590 million Commodity fund grew 40% thanks to large positions in Suncor Energy, ExxonMobil and Occidental Petroleum. For hedge fund billionaires Pickens and 2nd-ranked George Soros ($2.4 billion), whose own investments compose a significant portion of their funds, there is more to be made from asset appreciation than from fees. Soros made $2 billion from the growth of personal investments within his $17 billion Quantum Endowment Fund, which returned 32% for the year.
To determine Wall Street's 20 highest earners of 2007 we examined hedge, private equity and mutual fund principals and traders, as well as investment bankers. The hedge fund and leveraged buyout bosses typically reap fees equal to 20% of profits and 2% of assets. Our paychecks are pretax and net of the firm's expenses, and exclude proceeds from selling shares in their own business.
For example, we count the $400 million that Stephen Schwarzman of Blackstone Group earned from annual salary, distributions of percentage fees and capital appreciation on his investments in Blackstone's funds, but exclude the $4.8 billion that he took out of the business when he sold shares to the public and to the Chinese government.
What is the common element here? The winners took advantage of the distortions created by the central banks. The "pain" and "gain" both have those misbegotten policies at their roots.
Passport to Profits
John Burbank parlayed a taste for Warren Buffett-style investing into a $370 million paycheck last year. It was almost enough to make him smile.
One look at some of the portfolio favorites of hedge fund manager John Burbank might cause one to question any comparisons to Warren Buffett. But here is where they converge: They both make big investments in situations they feel they understand very well. Results do not always speak for themselves, but a closer look at Burbank's record indicates the outstanding results do not deceive.
John Burbank, founder of Hedge Fund Firm Passport Capital, became one of the highest-paid people in America last year by focusing on faraway places like China and India. It all began four years ago, when he got to worrying about what could go so wrong on this side of the Pacific as to muck things up over there. His answer: subprime mortgages.
With housing all the rage in 2004, home lenders were throwing money at people with lousy credit. Confident the market would eventually crack and intent on cushioning his global portfolio when it did, Burbank began shorting the stocks of U.S. subprime lenders. Housing continued to go up. So Burbank doubled down by purchasing credit default swaps that would pay bounties if securities backed by subprime mortgages went into default.
This short summary glosses over what must have been a few anxious moments as housing-related stocks continued to go up through 2005.
When housing began to melt down last summer, the value of Burbank's short positions and swaps soared. Investors in his flagship hedge fund, $2.5 billion (assets) Passport Global Strategy, ended 2007 up 219%, even after his 1.5% management fee and 20% cut of profits. Passport also runs three smaller funds, with total assets of $1 billion, that own slices of what Global does in basic materials, oil rigs and India. They ended last year up between 64% and 134% after fees. All this earned Burbank an estimated $370 million, ranking him #17 on Forbes's list of Wall Street's Highest Earners [see above].
"There's no way you can make 30% returns being long the S&P 500," the scruffy 44-year-old says of his swing-for-the-fences investing style. "If you're going to hit that kind of return, you have to go places where it can happen."
It is Burbank's gutsy long-term bets of up to five years, and willingness to endure short-term pain, that sets him apart from the hedge fund masses. That and the 40% annualized gains he says he has netted investors over eight years. Along the way, neither Passport Global nor the younger sector funds have had a single down year. Global's worst was 2001, when investors netted 7% as Morgan Stanley's global EAFE index lost 23%. Another Burbank hallmark: He uses very little leverage to post those numbers.
When you go short, you are margined whether you want to be or not. The writer must mean that Burbank puts up a lot of margin on his short positions.
That is not to say it has been a flawless ride for investors. Double-digit down months are common at Passport. After last year's home run its Global fund opened 2008 with a 14% monthly loss. A new energy fund fell 11% in January.
With not a single down year -- interim hair-raising months or not -- the pain-bearing capacity of Burbank and his investors has not exactly been severely tested. It is the prolonged month upon dreary month losses that wear down one's resolve.
Burbank shrugs. His objective has always been to rack up gaudy, double-digit gains over the long haul. Investors who are not willing to take some chances, and lumps, along the way need not apply. Passport requires a $1 million minimum and a 1- to 3-year lockup. "To invest with John you have to put your seat belt on," says Timothy Schilt of Berens Capital Management, a fund of hedge funds that is invested in Passport.
Burbank, like a lot of investing greats, is a bit of an oddball. The son of a Russian and Slavic literature scholar who taught in private schools and a book editor mother, he majored in English at Duke and then took off for a year to teach in Ningbo, China. Returning to the U.S., he earned a Stanford M.B.A. in 1992.
