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ROYAL BANK OF SCOTLAND ISSUES GLOBAL STOCK AND CREDIT CRASH ALERT
Like all predictions, the ones covered in this article and the one below regarding a similarly dire warning from Morgan Stanley concern the future, and thus may or may not come true. The interesting angle, in our view, is that such predictions which were confined to "out there" hard money nuts and the like for years -- especially while the bull markets and manias were were raging -- are now emanating from the most conventional of sources. Which may not be a bad thing.
The Royal Bank of Scotland has advised clients to brace for a full-fledged crash in global stock and credit markets over the next three months as inflation paralyses the major central banks. "A very nasty period is soon to be upon us -- be prepared," said Bob Janjuah, the bank's credit strategist.
A report by the bank's research team warns that the S&P 500 index of Wall Street equities is likely to fall by more than 300 points to around 1050 by September as "all the chickens come home to roost" from the excesses of the global boom, with contagion spreading across Europe and emerging markets.
Such a slide on world bourses would amount to one of the worst bear markets over the last century.
RBS said the iTraxx index of high-grade corporate bonds could soar to 130/150 while the "Crossover" index of lower grade corporate bonds could reach 650/700 in a renewed bout of panic on the debt markets.
"I do not think I can be much blunter. If you have to be in credit, focus on quality, short durations, non-cyclical defensive names. "Cash is the key safe haven. This is about not losing your money, and not losing your job," said Mr. Janjuah, who became a City star after his grim warnings last year about the credit crisis proved all too accurate.
RBS expects Wall Street to rally a little further into early July before short-lived momentum from America's fiscal boost begins to fizzle out, and the delayed effects of the oil spike inflict their damage.
"Globalization was always going to risk putting G7 bankers into a dangerous corner at some point. We have got to that point," he said.
U.S. Federal Reserve and the European Central Bank both face a Hobson's choice as workers start to lose their jobs in earnest and lenders cut off credit. The authorities cannot respond with easy money because oil and food costs continue to push headline inflation to levels that are unsettling the markets. "The ugly spoiler is that we may need to see much lower global growth in order to get lower inflation," he said.
"The Fed is in panic mode. The massive credibility chasms down which the Fed and maybe even the ECB will plummet when they fail to hike rates in the face of higher inflation will combine to give us a big sell-off in risky assets," he said.
Kit Jukes, RBS's head of debt markets, said Europe would not be immune. "Economic weakness is spreading and the latest data on consumer demand and confidence are dire. The ECB is hell-bent on raising rates. The political fall-out could be substantial as finance ministers from the weaker economies rail at the ECB. Wider spreads between the German Bunds and peripheral markets seem assured," he said.
Ultimately, the bank expects the oil price spike to subside as the more powerful force of debt deflation takes hold next year.
Morgan Stanley Warns of “Catastrophic Event” as ECB Fights Federal Reserve
The clash between the European Central Bank and the U.S. Federal Reserve over monetary strategy is causing serious strains in the global financial system and could lead to a replay of Europe's exchange rate crisis in the 1990s, a team of bankers has warned.
"We see striking similarities between the transatlantic tensions that built up in the early 1990s and those that are accumulating again today. The outcome of the 1992 deadlock was a major currency crisis and a recession in Europe," said a report by Morgan Stanley's European experts.
Just as then, Washington has slashed rates to bail out the banks and prevent an economic hard-landing, while Frankfurt has stuck to its hawkish line -- ignoring angry protests from politicians and squeals of pain from Europe's export industry. Indeed, the ECB has let the de facto interest rate -- Euribor -- rise by over 100 basis points since the credit crisis began.
Just as then, the dollar has plummeted far enough to cause worldwide alarm. In August 1992 it fell to 1.35 against the Deutsche Mark. This time it has fallen even further to the equivalent of 1.25. It is potentially worse for Europe this time because the yen and yuan have also fallen to near record lows. So has sterling.
Morgan Stanley doubts that Europe's monetary union will break up under pressure, but it warns that corked pressures will have to find release one way or another. This will most likely occur through property slumps and banking purges in the vulnerable countries of the Club Med region and the euro-satellite states of Eastern Europe.
"The tensions will not disappear into thin air. They will find fault lines on the periphery of Europe. Painful macro adjustments are likely to take place. Pegs to the euro could be questioned," said the report, written by Eric Chaney, Carlos Caceres, and Pasquale Diana.
The point of maximum stress could occur in coming months if the ECB carries out the threat this month by Jean-Claude Trichet to raise rates. It will be worse yet -- for Europe -- if the Fed backs away from expected tightening. "This could trigger another ‘qcatastrophi‘r event," warned Morgan Stanley.
The markets have priced in two U.S. rates rises later this year following a series of "hawkish" comments by Fed chief Ben Bernanke and other U.S. officials, but this may have been a misjudgment. An article in the Washington Post by veteran columnist Robert Novak suggested that Mr. Bernanke is concerned that runaway oil costs will cause a slump in growth, viewing inflation as the lesser threat. He is irked by the ECB's talk of further monetary tightening at such a dangerous juncture.
The contrasting approaches in Washington and Frankfurt make some sense. America's flexible structure allows it to adjust quickly to shocks. Europe's more rigid system leaves it with "sticky" prices that take longer to fall back as growth slows.
Morgan Stanley says the current account deficits of Spain (10.5% of GDP), Portugal (10.5%), and Greece (14%) would never have been able to reach such extreme levels before the launch of the euro. EMU has shielded them from punishment by the markets, but this has allowed them to store up serious trouble. By contrast, Germany now has a huge surplus of 7.7% of GDP.
The imbalances appear to be getting worse. The latest food and oil spike has pushed eurozone inflation to a record 3.7%, with big variations by country. Spanish inflation is rising at 4.7% even though the country is now in the grip of a full-blown property crash. It is still falling further behind Germany. The squeeze required to claw back lost competitiveness will be "politically unpalatable."
Morgan Stanley said the biggest risk lies in the arc of countries from the Baltics to the Black Sea where credit growth has been roaring at 40% to 50% a year. Current account deficits have reached 23% of GDP in Latvia, and 22% in Bulgaria. In Hungary and Romania, over 55% of household debt is in euros or Swiss francs.
Swedish, Austrian, Greek and Italian banks have provided much of the funding for the credit booms. A crunch is looming in 2009 when a wave of maturities fall due. "Could the funding dry up? We think it could," said the bank.
STRATEGIES FOR CURRENCY INVESTORS
This is an excellent introduction for the knowledgeable investor who is nevertheless new to foreign currency trading, and a useful update as well for those more experienced. The number of options for trading or investing in the currencies amazes. Competition is driving down trading fees, and management fees for managed products. What is not to like?
This is the best of times for investors who trade in foreign currencies. The online trading platforms are refined and powerful, and competition has driven the price of buying and selling currency pairs down to a few pips. Add to this the advent of ETF and ETN currency funds, and we find ourselves with more trading options than we ever had in the past. So, what strategy should be used to take advantage of this new freedom? That is the question this note addresses.
For years trading in foreign currencies was the special province of professional traders. The large, international banks and other financial institutions that supported international trade were the ones who participated in the market. The online trading platforms were mostly for this type of investor -- those whose entire professional life was engaged in foreign currency trading. They did large volumes of trades, often highly leveraged. Ordinary investors are not suited for this environment, and it was not until exchange traded products became available that trading in single currencies was practical for them. Prior to ETFs and ETNs, the non-professionals had to use more indirect ways of investing in foreign monies.
Now, however, things are different. You can buy a relatively few dollars of unleveraged foreign currencies and then sit back and watch them along with the rest of your portfolio.
How do these trading abilities fit in with overall trading strategies? There are four primary strategies used by investors to make money in currency markets:
Professional currency traders use online trading platforms to execute the particular strategies they choose to follow. An American could take money out of a U.S. money market account and invest these monies in, for example, Australian dollars. This is a classic carry trade transaction, since the interest earned in an American money market account is far below that earned in Australia for Aussie dollars. The online trading platforms pay holders of foreign currency a "roll" for each overnight period the currency is held. The roll is keyed to the interest rate prevailing in the country of the foreign currency. Today, for example, if you bought Australian dollars with U.S. dollars, you could expect a daily roll that should total about 6%-7% annualized.
- The carry trade, which involves borrowing in low-interest rate countries and buying currencies in high-interest rate countries. This is an ancient strategy -- there are references in Roman times of using this method.
- Momentum trading, which attempts to read the immediate direction of currency markets and buy or sell short those currencies that are strongest in either direction. A technical method, it is also touted by technical analysts in stock and bond trading.
- Valuation trading, which attempts to find currencies that are trading above or below the trader's perception of the underlying value of the currency.
- Arbitrage is also an ancient strategy. When currency pairs trade in different markets, it is always possible for there to be price discrepancies between various pairs. An astute and close observer of these events can spot an opening, and jump in to profit from it. For example, an arbitrageur could buy pound sterling on the Paris market and sell in London at a better pound/franc price. Computer modeling used by the major trading banks, however, have made this strategy their sole province -- I am not sure individual investors can still take advantage of arbitrage opportunities like they could in past decades.
The carry trade is easy to translate into ETF or ETN buying. Use your U.S. money market account balances to buy an Australian dollar ETF (FXA), hold it for a month, and you will earn about the same interest rate a roll would provide. This is as straightforward a comparison as you will find between online trading platforms and exchange traded products. The major difference, of course, is that with the online trading platform, you can use leverage to enhance earnings or exacerbate losses. While technically by using options you can do about the same thing with exchange traded products, though not as easily and not as inexpensively. And, with an ETF you must hold the investment until the x-date for the dividend. With the online platforms, roll is earned daily.
Momentum trading is done with greatest ease with the online trading platform. You are getting quotes to the fourth or fifth decimal place in close to real time, so you can easily track momentum with their built in graphics capabilities. While this strategy could conceivable be used with an exchange traded product, transactions costs could easily be higher, and ETNs and ETFs do not give you the execution speeds and currency pairs to match the online platforms.
Valuation strategies are easily executed with either platform, but the number of currency pairs available for trading in exchange traded products are relative few. Plus, all currency pairs available in American markets for exchange traded products are denominated in U.S. dollars. With the online platforms, you can trade Australian dollars/Chinese Yuan pairs as easily as dollar denominated currencies.
Exchange traded instruments have recently added another dimension to currency trading that was not available from the online trading platforms in the past: packages of managed (strategy) currency accounts. Already, both PowerShares (DBV) and Barclays (ICI) offer a carry-trade strategy account with the U.S. dollar vs. the Group of 10 currencies. They borrow in low interest rate countries and buy currencies in the high-interest rate environments. What is unique is that the package is offered to individual investors without having to risk large sums in the process. If you can buy a single share in a strategy ETN, you can be a player.
The problem, in my view, with these managed accounts is that they are constrained by an index rule for what to borrow and what to buy. They are programmed to bring all G10 currencies into play, so they must make a buy or borrow decision on each currency. Oddly enough, if you look at the current composition of each of these products, you will find a divergence in what to buy and what to borrow. For example, ICI (using a Morgan Stanley Index) is buying Yen! With interest rates in Japan near the zero mark, the classic play would be to borrow there and buy elsewhere. I cannot figure how their trading algorithm works. DBV (using the Deutsche Bank Index) is borrowing Yen.
Both the PowerShares and Barclays shares are down for the year. The culprit is, as you might have guessed, the recovery (such as it is) of the U.S. dollar. When the dollar is in free fall against all major currencies, as it has been for almost a decade, anyone can make money betting against it. But when the pendulum swings, all the geniuses lose their bearings until things settle out.
The only other exchange traded product that offers something vaguely akin to a strategy fund are the double-down and double-up products offering highly leveraged bets against the Euro or dollar, etc. Van Eck offers two now (URR) and (DRR) which double up or double down (short) on the Euro. I cannot call this approach a strategy; it is more simply a raw bet. Perhaps a better description would be to borrow the Japanese word we know as kamikaze. For an investor who does not spend all his or her time in the foreign exchange market to place such a super-powered bet is nothing more than hoping a divine wind will blow your shares in the right direction.
The newest wrinkle I have found in the strategy-type investing is from Forex Capital Markets, FCXM, a relatively new forex trading firm that opened in 1999. They offer traditional online trading accounts, highly leveraged with a number of trading pairs. But, they have now introduced four strategy accounts that allow an inexperienced investor to jump into the rarified air of currency speculation without having to make the specific buy and sell decisions. They let the pros call the shots. There are two basic strategies: a short-term program and a long-term one, but each strategy is also offered in a leveraged and unleveraged version. Here are the four strategies [returns numbers should be read with the usual warning that past results are no guarantee of future performance; moreover some are "paper" rather than real trades]:
I have looked into these black boxes trying to divine their hearts: both are programmed traded units, i.e., all trading is automated -- no portfolio manager is making decisions. They have their strategy and their computers follow it by rules. The short-term opportunity program uses a momentum strategy without leverage. The Sentiment Program uses a longer term momentum strategy where their own database of sales and purchases in the markets are used to spot market-wide trends.
- Short-Term-Opportunity Aggressive Program (No leverage) (Last 12 months [May 2007 - April 2008]): 77.89% growth. Minimum deposit: $1,000. (This program began live trading in March and achieved a 14.19% growth. Results prior to March represent hypothetical performance results.
- Dynamic Multi-Strategy Program (Leveraged) (Last 12 months [May 2007 - April 2008]): 82.91% growth. Minimum Deposit: $1,000. (This program began live trading in April and achieved a -1.73 drawdown. Results prior to April represent hypothetical performance results.)
- Sentiment Program (No leverage)(Last 12 months [May 2007 - April 2008]): 18.25% growth. (Live performance) Minimum deposit: $5,000.
- Sentiment Aggressive Program (Leveraged) (Since inception [July 2007 - April 2008]): 35.76% growth. (Live performance) Minimum deposit: $5,000.
It is an interesting program, and the returns they post make it look great. But, remember that some of their posted returns are hypothetical -- always cause for suspicion. The biggest cause for concern from my perspective are their high costs. The monthly fee is quite reasonable. It annualizes at about 2%. But, they take 30% of the profits, with some relief if the account is recovering from a loss. I am not a buyer, but I find it interesting as a concept. I wonder if, in the future, other forex traders will offer some kind of managed accounts for small investors.
The 30% of profits management fee looks excessively greedy, especially for an automated trading program. Even the notorious hedge fund compensation scheme is "only" 2% of assets and 20% of profits.
For purposes of full disclosure, I own two currency ETFs: Mexican Pesos fund (FXM) and the Brazilian Real (BZF). I own both as a classic carry trade play, and I am not hedged in either position -- a valuation play of sorts. I use money market funds for the purchase, and I hold them with a keen eye on economic conditions in Mexico and Brazil. Things can change fast in Latin America. I also limit these holdings to less than 10% of my total portfolio.
I have already provided a list of exchange traded products in an earlier post. Here is a short listing of some of the online trading platforms:
I close this brief description of trading currencies by passing on a suggestion I received in an email from Deutsche Bank. Their list of 10 trading tips [see below] is provided in a companion post, and I think it deserves a wide reading. These suggestions are well thought out and has raised my esteem for this old German bank to a new level. I urge anyone new to currency investing to read it carefully. I believe that currency investing (as opposed to trading) is viable as part of one's portfolio allocation -- currencies are, in a simple way, an additional asset class that is somewhat independent of equity and fixed income markets. But, the suggestions offered by Deutsche Bank give us some rules to follow before jumping into the deep waters of this highly liquid asset class.
- Deutsche Bank Trading Station II [DBFX]
- CitiFX Pro
- FXCM Trading Station II (Same platform as DBFX, but a different provider of the service)
- DealBook 360
Top 10 Currency Trading Tips from Deutsche Bank
These forex trading tips, with appropriate modifications, would apply to any asset market. One tip we would add (it seems a commenter on the article has beaten us to it, in so many words) is the Buffettesque: Wait for your pitch. There is no umpire calling balls and strikes, so there is no need to swing when the odds are not manifestly in your favor.
An e-mail from Deutsche Bank contained the following list, which will serve an investor well who is contemplating buying foreign currencies as part of their overall portfolio. Top 10 currency trading tips from Deutsche Bank dbFX:
BARRON’S ROUNDTABLE EXPERTS EXPOUND, PART I
Eleven of Wall Street’s most insightful investment experts weigh in on the uncertain prospects for the economy, stocks, bonds, commodities and more in our midyear Roundtable. Some good and bad news about oil and banks. And an early read on 2009 -- and yes, 2010.
Barron's semiannual "Roundtables" are always well worth reading -- sometimes for the ideas, and always to channel the thinking of some of the smarter investment pros around. Lest you worry that any of those interviewed are plugging certain ideas in order to pawn them off on the public, we assume if anyone overplays that hand they will not be invited back. In any case, pick your own price on any ideas you find attractive and wait until your price is hit -- or not.
You cannot trust anything these days. Take the innocent-looking tomato -- delicious, nutritious and now a weapon of mass digestive destruction. Or inflation, still soothingly low, so long as you do not eat or drive.