Still unsure what he wanted to do, Burbank took off once again for Africa and Europe with James Cunningham, a business school buddy who is now Passport's basic-materials portfolio manager. By the time he returned to the U.S. from his second foreign stint, Burbank was intent on becoming a professional investor. He took out $50,000 in credit card debt in 1994 to find out what it felt like to make, or lose, real money in the stock market.
He plowed a big chunk of his cash into a hot biotech stock he was sure was a winner -- only to lose most of it. Burbank eventually clawed his way back and paid off his plastic. His takeaway: Wagering on short-term movements is a crapshoot; serious investing requires lots of homework and patience.
That lesson was reinforced over the next three years when Burbank worked as a $1,000-a-month researcher for ValueVest, a small, roll-up-the-sleeves hedge fund that was one of the first to specialize in emerging markets. Scrounging up $800,000 from friends, and office space from a former boss, he founded Passport in August 2000 -- just as the technology market was cracking. Burbank went long energy and shorted technology, ending 2000 up 36% during five months when the S&P 500 lost 7%.
Burbank invested his early gains in hiring his first researcher, who now runs Passport's energy investments. His professional staff of 26 includes Ph.D.s in mining, geology and biotech. The firm, now headquartered in San Francisco's antiques district, spends months sifting through markets before committing a dime.
Like value investing greats Warren Buffett and Sir John Templeton, whom Burbank has studied closely, he thinks diversification is for those who do not know what they are doing. Instead, he has consistently taken big positions based on the notion that his long-term worldview is correct. That has included owning gold, basic materials and emerging markets since shortly after he founded Passport.
These days Burbank is decidedly a bear on the U.S., believing housing prices will fall for some time and that overextended consumers will hurt growth and further pressure the dollar. The currency's declines will, in turn, create "a systemic, long-term problem" of rising prices, he says.
As a hedge, he expects investors for years to come to continue pouring capital into emerging markets, most notably China and India, and into gold and other hard assets. "The supply of oil, commodities and things that come out of the ground isn't changing that much, and the demand keeps growing, so the price is generally going higher," he says.
Burbank, now with some $4 billion under management, has a quarter of it invested in basic materials like iron ore and gold-mining outfits. His other big positions include: Financial Technologies, an Indian firm that runs financial exchanges; Raffles Education, which offers college courses in business and design in Asia; and Yamana Gold (AUY), a Canadian metals producer with big operations in Brazil.
Another favorite holding is Transocean (RIG), the world's largest offshore drilling contractor. Burbank expects it to benefit from strong oil demand and views its price, 10 times trailing earnings, as low under the circumstances. He is bullish on companies poised to capitalize on rising consumer demand in the developing world. One Burbank play on that theme is EFG-Hermes, an Egyptian investment bank with a sizable money management operation.
With RIG's price up around 8-fold the past five years, and at 4 times book value, the easy money has been made. If the earnings are sustained then there is still some upside. We think this amounts to a bet that the current high oil prices do not have excessive speculative fluff in them. A return to, say, $80 would lead to a major correction in energy-related stocks.
TALE OF TWO ECONOMIES
On a recent Forbes investment cruise, super-pessimist A. Gary Shilling and modest optimists -- vis a vis the stock market at least -- Ken Fisher and John Buckingham got their turns at the microphone. The first two are Forbes columnists whose views have been covered in these pages before. They basically reinterated the contents of their most recent columns. Mr. Buckingham is a bottom-up stock picker with an excellent long-term record who is finding value in beaten-up small cap technology stocks.
If you reject Shilling's gloomy outlook -- shared by many who think the current credit crunch is the symptom of deeper problems that cannot be deferred any longer -- then buying stocks is a reasonable course of action. If you accept Shilling's gloomy outlook but think the outcome will be inflation rather than the deflation he foresees, then his advice would not look so good either. We are at a stage where simply going about one's business while ignoring the big picture seems like an unaffordable luxury.
The Libertarian [huh?!] former Federal Reserve chairman Alan Greenspan and the social democrat hedge fund billionaire George Soros agree on at least one matter: that 2008 has presented us with the worst global financial crisis in a half-century.
Yow! Is it really that bad? U.S. unemployment sits at 5.1%. The scary liquidity crisis is hard to see with $3.5 trillion parked in money market funds. Sure, at 3.8% global growth will be off this year if the standard you have come to expect is the annual 5% of 2004-07. As for stocks, they could finish the year strong. Large caps such as Microsoft are selling for only 16 to 17 times earnings. If these rally only modestly, the Dow could nip 15,000 this year. Hard to believe, isn't it?
Worst economy or decent economy? Buy stocks or duck for cover? The great unknown is housing prices, of course. American homes have fallen, on average, 12% since 2005. How far will they go? If houses drop another 15% to 20%, the ripple will wash over more than just builders and financials. The whole consumer economy could go south. The damage would be comparable to the 1973-75 recession, when unemployment hit 9% and stocks fell 40%.