Then there is Wall Street, where humongous earnings these past few years have fed similarly humongous bonuses. Sorry, wrong numbers. Just ask Lehman Brothers, which announced last week that it will report a loss of nearly $3 billion for the second quarter, wiping out numerous periods of supposed gains.
The Barron's Roundtable represents a notable exception to the current bull market in duplicity and false impressions. Year in and year out, we can trust its members -- 11 of Wall Street's most insightful investment experts -- to give us the straight skinny on the economy, the financial markets and dozens of individual stocks and funds, even if the truth is sometimes painful, as it has been this year.
When the Roundtable last met January 7 with the editors of Barron's, our distinguished panelists minced no words: This year would be difficult to dismal for the economy and stocks, as the bubbles in housing and credit unwind. So far, so good (er, bad). Most still feel that way about 2008, and even 2009, though a handful see the skies clearing at last, even for decimated financial and home-building shares.
In the pages ahead, we have distilled the latest views of the Roundtable crew. We hope you are enlightened, amused and provoked by them to discover your own truths about markets. And, should you disagree with any of the opinions expressed herein, please, no tomatoes.
Barron’s: What a year it hs been for investors -- and it is only June. How do things look to you, Bill?
Gross: The economy has fooled us. Pimco expected at least a quarter of negative GDP growth, but we have not seen it yet. We do not expect a return to normalized growth rates in the next six months, however. There still are weaknesses in housing, and housing deflation affects employment and consumption. Also, the states, which had been reluctant savers, will have to cut back because they are over budget. Growth will stay positive, but very, very low.
How will the markets deal with this?
Relatively high inflation combined with meager economic growth sends a mixed message to the bond market. With the economy down, the Federal Reserve cannot raise rates to tame inflation. Yet, higher inflation means it should, or at least should be thinking about it.
What advice would you give the Fed?
The U.S. should simply stand pat. About a month ago the Fed sent a clear signal that 2% was it on the downside for rates, and that further stimulation would come from policy changes such as its liquidity provisions for Wall Street and heavy lifting from the Treasury and Congress to ease the mortgage crisis. But it is difficult to raise interest rates in the face of a housing market that is falling by double digits.
The good news for stocks is that economic growth has not turned negative and that corporate profits have not declined. A substantial portion of profits comes from outside the U.S., either through currency adjustments or greater growth in foreign markets. That said, financials play a dominant role in the market. That means lower profit margins, and lower profits. It is a tale of two stock markets.
Nonfinancial companies are doing better, you mean.
Finance companies are stinking up the joint, but the industrial economy is benefiting from a lower dollar and more exports. The railroads are doing well. The stock market might not have much upside, although foreign reserves have to go somewhere, and with oil prices at records, we are talking about an additional $500 billion of reserves generated in the past six months. That money will come to the U.S., and its owners do not want bonds. Almost by default -- if you will pardon the term -- stocks are benefiting. They are the least bad choice. But be cautious: This is not a new bull market.
Your January picks -- auto bonds and some closed-end funds -- did well, especially relative to the market. How about a few new ideas?
Fairpoint Communications [7.79, FRP], a land-line phone company, acquired substantial properties from Verizon Communications. Related to the deal, the dividend will fall to $1.03 from $1.59, for a yield of 11% for the next year.
JPMorgan Chase has a 7.9% preferred stock due April 29, 2049. This is the crème de la crème of banks today; the Fed loves [CEO] Jamie Dimon. Why shouldn't you? This preferred can be bought for 96 cents on the dollar, for a yield of 8%-plus.
Lastly, Countrywide Financial [4.58, CFC] trades at a 10% discount to the price that Bank of America, its future parent, has agreed to pay in an all-stock deal. The deal will close in a few months, and Countrywide yields 10% while you wait.
Sounds like it is worth waiting. Thanks, Bill.
Barron’s: What is your second-half forecast, Oscar?
Schafer: We are in the 6th or 7th inning of losses taken on subprime and other financial instruments. But we are in the third or fourth inning of deleveraging the economy after four or five years of borrowing. Growth will remain slow as we reverse the trend of having spent more than we earned. And we have not yet seen all the problems of the regional banks, which, although they hold less of the risky financial instruments, will have problems with customers defaulting on credit-card debt and auto loans.
Consumers will continue to be under pressure as house prices fall, mortgage-equity withdrawals decline and gas is at $4 a gallon. That is why companies like Wal-Mart Stores are doing better than expected. The U.S. has $20 trillion in household wealth. House prices have come down 13% or 14%, so that is $2.6 trillion in wealth destruction. Compare that to tax cuts, which have been all of $150 billion. The continuing erosion in household wealth will make consumers spend less. And the banks, with big write-offs, are constrained in lending money, even if the Fed lowers rates. The growth of the past few years was credit-driven, and credit is drying up.
How long will the deleveraging take?
It could last another 12 to 18 months. We look for companies that are somewhat immune to these problems. The further you get from housing and consumer spending, the less the impact is likely to be. If the rest of the world -- China, India, Brazil -- does not collapse, the industrial part of our economy will keep going.
Are you expecting them to collapse?
It is the $64 question. If it happens, all bets are off for the rest of the world. The stock market probably will not do much this year. There is a yin and yang between the financial sector and everything else. We will have a standoff. As long as there are not significant layoffs, the economy -- and the stock market -- will muddle along.
What stocks do well in this sort of market?
I have got two special situations. Tyco International [TYC] sells for 43 a share and has a $21 billion market cap. After spinning off its health-care business into Covidien [COV] and electronics manufacturing into Tyco Electronics [TEL], the remaining Tyco is a diversified manufacturing and service company operating in several business segments. These include ADT, the nation's largest electronic-security provider; Flow Control, the largest manufacturer of flow-control products, and fire-protection, safety-products and electrical and metal-products businesses.
Tyco is significantly undervalued. The company has big opportunities to improve margins across various business segments and reduce corporate overhead. In particular, ADT's European business has operating margins less than half those in the U.S. The company is in the early stages of an operational turnaround. Also, the flow-control business is underappreciated, as its end markets -- par- ticularly oil and gas, power, waste and water -- have excellent growth prospects, and it is 75% international. The growth in these end markets could continue for several years.
What do Tyco's financials look like?
The company is underlevered, with current net debt equal to EBITDA [earnings before interest, taxes, depreciation and amortization]. Tyco's businesses generate significant cash flow due to high recurring revenue, a strong service-revenue component and relatively modest capital-expenditure requirements. The company is making tuck-in acquisitions and is in the process of divesting its engineering and construction business, the proceeds of which will be reinvested and used to repurchase stock. Tyco has a great management team led by CEO Ed Breen, who can focus on the core businesses following last year's spinoffs.
Did Tyco retain a piece of the spinoffs?
No, though all the pieces are interesting. The company is not economically sensitive; management is in control of its destiny. The stock is selling for about 6.5 times next year's estimated EBITDA, and about 11 times 2009 estimated cash earnings of just under $4 a share. Tyco could be worth in the mid-60s. If it does not get credit for hidden gems such as Flow Control, it could spin those off, too.
CommScope [52, CTV] is a producer of antennas and cabling for wireless towers, data transport and cable companies. It is a leading producer in all its segments, domestically and internationally. The key to the story is the superb execution capabilities of the CommScope management team. The CEO, chief financial officer and chief operating officer have been running this company together for more than 30 years. ... CommScope's wireless antenna and cabling business should benefit from the rapid increase in wireless-data demand.
Where is the stock?
While the stock has run up 30% to 53-54 since the company reported its first quarter in April, there is at least 25% upside from current levels. Wall Street's estimate for this year is $3.36 a share. For next year, it is $4.10, and there is upside to both years' estimates. CommScope trades for 13 times 2009 earnings. The market cap is $3.7 billion. With both Tyco and CommScope, we are betting on the management, not the economy. You have to focus on management that can execute despite headwinds.
Good advice. Thanks, Oscar.
Barron’s: How is the year treating you, Archie?
MacAllaster: I have been neutral on the market for a year and a half. I have survived and my customers have survived. But these are brutal markets and you have to be careful. You wish everybody was off margin, because this is not a time to be speculating with borrowed money.
Tell that to Wall Street.
Lehman Brothers has reduced its leverage from 32 times equity to about 25 times in one quarter, which is good. But they have a long way to go. They raised $6 billion of equity and they are probably going to lose that $6 billion.
The economy has performed well if you get away from housing and the financials. Companies with foreign operations have done well. McDonald's reported good earnings and its stock is up. I am an optimist. The economy has not had a negative quarter yet, and if it does, the downturn will not be deep. I have three bank stocks to recommend.
Surely, you are joking.