This depiction of hell was painted by Forbes columnist A. Gary Shilling during the 13th Forbes Cruise for Investors. If Shilling is right about housing prices, here are some defensive actions you might take. (Shilling's reasons are quoted.)
Fair enough. But what if you think Shilling overstates the crisis or -- God forbid -- he is right but financial Armageddon is already priced into the market? Then you buy stocks and buy big. But exactly what should you buy?
- Short commodities. "As global demand falters in a global recession, commodity prices will fall."
- Sell or sell short emerging-market equities. "As the U.S. housing collapse and recession depress consumer spending, U.S. imports will weaken and drag the rest of the world into economic decline, with the usual lag of about six months. China is especially vulnerable."
- Buy the U.S. dollar. "With a global recession, the dollar will rally as it plays its usual role as a safe haven."
- Sell or sell short U.S. stocks in general. "We expect a total decline of more than 20% from the October 2007 peak."
- If you plan to sell your home, second home or investment house(s) soon, do so yesterday. "You may think your house is worth more than the current market indicates. But the market is the market, and prices are likely to fall much further."
- Sell or avoid most commercial real estate. "Bigger egos with more money may not materialize as the financial crisis broadens and deepens."
- Buy long Treasury bonds. "We buy Treasurys the way we buy stocks -- for appreciation. We do not care about the yield on Treasurys as long as interest rates are going down and prices are rising. If the recession is major and inaugurates a mild and chronic deflation of 1% to 2% a year, Treasury bond yields will probably fall to 3%."
One idea is to start with a global view. Forbes columnist Ken Fisher offered this tip to the investor cruisers: "America is 25% of the global GDP and 40% of the global stock market capitalization, depending on how you measure. Any analysis of economics and stocks, therefore, must not begin with the U.S. but with what is happening in the larger arenas -- the global economy and markets."
For Fisher, the benchmark to beat is the MSCI, the Morgan Stanley World Index. Fisher's investment method is to model the MSCI and then try to beat it by overweighting countries and industry sectors he thinks will do better in the coming year. For 2008 Fisher has underweighted U.S. stocks and overweighted, compared with the MSCI, sectors such as materials, industrials, cyclical tech and energy.
Fisher thinks global "supercaps" will outperform the market this year. A supercap, says Fisher, is a stock with a market cap topping $80 billion. British Petroleum, Shell, Chevron, IBM, Intel, Microsoft and Wal-Mart are some supercaps that will do well in the months ahead.
California money manager John Buckingham takes an opposite approach to Fisher's, one that is "bottom-up." As with Ben Graham's philosophy and that of Warren Buffett from 1954 to 1969, Buckingham's axiom is to "buy dollar bills for 50 cents." Buckingham also likes a safety cushion and, therefore, buys stocks with little debt and lots of cash: for example, Apple at its decade bottom, when it had $5.74 of cash per share, no debt and traded for a bit over $7.
These days Buckingham likes roughed-up tiny tech stocks, such as Dataram (DRAM), Ditech, Rackable Systems (RACK) and United Online (UNTD). Buy these risky stocks as a portfolio or leave them alone. He also likes some cheap big caps such as Microsoft and Cisco (CSCO), both trading with price-to-earnings ratios of around 16 to 17.
Fisher says his goal is to "beat the relative competitive index by two or three points per year, over time." He has done that. Buckingham says his goal is to "double your money every five years." Since 1990 he has done that, too. I find it enormously interesting that two stock investors, using two wholly different ideas, have both trounced the market over the last two decades.
Worst economy or decent economy? If you think housing prices are near the bottom, buy stocks and buy big.
INVESTING IN SULFURIC ACID
We have seen dramatic prices moves upward virtually across the whole spectrum of commodities this decade. Everyone knows about energy, metals, and agriculturals. Anyone heard about sulfuric acid? It turns out to be the largest volume chemical in the world.
As with most capital intensive products, there is a thin line between surplus and shortage -- when industry capacity utilization goes from under- to fully-utilized. Apparently the lines have crossed recently with sulfuric acid. Less than two years ago a plant was shuttered due to the cliche "adverse market conditions." But now the price is up almost 4-fold in the last seven months. And there is little additional capacity scheduled to come online. How might one play this? Chris Meyer has a "pure play" idea.
I read recently that copper producers are complaining about the skyrocketing costs of sulfuric acid. A few days later, I read about Mosaic, a fertilizer company -- about how the rising cost of sulfuric acid could impact its profit margins. Then last week, I came across a piece about how the cost of treating water is "going through the roof." The main culprit is, once again, the rising price of sulfuric acid.
One water utility rep said: "As sulfuric acid prices increase, so do the products that contain this ingredient. The U.S. has imported the majority of sulfuric acid from China in the past, but recently, China has slowed the trade of sulfuric acid to the U.S., because its own demand is greater than what China can produce for both the U.S. and itself. In short, demand is swamping supply. Sulfuric acid prices in March hit a record high of $329/ton, according to Purchasingdata.com, after trading at $90/ton as recently as October. Sulfuric acid shortages? Hmmm ... Well, it is time to take a look at this, I suppose.
"Sulfuric acid is one of those unheralded lubricants that keep the gears of the industrial economy spinning," says Chemical and Engineering News. "Although less in the limelight than petrochemicals such as ethylene or polyethylene, it is in fact the largest volume chemical in the world."
We use sulfuric acid in mining to extract copper, nickel and uranium. We use it in steel production and in making fertilizers. We use it to refine oil and treat wastewater. It goes into the plastics we make and a bunch of other things. The biofuel boom has also kicked off a big increase in the demand for sulfuric acid. In fact, some 60% of the sulfuric acid ends up in agriculture. The surge in ethanol production is a double whammy for sulfuric acid. First, all that corn needs fertilizers. And second, the ethanol facilities themselves also use sulfuric acid in their own processing. A typical ethanol facility requires 2,000-4,000 tons of sulfuric acid per year.
Then there is that great demand pull from China and India. Traditionally, these two countries produced more than enough for themselves and exported the rest. But now their own rapid industrialization has turned the tables. They have switched from being exporters to importers of sulfuric acid.
The boom in metals such as copper and nickel also drives the demand for sulfuric acid. Smelting operations typically throw off sulfuric acid as a byproduct. But even here, metals companies need more than they can produce. Supply is also tight. As with many commodities, there was a long period when sulfuric acid prices went nowhere. This led to a decrease in production facilities. I found one example of a closure as late as November 2006, when GenTek shut down a sulfuric acid facility due to "adverse market conditions."
There also seems to be little new capacity on tap. Industrial Info Resources, in Sugar Land, Texas, tracks this sort of thing. According to IIR, of the $89 million invested in sulfuric projects in the U.S. in 2007, most of the funds went toward planned maintenance, rather than expanded capacity.
It also turns out that not only is supply tight, but there are all kinds of transportation bottlenecks in delivery -- such as a shortage of rail cars. Key Compton, president of a sulfuric acid producer in Texas, said toward the end of last year that customers soon "may be paying prices for sulfuric acid that they"ve never seen before."
So how can you play it? Well, there are a number of producers of sulfuric acid. Most are big chemical companies that you would not buy if you only wanted exposure to sulfuric acid. Owning them is like buying Home Depot because you think it sells a great lawn mower. The only "pure play" on the idea I could find is a little company called Chemtrade Logistics in Canada, one of the world's largest suppliers of sulfuric acid. It trades in Toronto under the ticker symbol CHE. You can find a quote on Yahoo using CHE-UN.TO.
It is a Canadian income trust and pays a monthly distribution of about 10 cents. Based on a price of $11.44, that is a yield of 10.5%. The company appears to be in good financial condition and throws off a lot of cash flow, much of which investors pocket in the distribution. It is not a sexy business, but it looks like an interesting play on what seems at least a temporary scarcity of a key chemical. Chemtrade is not a one-trick pony. It also produces liquid sulfur dioxide and sodium hydrosulfite. The company also sells into a wide range of end markets, so you are not tied to the fortunes of any single sector. The company has an excellent presentation of its business, complete with slides, on its Web site.
Since I have not completed my research on either Chemtrade or on the overall sulfuric acid industry, I did not recommend Chemtrade to the subscribers of my investment service, Mayer's Special Situations. But since this sector is red-hot at the moment and appealing on many levels, I decided to share the insights I have gleaned so far. I plan to do more research on the idea and keep an eye on it.
The company may not be a one-trick pony, but its "tricks" are highly correlated. This situation readily admits to a private market value type analysis. You are buying a portfolio of facilities. What is their replacement value? We seem to be in a situation where they are actually worth replacing, if current prices sustain. What is the risk of market conditions reverting to "adverse" again? And so on.
I would advise all investors to do the same. The skyrocketing price of sulfuric acid shows how interrelated the world's commodity markets and economies have become. And these interrelationships can produce investment opportunities at light-speed. Agriculture, energy, metals -- they are all part of one big story -- one big rapidly evolving story. Don't miss it.