If nobody loves banks, at the least they are fairly priced. The five largest banks in America have 44%-45% of the total assets of the banking system. They have increased that percentage year after year, and it will not be long before they own more than 50%. Two [Citigroup and Wachovia] have cut their dividends, but the other three are a good investment in the next 12 to 18 months. One is conservative, one a growth company and one speculative.
JPMorgan Chase [JPM] has the most conservative balance sheet and the fewest problems. The stock sells at about 37. The high for the past year was 51, the low 36. The dividend is $1.52 a share and the stock yields 4%. JPMorgan earned $4.37 a share in 2007. The estimate for 2008 is $2.50. If they pay out $1.52 a share, they will earn well in excess of the dividend. There is no reason it should be cut. You do not have to hurry to buy these things because they could go down in the next month or two. But in 12 to 18 months, the stock ought to be somewhere in the neighborhood of 46 to 48.
Which is the growth company?
Wells Fargo [WFC]. It has a major problem in home-equity loans, but has reserved well. The stock is about 25, and the range is 38 to 24.38. Wells has had the best growth of all the large banks for many years, and it still will. It is well run. It does three or four different kinds of business with its customers. The market has knocked its shares down too far. Wells Fargo earned $2.41 a share last year, and the estimate this year is $2 to $2.10. This, too, is well in excess of its dividend, which is $1.24 a share. The stock yields almost 5%. My earnings estimate for 2009 is $3.10 a share.
Your speculative bet must be Bank of America [BAC].
Yes, because they may cut the dividend. Bank of America offers the greatest potential. It is trading around 29, the low for the year. The high was 53. The dividend is $2.56 a share, and it yields about 8.6%. They do not have to cut the dividend, but with the yield over 8%, the market is saying they will. Bank of America's pending acquisition of Countrywide Financial has been criticized. People are worried about the size of the reserves they will have to take against Countrywide's loans. Long term, the deal will be a positive, though it is going to take 18 months to two years.
Bank of America also owns about 20 billion shares of China Construction Bank [939.Hong Kong]. It accounts for about $15 billion of the bank's market value. The first piece they purchased becomes marketable in October. They'll sell part of it. When they do, they'll have a big profit. That will allow them to offset some of the losses, and perhaps preserve the dividend. The bank earned $3.32 a share in 2007, and that's after taking big write-offs in the fourth quarter. My estimate for this year is $2.50 to $2.60, which is about equal to the $2.56 dividend. My 18-month target is $50 to $52.
Thank you, Archie.
Barron’s: Some of your January picks did well, including Devon Energy, Ensco and Ross Stores.
Black: You did not have to be a genius to do well in oil stocks, given oil is $134 a barrel and gas is $12.67 per million British thermal units -- well above levels earlier this year. It is like having a big wind to your back as you are sailing off Newport to Block Island. Devon Energy also is great with the drill bit. I originally thought earnings would be around $7.50 a share. Now they could top $11. It is a good company, but the price is a lot higher now. Ensco International also is doing well. They still have 45 rigs -- 44 jack-ups and one semi-submersible -- and six semi-submersibles on the way. The upside lies in the semi-submersibles; the first will be delivered next spring. The company is almost debt-free. Earnings estimates have been ratcheting up, and the stock still sells at nine times this year's estimates.
As for Ross Stores, women like to shop. They like to buy name brands at a bargain. Ross sells name-brand merchandise at 25% to 40% off department-store prices. Comp-store sales [sales at stores open a year or more] were up 7% in May, versus estimates of 4%. I thought they would earn $2.10 to $2.12 a share. The estimates are now $2.25. But the stock -- at 37, or 16 times this year's earnings -- is too expensive to initiate a position.
Thanks for the update. What is ahead?
Analysts estimate the S&P 500 will earn $89.27 this year. Strategists say $79.25. If we use $84.25, which is in the middle, the P/E is 16. The market is fully valued. On a dividend-discount model, as well, it is efficient. In January and February we had the greatest opportunity to buy name-brand technology stocks since the Long Term Capital debacle in 1998. We bought Oracle at 12 times earnings, Texas Instruments, KLA-Tencor, Xilinx.
There are no more pockets of opportunity. We are ignoring consumer-discretionary stocks. Everyone is recommending financials. We are not. We have the lowest weighting in financials since I started Delphi. The only major brokerage we own is Goldman Sachs, because they seem to have weathered the storm. Elsewhere in the industry, the bloodletting continues. The meltdown in housing also is ongoing. The stock market will not get out of its own way until the banking system regains transparency. This also overhangs S&P earnings.
The unwinding of the housing bubble is killing the economy. Household net worth is dropping for the first time in five or six years. The average family income in America is $48,600. For Main Street, this is a recession. Real GDP growth in 2008 and 2009 is going to be weak, at 1% to 1.5%.
That is robust compared with some estimates.
Everybody knocks Ben Bernanke, but I give him kudos. He could have kept interest rates high and defended the dollar, and risked a massive recession. He did the right thing by cutting rates. Opening the discount window to the investment banks was smart. So was bailing out Bear Stearns. We could have had a banking crisis like 1928-29 if Bear had failed.
If the market thinks S&P 500 earnings can get up to $100 in 2009, as some predict, stocks will take off later this year. But if S&P earnings come in around $84-$87 this year, it is going to be a stockpicker's market. Treasuries are a fool's bet. With headline inflation at almost 4%, parking money in 2-, 5- or 10-year Treasuries yields a negative real return.
Where are you parking money for Delphi's clients?
We like Bolt Technology [BOLT] ... It trades for 20, and has a market cap of $172 million. The high last year was 39.57, the low 14.67. We have been buying the stock at 18-19. Bolt makes a compressed-air gun for offshore seismology and has an 80% market share worldwide. It also makes underwater electrical connectors and cables, but the gun accounts for roughly 60% of sales. The company benefits from offshore seismology, and is in the sweet spot right now. Big customers include Schlumberger and SeaBird Exploration.
For the year ending June 30, Bolt could do close to $67 million in revenue and earn about $1.65 a share. There is not much Street guidance on 2009, so I do my own. Conservatively, we have revenues going up 12%, to $75 million. Cost of sales is about 55%, and SG&A [selling, general and administrative expenses] is up 5%, to $9.6 million. Research and development spending is about $200,000. They have more than $2 a share in cash, no debt. There is about $300,000 in interest income. After taxes at 33%, you get $16.3 million in net income. Divide by 8.58 million fully diluted shares, and Bolt will earn $1.90 a share on the low end.
And on the high end?
Revenues will grow 16%, to $78 million, and they will earn $2 a share, versus $1.65 this year. That is 20% growth and a 10 price/earnings multiple. They have a steady book of business. Schlumberger is a great company, but at a 20 P/E it is not a great value. Bolt, nobody ever heard of.
Belden [BELD], in St. Louis, is not well known, either. It manufactures electrical cable and wire. It trades for 36 a share and there are 47 million fully diluted shares, for a $1.7 billion market cap. The high on the year was 60; the low, 30.28. I like industrial companies that have a big presence outside the U.S. Only 41% of Belden's revenue is U.S.-based. The company made acquisitions at the end of 2006, one in Germany and another in Hong Kong. Revenue guidance for 2008 is around $2.25 billion. Operating margins are 12%. That gets you to about $270 million in operating income. They have $31 million in interest expense and $4 million in interest income, so before a recent acquisition, they would have made $243 million, taxed at 32%. I had them earning $3.51 on the low side and $3.68 after economies of scale. The acquisition will dilute 2008 earnings by 30 cents a share. Belden is a mundane manufacturer in the right markets.
Thank you, Scott.
Barron’s: What do you make of 2008, so far?
Faber: Measured in euros, the U.S. is down around 13%. But it has outperformed many other markets. The U.S. has many problems. One is the slowdown in credit growth. Another is recession. The statistics do not indicate the economy is in a recession, but we question the statistics.
The Federal Reserve's aggressive interest-rate cuts -- to 2% from 5.25% last September -- make equities relatively attractive compared to cash yields. But in the second half and the first half of 2009 it will become evident that 2009 earnings for the S&P 500 will not meet consensus estimates of $110 per S&P share. Earnings instead are coming down and will stay down, and this will weigh on stocks. The recession will not be deep but it could be long. And it could be deep for corporate profits.
How much further will the market fall?
The situation is similar to 1973-74. It is water torture. We may have a rally here or there, but once investors notice that Mr. Obama has a good chance of winning the presidential election, this will be another negative for stocks. He is not going to be good for the market.
Also, the bond market is not acting well. Bond yields are higher than when the Fed cut rates between December and January. The bond market looks as though it could weaken considerably. Once interest rates go up again, that will be another strong headwind for stocks.
The U.S. is down just 8% this year in dollars. India is down 30%; China, 40%; Vietnam, down 60%. Are those markets buys at current levels?
Among emerging markets, only Mexico and Brazil have been strong. I would get out of them. There is no hurry to buy anything in Asia, though stocks are not expensive. Thailand, down 7%, could fall another 5% or even 10%.
Japan is the exception. The Japanese market has performed badly in the past 18 months, and stocks are low compared to cash yields. Some corporations have increased their dividends. Steel Partners' ouster of the management of Aderans Holdings [8170.Japan], a Japanese wig maker, was an important event. Pension funds and foreign investors are starting to have more power over Japanese management.
Do you still like the iShares MSCI Japan Small Cap exchange-traded fund [SCJ], which you recommended in January?
Buy that, and some Japanese banks: Sumitomo Trust, Mitsubishi UFJ and Mizuho Financial. I would still go long the dollar against the euro, which is overvalued. The tightening of global liquidity and the contracting U.S. trade and current-account deficits are likely to be dollar-supportive. Mr. Bernanke does not understand anything about international economics. It is not a weak currency that leads via import prices to inflation, as he suggested, but inflated money and credit growth that leads to a weak currency.
Where is oil headed, now that it trades in the $130s?
Prices should ease a bit. It would not surprise me to see oil dropping to around $80 a barrel. If you are bearish about oil in the next three months -- though long-term, commodities will go higher -- it is best to own Japanese stocks or airlines. A drop in oil might not help the airlines much, but sentiment toward airlines will improve considerably. Buy AMR, Lufthansa, Singapore Airlines and Japan Airlines.
And sell oil stocks?
Interestingly, they have not done well relative to crude. One problem is declining reserves. Also, I would rather own physical commodities than commodity-related equities because resource nationalism is on the upswing. That is also true of gold, which has fallen to $870 an ounce from $1,000. The price could go down to $780 to $800 an ounce. If you have no exposure to gold, start buying it here. People are blaming speculators for the recent run-up in commodities, but they are a symptom rather than a cause of the problem. The cause lies in excess liquidity, and the Fed is responsible for that.
My last suggestion concerns steel. If world economies decelerate, the pace of building in places like China will slow, hurting demand for steel. Steel stocks have been among this year's best performers. Short U.S. Steel.
Thank you, Marc.
Barron’s: How does the big picture look to you, Mario?
Gabelli: The consumer, as we discussed in January, ran out of money and went off a cliff. Food and fuel costs have been a bigger negative than we expected. Rebate checks are hitting people's pocketbooks now, and we need another round of fiscal stimulation, focused on productivity. As for inflation, as Karl Otto Pöhl, a former president of the German Bundesbank, said, "It's like toothpaste. Once it gets out of the tube, it's very hard to put back." Inflation expectations have been accelerating. That will remain a challenge.
There will be less stress in the financial system in the second half of 2008, but continuing uncertainty with regard to the underpinnings of that stress: the housing market. Likewise, the auto market needs help. A lot of auto loans are underwater because of the declining value of the cars they financed. In 2009, however, we will be further along in correcting the housing balances, and we will have an OK economy.
And an OK stock market?
Originally I thought the market would be flat to up 5%. It will probably close up. If the Democrats control Congress and the White House, they will raise taxes. If you own a company, you may want to sell it and pay long-term capital gains this year. Companies may issue more special dividends over the balance of the year.
There is no question the amount of money earmarked by pension funds, endowments and others toward commodities is having an impact on prices, well beyond Chinese or Indian demand. This speculative bubble should be nipped in the bud. Margin requirements on commodities accounts must be increased or we will have another bust.
Where do you see value these days?
We like companies with an environmental focus. Going green is good for business. We also like companies with pricing power, and we like takeovers. Strategic buyers are at center stage. Telephone & Data Systems [TDS] has a takeover angle. There are 117 million shares outstanding, the stock is 45, and the company has two businesses: wireless, through U.S. Cellular, and telephone companies in rural America. TDS has about $350 million in net cash. EBITDA is $300 million. Valued at six times, that is $2 billion. With every TDS share, you get 0.61 of a share of U.S. Cellular, which trades at about 62 but is worth $100 to $120 a share. In all, you are getting $5 billion of value for free when you buy TDS at 45. Alltel or Verizon might buy U.S. Cellular, and there is speculation that TDS received a bid in the $90-a-share range. It is a potential takeover target.
Next, Tootsie Roll Industries [TR]. It has about 55 million shares. Chairman and CEO Melvin Gordon -- he is 88 -- and his wife, Ellen, the chief operating officer -- she is 76 -- control the voting shares, which have 10 votes each. Tootsie Roll has $120 million in cash. Revenues are flattish around $500 million, growing about 3% or 4% a year. Earnings are about a buck a share, going to $1.20. A takeout in the low $30s per share is likely. The stock sells for 26.
Who are the logical buyers?
There are many. With capital-gains taxes at 15% and likely to rise, it may be time for the Gordons to look at alternatives.
Tredegar [TG], located in Richmond, Virginia, makes diaper components. The number of children 4 years old and under is going to stay flat at about 600 million for the next 30 years, but the use of diapers for incontinence is rising dramatically with the elderly population. Third-party pay is increasing. Tredegar also makes a fiber shield for flat-screen devices, and has an aluminum-products business. The company has 34.5 million shares and has been buying in its stock, which trades for 14.50.
What is the market cap?
It is $500 million. A transaction is likely here, too. Management could take the company private, or continue to shrink its capitalization. Tredegar will earn about 70 cents this year, but earnings could rise 50% in the next few years.
Herley Industries [HRLY], a maker of defense electronics, also may be taken over. The stock is 15-16. There are 13.5 million shares outstanding. Revenues for the year ending July 31 will be about $150 million, and profits will be break-even to a small loss. Herley could earn a dollar a share in the next 12 months.
Any other ideas?
Diebold [DBD], which makes automatic-teller machines, sells for 39.50. United Technologies bid $40 a share for Diebold, which rejected the offer. Diebold could earn about $2.35 this year, $2.85 in 2009 and $3.50 in 2010. The balance sheet is in good shape. They should announce a large capitalization shrink. Self-service at banks is going to be highly sought after in Europe and Asia, and Diebold knows how to work with the banks. NCR has terrific management and we are buying it, as well, but Diebold is our official pick.
The rest of the Roundtable is covered in next week's Financial Digest.
FLIPPING FOR PROFIT
All turning foreclosed homes into cash takes is legwork, a line of credit and a lack of emotion.
Housing investor Kirk Leipzig sold the houses he owned when he sensed forclosures were starting to rise, in early 2007. Now he buys houses on the cheap out of foreclosure. The approach he uses sounds a lot like that of a deep discount value stock buyer, except with houses instead of stocks: buy them more cheaply than comparable houses have recently sold for, get them where rental revenues more than cover carrying costs, research an area before buying in, and have a cash cushion so you can hold out for a while if you have to.
Around the time his fellow Nashville, Tennessee residents are sipping their coffee some mornings, Kirk Leipzig finds himself standing elbow-to-elbow with a gaggle of bankers on the steps of the nearby Williamson County Courthouse.
Leipzig is there to scope out which banks are buying which houses out of foreclosure. Once they do, the properties are wiped clean of liens and other debts, and the bankers are often itching to unload them. Sometimes they do so right on the spot.
That is where Leipzig jumps in. Over the past 10 months the 41-year-old Waterford, Wisconsin native has used his courthouse intelligence, a $49 monthly subscription to listing service RealtyTrac, a title company on speed dial and comparable sales data to buy four houses out of foreclosure. He has already sold two of them for a quick $458,000 profit. As Leipzig parses through homes, he does not give a whit whether they appeal to him personally.
"I have seen plenty of investors go under because they fall in love with a house," he says. "I am strictly a by-the-numbers guy. If you know neighborhoods, comps [statistics on comparable home sale prices] and do your research ahead of time, you won't lose money."
Amid the first national home price decline since the Great Depression, an estimated 2 million to 3 million homes are expected to go into foreclosure this year. Big institutions are buying them in bulk. Blackstone Group has raised $11 billion to buy distressed property. A separate private equity consortium bought 8,500 properties in April from builder Centex Homes for $161 million, which was a mere 30% of their book value.
There is still plenty of room for little guys, says Leipzig, a classic up-by-the-bootstraps entrepreneur. ... Leipzig first tried his hand at real estate eight years ago, when he put down 3% of the $747,900 sale price to buy a home from Lloyd Ward, then chief executive of Maytag. Leipzig sold it 11 months later for $1.5 million. He soon quit the grocery business to trade homes full-time -- and cautiously.