A CHINESE STOCK THAT WILL ROCK YOUR SOCKS
This article offers up, without officially recommending, an interesting low-priced Chinese stock that trades on NASDAQ. Clearly speculative -- if the Chinese stock market endures a major bear market this financial news stock is toast -- it is also intriguing
"A year ago, there were 15 billionaires in China. Now, there are more than 100," said the New York Times in a piece about the growth of China's incredible growth. But that number is more than a statistic -- it is a glimpse at the fact that the Chinese population is getting richer as a whole.
China's new money goes well beyond the ultra-rich. The country is also home to a fast growing middle class that is out there to consume. And that middle class is potentially more valuable to investors here in the U.S. than all of those billionaires put together. Since last April, China's biggest 25 companies [stock prices] are up 33%, versus an S&P that has seen an 11% decline over the same period. ...
There is no question about it -- Chinese stocks are hot right now, but some are definitely hotter than others. With a recession nipping at our heels here at home, is it even possible to find an undervalued, bubble-proof Chinese stock these days?
As hard to fill as that order may seem, at least one company is looking pretty salacious for the American investment dollar right now: Xinhua Finance Media Limited (XFML). Xinhua Finance Media is -- you guessed it -- a media company that creates and broadcasts finance and entertainment content to millions of Chinese people. But here is the kicker -- the company targets high net worth individuals in China ... We are talking professionals who can give advertisers the most bang for their buck (or yuan, as the case may be).
XFML is an interesting story because it takes middle class Chinese consumers on from all sides ... They are in print, TV broadcasts, online ads, and mobile devices that reach more than half a billion people. And management is no slouch either. Their CEO was chosen as one of the Wall Street Journal's Top 50 Women in 2004.
Even though the company has only been listed here in the U.S. for the past year, they have already posted some impressive numbers. They have got positive earnings, a double-digit profit margin, and some impressive net assets on the books. How impressive? More than $6 per share!
What is not to like? Well, one small blip on the radar is the fact that so much of their assets are made up of intangibles. Can their figures hold up to scrutiny in a bad market? Still, with a low P/E and a share price hovering around $3 and change, there is a lot to like about this stock. Even a conservative analysis puts XFML above the $5 mark in the next couple years.
The stock is now closer to $4 as this is written. An upside of 25% is less tantalizing than 67%.
Another thing that makes Xinhua Finance Media unique is the fact that they are selling financial news, a service that gets even more eyes on it when the economy is in a slump. Institutional investors agree ... California-based investment firm Yucaipa recently took a 12% stake XFML. "The investment will strengthen our financial position and enable us to better capitalize on the opportunities in China for growth and expansion," Xinhua CEO Fredy Bush said in a press release.
China is already proving itself to be a workhorse market this year, and Xinhua Finance Media looks like one of the cheapest Chinese plays out there. We will not be tracking it here, but if you are looking to add an interesting penny play to your portfolio, this one might be worth taking a look at.
DEBUNKING MANAGED FUNDS
Warren Buffett memorably characterized hedge funds as not an asset class but a management compensation scheme. The hedge funds' duller and more respectable brothers, the traditional mutual funds, basically deserve the same term of opprobrium. The compensation excesses are less egregious with mutual funds, but collectively the whole industry is built on a fraud. They all promise to outperform the market, but this has never been the case and cannot be the case. Why? In aggregate they come close to being the market, which means their pre-fees and expenses performance matches the market. And fees and expenses are a crushing performance drag for fund holders. Tim Price "debunks" the fund management business in in a little more detail.
Just following the investment markets this past year has been a largely thankless task. A Chinese water torture of ongoing black comedy from a now distinctly subprime banking sector has reduced formerly strong individuals -- and hitherto credible financial institutions -- to gibbering rubble. In the wake of Northern Rock, Bear Stearns (BSC) and <insert the name of any random bank here>, the financial sector has largely taken its lumps and moved onward -- if downward. Banks are not necessarily fairly priced yet (water may be an increasingly scarce resource; bank shareholders, however, are still in for further dilution), but the bad news is well and truly in the market. Time for the rest of us to move on.
In search of new enthusiasms, one opens the second section of the Financial Times with an almost giddy sense of optimism, only for one's spirits to sag once again at around page 29 or so -- the start of the London Marathon that is the Managed Funds section -- lots of entrants, and plenty of them both amateurs and comedians. To view this jammed thoroughfare of 3rd-party managed funds in a vaguely positive light, it at least points to the vigor of competition in the asset management market -- if not necessarily to the health of the underlying funds.
An anniversary that never fails to fire six bullets into one's joie de vivre as an asset manager is that point in the early 1990s when the number of mutual funds (roughly 4,300) on the New York Stock Exchange amounted to double the number of stocks listed on that same exchange. A particularly fat tail had started to wag a somewhat vulnerable dog. Now a new book by Louis Lowenstein (the title seems to give the game away: The Investor’s Dilemma: how mutual funds are betraying your trust and what to do about it) serves to remind us of one of the financial services industry's dirtier not so little secrets:
There is a profound conflict of interest built into the industry's structure, one that grows out of the fact that (mutual fund) management companies are independently owned, separate from the funds themselves, and managers profit by maximizing the funds under management because their fees are based on assets, not performance.
The figures are startling, and drive a peculiarly large nail into the coffin of efficient market theory, or for that matter plain economic sense. Between 1980 and 2004, the assets of stock funds in the U.S. increased 90-fold, from $45 billion to $4 trillion. Fund managers harvested a lustrous crop of fees irrespective of whether their investments rose or fell in value. (Many of the same managers spend much of their time criticizing their hedge fund rivals for charging too much fee income for the surely more ethically defensible goal of making absolute, rather than relative, returns.) What is almost painful to relate is that while the industry now manages $6 trillion in equity funds, it manages a further $3 trillion in bonds and money market funds. Portfolio theory, and plain common sense, would suggest that while there are limited opportunities to generate value ("alpha") from inefficiencies in the equity market, there are virtually none in the bond market and certainly not over-many opportunities in the money market once fees are taken into account.
Mr. Lowenstein evidently marshals a number of damning arguments in his systematic dismantling of the mutual fund industry. One of the more compelling touches on the alignment of interests between manager and client. From 2003 to 2006, by way of example, the chief investment officer of T. Rowe Price amassed ownership of equity in the management company worth over $75 million. His total personal investment in T. Rowe Price's mutual funds amounted, apparently, to $1 million. Whatever the quality of the cooking, there was precious little eating going on. The contrast between "traditional" funds and hedge funds, in this respect, is explicit. The role played by hedge fund management fees is worthy of a whole separate jeremiad, but the alignment of manager and client interests in the form of equity participation in the underlying funds is worthy of note. Many hedge fund managers -- as the failure of Peloton earlier this year revealed -- have much of their personal net worth invested in their funds. That obviously betokens no guarantee of ultimate success, but if failure is the outcome, investor misery can at least enjoy some company.
As we have noted before, egregious fee extraction is not restricted to so-called hedge funds. Traditional fund groups are perfectly comfortable charging high fees for substandard performance. If future market returns are likely to disappoint by comparison with the now almost mythical 1980-2000 bull market, and they surely may, then the imposition of any fees whatsoever will hinder portfolio returns. As Alistair Blair, writing for Investors Chronicle, wrote last year:
Consumers simply cannot grasp the fact that the man sitting in front of them and the people behind him are being paid via a long-term and hugely expensive levy on the returns from their savings ... Investment products should be required to be sold with a warning comparing the total impact of fees over 20 years with the impact of fees on the least expensive indexed product on the market. I believe this slot is currently occupied by the Fidelity Moneybuilder UK Index Fund, which has an annual management charge of 0.1% and total expenses of 0.3%.
The warning would run like this:
Of course, not everyone wants index performance, hence the continued rise of the hedge fund sector. But the recent divergence of the asset management industry between low-cost tracker products (now ETFs) and high-cost "market neutral" structures leaves an increasingly awkward-looking no man's land in the middle of mongrel vehicles of no real underlying merit: funds which at best could track the market but are destined to underperform due to high active management fees. Just as the banking sector is going to see an inevitable compression in returns (if not outright consolidation) as the credit crunch allies with heightened regulation to stifle growth, so the number of managed funds should, if there is any natural justice whatsoever, finally contract as investors become increasingly familiar with both the lower cost exchange-traded proposition and with the higher cost absolute return offering. No man's land is not a pleasant place to spend any length of time.
- This product aims to deliver you a greater return than you would obtain by buying the Fidelity Moneybuilder Index Fund directly. It will need to do so because our costs are much higher. Very few people understand the effect of fees -- even apparently small ones -- on investment returns, SO PLEASE READ THE FOLLOWING CAREFULLY.
- If you invest £5,000 in the Fidelity Moneybuilder Index and it achieves 7% growth a year for 20 years, your £5,000 will grow to £18,000. If you invest in our product and it achieves 7% growth for 20 years, the effect of our higher fees will be that you will end up with only £12,000.
- But we aim to do better. In fact, even to match the Fidelity Moneybuilder, we will have to outperform the index by an average of 2.4% every year for 20 years.
- In the FSA database of 15,000 funds offered to the public over the past 20 years, only 10 funds have achieved this kind of performance. We aim to be the 11th.
WHY HAS GOLD TURNED DOWN?