Sensing early last year that foreclosures were rising, he unloaded the two homes he owned and kept out of the market while researching how to buy busted properties. Late last year Leipzig scouted out two Brentwood, Tennessee homes that had been foreclosed on by First Tennessee Bank. The four-bedroom properties were appraised for $725,000 each in November. Tax records showed comparable homes selling for slightly less.
Leipzig bid $400,000 for each of the properties. First Tennessee accepted his lowball offer last December. Leipzig paid with $120,000 in savings and $680,000 from Wells Fargo (where his lofty 819 average score among three big credit bureaus garners him preferential mortgage rates). Six weeks later Leipzig sold the homes for $689,000 apiece. After broker fees, closing costs and other expenses, Leipzig netted a total of $458,000.
"Half the houses I look at you can get for 40 to 50 cents on the dollar [of the pre-foreclosure selling price], but banks are starting to think 'Just get rid of it for less,'" he says.
The best places to start searching for foreclosed homes are Web sites like Foreclosures.com, RealtyTrac.com and Trulia.com, which link to foreclosure databases. Realtors are another good source. Calculating home values means scouring sites like Zillow.com and Eppraisal.com, as well as tax assessors' records block-by-block. Avoid neighborhoods where high foreclosure rates are depressing prices. Given how fast conditions are changing, that means spending time in neighborhoods before investing in them.
Leipzig is targeting upscale Brentwood and Franklin, Tennessee, where the economy is strong, amenities appealing and schools well regarded. Two attractive larger cities are Denver, with its strong energy sector, and Charlotte, Noorth Carolina, a low-cost financial services center.
Beyond buying into markets with strong long-term growth prospects, another way to cushion risk is to look for properties whose rental incomes cover mortgage and other costs. Figuring out whether that is the case involves factoring in things like mortgage payments, taxes and other expenses. However, properties are paying attractive rental yields even in some cities where sale prices have continued to rise during the broader downturn ...
Or you can go ultrasafe, like Leipzig. Even as he rents out properties, he keeps a 5-year cash hoard in the bank. "I can hold on until the market improves," he says.
Economics professor Steve H. Hanke finds the usual suspects behind some of the wild commodity price fluctuations this year. And it is not the favorite whipping boys, the speculators.
Scary rice and oil prices have sent politicians to their bag of tricks. Not surprisingly, they have pulled out one that has been a staple since the Middle Ages: blame the speculators and hoarders. But the politicos should be pointing fingers at themselves. Governments around the world buy and store commodities, especially rice and oil, with justifications stressing the value of everything and the cost of nothing. A notable proponent of commodity buffer stocks was John Maynard Keynes. As Keynes put it in 1942: "One of the greatest evils in international trade before the war was the wide and rapid fluctuations in the world prices of primary products." He recommended that governments use buffer stocks to smooth out price fluctuations by purchasing commodities when prices were thought to be low and selling them when prices were thought to be high.
Not surprisingly, this buffer-stock variant of "Father knows best" has not worked. For one thing, it assumes that government bureaucrats possess the same knowledge of market fundamentals and face the same incentives as well-financed, farsighted private traders. It also assumes that politics will not raise its ugly head. Both of these heroic assumptions are not met in the real world. Government buffer-stock schemes are rife with politics, and instead of generating profits from buying low and selling high, they tend to generate losses.
Rice is one of the most government-controlled commodities in the world. There are subsidies for rice producers and consumers. There are tariffs, quotas and, yes, buffer-stock programs. In consequence, the world's rice markets are fragmented and only 6% to 7% of world production is traded internationally.
Over the past year rice prices have more than doubled -- not because of private speculation and hoarding but because of government speculation and hoarding. As the price of rice began to climb, governments invoked their concerns for food security and increased their hoarding propensities. Exporting countries imposed restrictions to keep rice at home, while some of the largest rice importers signaled that they intended to significantly increase their buffer stocks. This proved to be a deadly supply-demand cocktail that set off panic buying, a price surge and food riots.
But this is not the end of the rice story. Japan announced last month that it wants to export rice. The Japanese rice industry is superprotected, and the government holds huge stockpiles. Part of these stocks are accumulated because Japan agreed, as part of a World Trade Organization deal, to make regular purchases from foreign producers, mainly the U.S. To keep domestic rice prices high, the Japanese government hoards its WTO-mandated imports. Now that Japan wants to unload some of its rice, opposition is flaring up in Washington and other capitals, claiming that re-exports are not allowed under the agreement. When it comes to filling or releasing government stockpiles, politics clearly rules the roost.
The mother of all commodity hoards is the U.S. Strategic Petroleum Reserve. At its current status of 97% full, the SPR is more than twice the size of private crude oil inventories, with enough reserves to cover about 71 days of U.S. crude oil imports or 47 days of total U.S. crude oil consumption.
Last month Congress voted overwhelmingly to force President Bush to stop filling the SPR just as its capacity was about to be reached. The President magnanimously complied, and Congress began to debate whether crude oil in the SPR should be released to break the back of speculators.
What should be done with the hoard of crude? It is time to remove the release rules from the grip of politics. Market-based release rules would transform the SPR into an oil bank. It would provide the country with a huge precautionary inventory of oil, generate revenue to defray some of the government's stockpiling costs, smooth out crude oil price fluctuations and push down spot prices relative to prices for oil to be delivered in the future.
How would an oil (or rice) bank work? The government would sell out-of-the-money call options on its stockpiles. It might, say, sell December 2008 oil options with a strike price of $200 a barrel. If the price surged above that level, the option buyer would exercise and take delivery of crude oil from the government's stockpile. If the price never reached $200, the option would expire worthless, and no crude oil would be released.
Let the market, not politicians, determine the flow of rice, oil and other commodities. Lower, more stable prices will ensue.
THE FORGOTTEN INVESTOR
Forbes columnist Laszlo Birinyi Jr. has a proprietary approach to analyzing stock market "money flows" that involves looking at large block trades executed on the uptick vs. the downtick. It is a sophisiticated modern-day counterpart to the ticker tape watchers of decades past. He maintains a blog, "Ticker Sense".
In his last column, he said that his analysis indicates that the precipitous climb in stock market volatility from all-time lows in early 2007 is here to stay. He believes that Wall Street is taking advantage of the volatility (which it generates in part itself) to skim trading profits at the expense of Main Street, but suggests a variety of ways to avoid being a victim yourself.
The decline in housing prices and its devastating effect on millions of Americans has been all over the front pages since the middle of last year. But another item on the typical individual's balance sheet has also caused real distress and has been almost universally overlooked. It is the performance -- or the lack thereof -- of the public's stock holdings, and it deserves much more attention.
At the end of 1999 the stock and mutual fund holdings of individual Americans, excluding pension accounts, totaled $12.8 trillion. By the end of 2007 that figure had fallen to $10.6 trillion. In between, individuals withdrew $570 billion of their holdings, so what they kept invested lost $1.5 trillion net in value, or 13% of what they possessed in 1999. This during a period when the Standard & Poor's 500 declined just 0.1% (or rose 14%, if dividends are included).
Obviously some of that loss can be blamed on poor investment decisions. My point is not to endorse indexing or other passive approaches, though. Rather, I think this illustrates how Wall Street has become a business that serves itself rather than its clients. Recent developments have only reinforced my view. Wall Street's primary customer is not Main Street but Wall Street.
As I mentioned in my last column, one brokerage firm booked $100 million in profits on each of 55 days last year. This year another firm has already reported -- with the year not yet at its midpoint -- 28 days of $100 million gains, and a third firm 20 days of them.
Now, I have no problem when a hedge fund manager correctly predicts that mortgage bonds will go down and is willing to invest accordingly, or for that matter when someone makes millions by betting against the dollar or the yen. My issue is with short-term trading profits, where professionals take their cut and collectively win to the detriment of individuals.
Those ultra-short-term trading profits, a sort of commission in disguise, are not my only beef. In April one brokerage announced it was moving its electronic trading platform to New Jersey so that its customers could save seven milliseconds per order (because the computer servers were now right next to one another). One remembers when electronic trading was going to lower trading costs and level the playing field. Sure, but level it for whom? Am I supposed to believe that the brokerage community is saving seven milliseconds on behalf of my Aunt Millie?
Brokerage firms and marketmakers are clearly making millions at the expense of individuals and mutual funds. They are playing by the rules, and rules are rules, as even Hillary Clinton has finally begun to learn. As a longtime shareholder and fan of Goldman Sachs (GS), I am glad that company and others like it recognize the landscape and profit from it.
Again, my issue is not with profits won by traders' insight and judgment. It is that the consistency and size of those returns make me suspect that there has been an awful lot of short-term trading profit swallowing up money that in the past would have ended up with long-term investors.