In case anyone had missed it amongst all the inflation scare mongering, the price of gold has fallen over the last month or so, from over $1000 to under $900 an ounce. Just taking a breather? Deflationary forces rearing their head? As usual, the Elliott Wave International analysts attribute it to internal market dynamics. The wave count said it was time to fall, so it did.
In an Act III scene in Oscar Wilde's all-time classic farce, The Importance of Being Earnest, Algernon explains to his Aunt Augusta (Lady Bracknell) the sudden disappearance of his imaginary invalid friend "Bunbury", who had previously provided a convenient excuse for ducking out of the house:
Algernon (groping for words): "My dear Aunt Augusta, I mean he was found out! The doctors found out that Bunbury could not live, that is what I mean -- so Bunbury died."
Lady Bracknell. "He seems to have had great confidence in the opinion of his physicians. I am glad, however, that he made up his mind at the last to some definite course of action, and acted under proper medical advice."
And the markets, we are led to believe, have great confidence in the readouts they get from taking their own wave count pulse.
In case you were wondering: You have not gotten taller over the last month. The financial sky is just falling in. Which begs the question: Why have gold prices been going down? After all, according to mainstream economic wisdom, when there is blood on the Wall Street, it is time to buy precious metals (or something like that). Yet, despite the hemorrhaging U.S. credit and housing market, gold has lost its luster.
On April 23, one industry "expert" took a stab at solving the mystery: "Gold prices [are] responding to declining crude oil." Sure, that explanation works for the hour at hand. But it does little to resolve the market's performance for the rest of the day, the previous week, or entire past month for that matter.
Check the charts: The most recent downtrend in gold got started on March 17. That same day, crude oil prices turned up in a relentless, $20 per barrel rally to all-time record highs.
Back to square one. There is no fundamental reason for gold to have lost its "safe haven" appeal. Coming across negative economic news these days is like finding hay straw in a haystack. ...
Why the metal is not soaring skyward is now beyond the rationalizing capabilities of the usual folks. In the words of one news source: "Participants continued to be frustrated by the metal's recent lack of response to outside drivers. Since hitting record high in mid-March, the precious metal has struggled to find direction."
Correction. Gold has had no problem finding a direction since its March 17 high, namely SOUTHWARD, in a sell-off that has slashed more than $130 per ounce from its value. The only "struggle" has to do with the fact that that particular direction goes against what fundamental analysis calls for.
It does not, however, go against what Elliott Wave analysis calls for. In the days leading up to the metal's recent peak, the March 14 Short Term Update presented a powerful close-up of Gold Prices alongside the headline: "Waiting For A Reversal".
In Short Term Update's own words: "Gold hit the psychological motherlode when it pushed to $1000. WE may have to wait until closer to the end of next week before prices make a turn lower, but any decline beneath $960 should be a clear early warning that a declining phase is starting." Directly off the metal's peak, the March 17 Short Term Update follow-up was certain: "This reversal looks like the real deal."
Good call, EWI people. We are still waiting for gold to bottom out at less than $200.
Bottom line: Gold has turned down because the wave pattern initiated a major change in trend.
WHAT THE DROP IN SILVER MEANS
In short: that a recession is on the way. Silver is more volatile and more economically sensitive than gold. An interesting corollary factoid is that gold performs poorly during economic contraction. If the central bank tries to hyperinflate its way out of a contraction, however, we bet gold does just fine.
Six weeks ago, Bob Prechter called the top in silver. He published his forecast in The Elliott Wave Theorist on Friday, March 14. The top came on Monday, March 17. This chart shows what silver has done since then, updated through April 23. To get a sense of how Bob sees a market in terms of wave patterns, please read the excerpt below from that March Theorist. He also suggests what will happen to gold and the U.S. economy.
Elliott Waves in the Silver Market (excerpted from The Elliott Wave Theorist, March 14, 2008)
Let us apply the Wave Principle to the silver market. The April 18, 2006, issue of The Elliott Wave Theorist predicted an imminent top in silver, with a price projection of $21.70 and a backup projection of $16.61 ...
Silver topped 2 1/2 weeks later and fell 37%. But the peak price just above $15 did not match either of the price projections. Though silver corrected for over a year, 2006 proved not to be the final top. ... The price projection of $21.70, however, is looking very good. The high so far is $21.32, and once again the wave structure appears nearly terminal while market sentiment is extreme ... The wave count is nearly satisfied, although ideally it should end after one more new high ... A slight new high would give this top the same profile as that of 2006. [Editor's note: Silver topped at $21.40, basis spot prices, on March 17, 2008.]