One way for the individual to cope with this environment is to buy and hold. If you do that, you do not have to fret over bid/ask spreads and daily volatility. One stock worthy of being held for a long time is Berkshire Hathaway (133,000, BRKA). This company is itself a giant portfolio, whose portfolio manager, Warren Buffett, has a lot of positions (like Coca-Cola and Washington Post) that he has held for decades and intends to hold indefinitely.
Another buy is a company that can only benefit from the gyrations of the market: CME Group (378, CME), the Chicago futures and options exchange formed by last year's merger of the Chicago Mercantile Exchange and the Chicago Board of Trade. While it is no bargain at 25 times trailing earnings, the stock is worth more, given the prospects for growth. The stock is a good play on volatility: Chaotic pricing of commodities and currencies makes for busier exchange floors.
A last name that I would suggest is Annaly Capital Management (17, NLY), which manages assets for institutions and individuals. It is not a stock likely to be traded by hedge funds and other short-term players. Financials stocks are not the flavor of the day, but this one recently raised its dividend, and it trades at seven times expected earnings. Annaly invests in high-quality home loans and, though down from its 12-month high of $21, has not been hurt like many of its competitors.
WINNERS, LOSERS, WHINERS
There seem to be as many opinions on financial stocks as there are analysts. We tend to side with the views expressed by Scott Black in the Barron's Roundtable above and others who think the recovery has a ways to go, but there are plenty who are at least recommending certain special situations in the sector. Richard Lehmann, editor of the Forbes/Lehmann Income Securities Investor, is among those in the later category. Here he recommends certain preferred stock issues of financial companies for their high yields.
When the history of this era is written, what will it say about the financial crisis of 2008? More important to investors today, who will have been the biggest winners and losers? My guess is that the winners list will include those who bought into financial stocks this year. These investors have figured out that things are not as dire as hyperventilating media experts and short-sellers have led the markets to believe.
Contributing to the gloom over the financial sector is something artificial -- mark-to-market accounting. The rules say that banks have to value derivatives like swaps and mortgage securities at their current market prices. The rules make no provision for what to do when there is no market. The result is to write everything down to such low valuations that smart money steps in to buy up the bargains (sometimes, as we saw in the Bear Stearns takeover, with a jump start from the Federal Reserve).
These paper writedowns of mortgage-related assets have real consequences. The banks, brokers and insurers taking hits on their inventories of securities wind up with impaired capital, the cushion needed to protect depositors, investors and policyholders from harm if the financial company gets into trouble. To restore their capital, financial institutions are selling common stock at depressed prices and selling preferred stock and debt with steep coupons.
Some distress on Wall Street is real, some merely a matter of perception. The situation was not helped when those important creators of perception, the credit-rating agencies, fell down on the job. The recent disclosure by Moody's Investors Service that a computer glitch led to its defective ratings of one type of particularly complex security does little to restore confidence. The purported remedy has been more CYA (call your attorneys) than CYC (correct your computing). The disclosure raises the equally disturbing question of what excuse Standard & Poor's can offer for coming up with the same ratings. The breakdown of the rating system has created an environment of fear and uncertainty -- fertile ground on which hedge funds short stocks and spread rumors.
The reality is that at this point no one can say how great the real losses will eventually be. However, historical experience argues that markets overreact in such situations, and there is ample reason to think this will be true in the current crisis.
The question for the here and now is how investors can be on the winning side of history. My answer is to buy some of the debt and preferred issues of high-quality, too-big-to-fail financial institutions that are being forced to raise capital to comply with the accounting rules. When was the last time AA- and A-rated institutions had to pay 8% for capital? Would you believe the early 1990s?
For those seeking the highest quality issues, I recommend the JPMorgan Chase Capital 8% preferred (26, JPM Z), which is cumulative, meaning its $2 dividend must be paid, with arrears, before common shareholders get anything. This issue is not eligible for the reduced tax rate on dividends. The preferred is rated Aa3 and yields 7.7% to its call date in May 2013. If Chase does not call in the preferred at that time, the interest rate goes to the 3-month London interbank offered rate (Libor) plus 4.12%.
Slightly less secure but also an excellent buy is the Citigroup 8.5% series F perpetual preferred (25, C M), rated A2. The yield is a full percentage point over that on similar Citi issues because the dividends are not cumulative; that is, a skipped dividend is gone forever. Your only protection here is that Citi cannot omit your preferred payout while simultaneously paying on the common. This one qualifies for the 15% federal tax rate through 2010.
One more to consider is a preferred with a stronger dose of equity flavoring: the 8.5% convertible preferred from American International Group (74, AIG A). This one is eligible for the 15% tax rate. The insurance company has an Aa3/AA- rating on its debt. The preferred converts (automatically, not at the option of the holder) in three years into a minimum of 1.64 shares of AIG common, a quantity now worth $59. If the value in 2011 falls short of the $75 par value, then you get additional common shares, up to a maximum of 1.97.
If you are one of those investors who have lost faith in the financial system because of losses suffered in the current financial meltdown -- get over it. Now is the time to ride a recovery. Don't let history leave you as one of the whiners.
VALUE IN REGIONAL BANK STOCKS?
More analyst opinion on bank stocks for the mix. R. J. Rhodes pretty well articulates our thoughts to a "T". We will say it until we are blue in the face: The banking business features high leverage (assets to equity is always high) and assets that are hard to value. It is a bit of a crapshoot in the best of times. There is no need to roll the dice in not the best of times.
Historically in a sector bear market, all the stocks decline together as investors fail to differentiate good from bad. Recently some signs of inefficiency have begun to creep into the bear market in regional bank stocks. The "good" are seen as bullet proof, while the bad have become unanchored from all valuation support as news flow has driven the share prices lower.
I started thinking about this several weeks ago when renowned value investor Michael Price commented in regard to Wachovia (WB) that he was not interested until the stock approached or hit tangible book value. The stock was around 24 at the time, I believe, but tangible book as of 3/31/2008 balance sheet is only $13.61. WB proceeded to trade relentlessly lower and hit a low of $17.34, which is a pretty vicious decline for a stock which had already been hammered by almost 56% from its 12-month high.
Regarding inefficiency, the sector has begun to show some significant "have vs. have not" tendencies. For example, US Bancorp (USB) is legitimately a "have" company, with less credit worries and a major hidden asset in its processing subsidiary. And the stock has held up superbly as investors correctly exclude it from the list of banks with significant earnings risk. However, the stock currently trades at around 5 1/2 times tangible book and 2.6 times stated book. To be sure, management has earned this valuation, but at some point when the credit cycle starts to improve, investors will typically rotate out of perceived safe names like this and gravitate to banks which have priced in reasonable worst case and have minimal insolvency risk.
5 1/2 times tangible book is preposterous.
At the other end of the spectrum, First Horizon (FHN) is a pure "have not" company. No current earnings, the cash dividend was omitted and a modest dividend is now being paid in stock, while all prior takeover speculation has been evaporated. That said, the stock traded right through tangible book and even after a lift today [June 17] is 59% of 3/31/2008 tangible book. Management has stated a "back to basics" strategy which may not be exciting, but is pretty straightforward to execute. This may or may not be the bank to buy, but it sure has the value criteria in place. If management can just earn 12.5% on stated book, that is about $2/share in earning power, and with the stock trading at $8.69, a low multiple on recovery earnings. A multiple so low, in fact, that the reward/risk is pretty good even if one has to wait several years for the payoff.
As long as the stated book value holds, which is the $64 question for most banks out there.
Another bank which "traded through" on adverse news flow is Key Corp (KEY), which is slashing its dividend in half and doing external financing. The shares are 69% of tangible book. Of course the financing will dilute book value and this adjustment needs to be taken into account, but at least there is now a cushion built in.
Before jumping into apparent "great values", I would urge investors to do their homework on where the bank is trading in this spectrum of wide valuation ranges for the industry. Be wary in particular of eroding credit quality statistics. My general sense is we are currently in the teeth of the storm on credit, but it is a big storm and it will spawn other storms, e.g., the problems in residential mortgage lending have already begun to back up into construction lending and next will be small business, commercial construction, commercial perm loans, etc. Credit cycles historically have been prolonged in duration, running 3 to 4 years from start of problems to when managements finally over reserve and earnings bounce back. So we are only in the 3rd or 4th inning of this contraction, at best.
Finally, investors need to think about the supply/demand for regional banks. I have maintained that in addition to the fundamental problems, there are several negatives which make bottom fishing premature:
- Banks are a pure value group. With the Russell 1000 Value Index down over 17% year/year as of last Friday, value managers are likely struggling with redemptions and thus have no net new cash to buy regardless of the attraction.
- Hedge funds have been short, and have not begun to cover. There is no reason, as yet, to cover shorts because the stocks are still trading down on any negative news, and until they trade up on bad news, the downtrend is friend of the shorts.