If this analysis of silver is accurate and silver does peak this year and begin a bear market, gold is likely to go down with it. As we have already seen, gold tends to perform less well during economic contractions, so the economy is likely to peak along with gold. This conclusion fits our long-standing observation that silver is an excellent predictor of recessions: When it goes down substantially, recession follows. Despite the recent torrent of bad news, the economy has yet to go into recession. So all this analysis fits our view: The economy is on its last legs, and the precious metals are nearing a top right along with it.
THE RATIO OF GOLD PRICES TO THE DOW JONES
If you think inflation is here to stay for a while, where to park your investment assets? Gold and stocks are where people usually look first. In choosing between the two one might look at the Dow Jones Industrial Average to gold ratio, which goes through very long bull and bear market cycles. After bottoming near 1-to-1 at the peak of the precious metals market in early 1980, it went all the way to 40+ in 2000-01 when stocks hit a major peak and gold was bumping along the bottom of a 20-year bear market. Now it is all the way back down to the 12-13 range -- the average of the last 80 years, for what that number is worth.
The principle arguments for the ratio moving lower is: (1) in the three major bear markets in the ratio of the last 80 years, if it does not move down to below 5 this time it will be a first; (2) this bear market is "only" 9 or so years old at this point, while the two previous ones bottomed out at least 14 years after the previous top. Not a lot of data to hang your hat on, but, as we said, this trends in this ratio last a very long time.
If Wall Street stocks can surge 160 points on falling earnings, an 11% drop in housing starts, and a 16-year record for consumer price inflation, then so can everything else that does not carry a picture of George Washington.
Crude oil, rice, gold, the euro, wheat, emerging market bonds, copper ... anything that is not stamped with the all-seeing eye of the dollar looks like a great bet once again. The Federal Reserve has seen to that, driving the real returns paid to cash down toward a 3-decade low.
Sinking to minus 2.05% in March, the real rate of interest [see chart] nearly equals the very worst returns to cash paid during the Great Greenspan Reflation of 2002-2005. This latest slump in real interest rates also comes thanks to "emergency" rate cuts. Plus, of course, the worst run for consumer price rises since the start of 1992. And I think the two are more closely related than the Olsen twins.
Rates down, inflation up? Well, what else did savers and retirees expect? The Fed cannot promise to forestall recession forever. But by God, it will try! So for the meantime at least, there is truly no fear of deflation here. ... Running at 4.3 percent yet again in March, the CPI just put in its longest stretch above 4.0% in 16 years. ...
It is not just U.S. cash savers being eaten alive, of course, by subzero rates of real interest. Here in London, the real returns paid to savings after tax and inflation have sat in the red for the last five years running. The latest shop price data from Europe now show a 12-year record for German consumers, giving the lie to "inflation vigilance" at the European Central Bank.
But the sudden bull market in everything really stands out in dollar terms. And hoarding cash -- the true meaning of "deflation," as well as the root cause of the current worldwide crisis in banking -- has become a sure route to the poorhouse again. How to choose the best escape route for your savings and wealth? Clearly, real estate is doomed, for the short to midterm at least. Government bond yields are now so far underwater you would be killed by the bends if they tried to come up for air.
That leaves commodities and stocks, the classic refuges for inflationary crises. And one way of judging the Dow -- free from all dollar distortions -- is to measure the index in terms of gold ounces [see chart].
Dividing the Dow Jones industrial average by the price of gold gives you a rough idea -- over time -- of where the real value might lie. It shows how many ounces of gold you would need to buy one unit of Dow stocks.
Hence, gold was a raging sell (in hindsight, at least) when the Dow/gold ratio touched 1.0 at the start of the 1980s. Stocks scarcely looked back for the next 20 years. But by the end of the 1990s, the real value had shifted again. And gold surged as the Dow sank after the tech stock crash of 2000.
That slump in stock prices compared with gold pushed the Dow/gold ratio down from its all-time top above 42.2 to just 12.6 in March of this year. That is pretty much exactly the Dow/gold average of the last 80 years. So which way will the ratio go now?
The Fed's new "reflationary melt-up" is clearly designed to keep stock prices buoyant. But it is only adding to the case for gold, too. "I would be very surprised if the Dow Jones industrials/gold ratio did not decline to between 5-10 within the next three years," said Marc Faber of The Gloom Boom & Doom Report recently.
If that call proves right, it might come thanks to gold prices doubling, or stock prices halving, or more likely some combination of both. But while the three peaks to date -- of August 1929, January 1966, and then late 1999 -- took the Dow/gold's top higher, the floor only held steady, down there at 2 ounces of gold and below.
And the last slump -- during the inflationary 1960s and stagflationary 1970s -- took a full 14 years to work itself out. So far in this bear market for the Dow/gold ratio, we are nine years through to date.
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