- Obviously the billions of new external financing are a supply issue for banks.
- As discussed above, on some criteria such as tangible book, the most rigorous of value managers do not see compelling value yet. I believe value hedge funds will at some point step up, but not until they are convinced the downside is fully discounted.
- Street estimates have been too high until recently, and earnings are still totally guesswork for 2008 until some sign of stabilization in credit quality is apparent.
- Other asset classes have captured the lions share of investor attention. Obviously, playing "momentum" works until a sector rolls over, but for now the "safe" trades have been in agriculture, energy, gold, infrastructure, etc.
Oil has become the "anti-dollar" of modern times, instead of gold, maintains Byron King.
Oil has become the "anti-dollar" of modern times. Oil is now serving as the source of global monetary discipline that gold used to perform.
Oil is the energy life-blood of all modern economies. So when a nation debauches its currency, the oil markets react instantly. And oil will not accept monetary malpractice, certainly not by the U.S. Federal Reserve. If traders perceive that the dollar is declining, this perception lights the fuse for oil prices to rise.
There is an old saying that "You can't fight the Fed." But oil is fighting the Fed. In fact, oil is scoring a knockout, like Muhammad Ali over Sonny Liston. Oil is floating like a butterfly and stinging like a bee -- landing body blows and pinning the Fed against the ropes.
The Fed can no longer cheat with the money supply and get away with it. There is a new gold standard and it is called "oil." This may not be a monetary "fact" that central bankers would acknowledge publicly. But it is a monetary fact of life out in the trading pits.
Even the President himself is powerless to alter this new fact of life. He cannot simply fortify the dollar's supremacy by seizing the world's oil at $20.67 a barrel, like Franklin Roosevelt seized America's privately held gold for $20.67 an ounce in 1933. And even if the President could confiscate the world's oil at below-market prices, he might not understand how such a confiscation would influence the dollar's value.
The "oil connection" to monetary policy is a new and poorly understood development. It is not what people expect. It is not how we all grew up. It sure did not used to be this way.
For the past 149 years, it has been a fairly safe bet that the world's oil supply would grow. The only truly difficult period for oil was between 1979 and 1981, when the Iranian oil industry collapsed in the wake of revolution. The world supply-chain lost nearly five million barrels per day of output. And that loss helped produce the worst recession in the U.S. since the 1930s.
But even back in the early 1980s, new oil sources were coming online. Everybody could see it. The fields of Alaska, the North Sea, Mexico, Angola and other places were just kicking into gear. So the price of oil could not go "too high" because there was a clear indication in the marketplace that there would be more oil coming down the pipes.
And that is exactly what happened. By the mid-1980s, oil was selling for less than $15 per barrel. Cheap energy made a lot of things look easy, from growing the economy to winning the Cold War.
There was a dark side to cheap oil, however. It produced and nurtured the illusion that oil would be cheap forever ... or at least for a very long time. But looking ahead from today, it is crystal clear that it will be more difficult to grow the worldwide oil supply than in the past. We may be at Peak Oil right now, but we will not know that for a while. ... [U]nlike in the early 1980s, there is no relief in sight.
Oil supplies are severely constrained. Dollar supplies are not. Perhaps these related facts are what inspired Alexey Miller, the CEO of Russia's oil giant, Gazprom to predict that oil would rise to $250 a barrel in "the foreseeable future." The Fed can "talk" a strong dollar all it wants, but as long as the supply of dollars and dollar-denominated credit continues to grow, the oil price will continue to climb.
In the era of Bretton Woods, the global monetary system followed the golden rule: "He who has the gold makes the rules." But today, the "rule of crude" dominates. Thus we are left to ask, what is the meaning of crude oil at $137? It means that the reign of the dollar is coming to a close. The dollar has reached the end of its post-Second World War period of dominance as the world's reserve currency.
That is why today's oil buyers, like the late French President Charles de Gaulle, are so eager to exchange their dollars for a tangible asset. De Gaulle shipped France's dollar reserves across the Atlantic in exchange for gold bars from the vaults of Fort Knox. Today oil traders are shipping their excess dollars to the New York Mercantile Exchange in exchange for barrels of oil. The motives are identical. Only the underlying monetary asset has changed.
PROFIT FROM THE NEXT TECH RALLY
A couple of the panelists in the Barron's Roundtable covered above (and next week) mentioned that they had achieved some quick gains by buying into the technology stock selloff earlier this year. And 8-odd years after the dot-com bubble started to deflate, the bear market in stocks in that sector is actually starting to get long in the tooth.
If you are interested in technology companies still in their hyper-growth stage, a possible area of interest could be those involved in "Web 2.0"-related tools. (The term is not that well-defined -- more a case of "I know it when I see it." See the Wikipedia link to get a grounding in the idea.) Technology stock analyst Wayne Mulligan has some insights on the subject.
It is pretty clear that TickerHound, while certainly focused on finance, is first and foremost a Web-based business. Therefore, I tend to pay a lot of attention to the Web startup scene. I like to know what else is out there, what is working, what is not, etc.
So when I saw this question on TickerHound the other day, my wheels began to turn right away: Are there any publicly traded Web 2.0 companies?
For the most part the Web 2.0 "bubble" has been isolated to private transactions. Meaning, we have not seen a serious tech bubble in the public equity markets like we did the last time around in the late 90's.
There really has not been much of an increase in the public markets at all. If you look at where we were at the market peak in 2000 (Dow at 11,700 and the Nasdaq at 4,900) the Dow is pretty much even and the Nasdaq is still way off its high. We have not seen any monstrous technology IPO's since Google and there are not any gargantuan IPO's on deck at the moment. This might lead many to wonder what all the "Web 2.0 fuss" has been about?
Well, to be sure, there have been several high profile private and public transactions over the last few years that have certainly caused many investors to take notice. For example, according to the National Venture Capital Association, 2007's private equity and venture capital equity investments rose 10% from 2006 to reach $29.4 billion -- the largest amount invested since the bubble popped in 2001. And we are seeing some serious activity in the public M&A markets as well:
Obviously some of these companies overpaid while some of them were probably great values. MySpace's $500 million buyout has already paid for itself due to a $900 million ad deal the company secured with Google. So while these Web 2.0 companies eventually became part of larger, first-generation internet businesses, it is clear that there has been some serious growth and profits being generated in this space for those that got in early.
- News Corporation's (NYSE: NWS) $500+ million acquisition of MySpace
- Google's (Nasdaq: GOOG) $1.6 billion acquisition of YouTube
- Yahoo!'s (Nasdaq: YHOO) has acquired multiple companies (Flickr, Del.icio.us, etc.)
- Time Warner's (NYSE: TWX) $860 million acquisition of Bebo.com
But back to the original question, are there any publicly traded Web 2.0 companies? Well, I think that question is slightly flawed. It should be: "Are there any publicly traded Web 2.0 companies AND are they worth investing in?"
The Answer: Yes and No! The pure play Web 2.0 companies out there are few and far between at the moment:
are probably the only 2 publicly traded stocks in the U.S. that are pure play Web 2.0 companies. However, you will note that neither company is traded on a major exchange. You will also notice that neither company went through an actual public offering of its shares, or an IPO.
- Foldera, Inc. (FDRA.OB)
- VOIS, Inc. (VOIS.OB)
Both companies are the result of some crafty financial engineering known as a "reverse merger". This tactic is when a privately held company acquires a publicly held company and then merges itself into the existing publicly traded stock. Typically, however, the publicly traded company is not much of a company at all, but more of a "shell" (as they have come to be known). Meaning, the public stock has no real following, no real business to speak of behind it, etc.
There were a few Web 2.0 plays that were on deck to go public but have since been pulled. United Online's (Nasdaq: UNTD) Classmates.com spin-out was supposed to be a testing ground for Web 2.0 IPO's, but they pulled the plug on that one last year. Another company, Synacor of Buffalo, New York, filed to go public last year but we have not heard much out of them either.
So the moral of the story is, while there might be a couple of publicly traded, small-cap Web 2.0 companies, I still do not see any real investment opportunities there just yet. If you are looking for exposure to the sector your best bet is to follow the Google's, Yahoo!'s and News Corp's of the world. But do not think we have seen the last of technology IPO's in this space. In fact there are a few privately held companies that I've been watching for IPO announcements lately.
If Facebook or LinkedIn happen to go public, you could bet your bottom dollar that there would be TREMENDOUS demand for those shares. Up until now, both companies have been closely held and limited to major institutions and Venture Capitalists for investment. So be on the lookout, you still might have a chance to get in on Google-like profits again in the near future.
For more on this subject, check out what the TickerHound readers have to say, right here ...
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