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GLOOM AND DOOM? NAH; JUST FOR THE U.S.
An interview with Peter D. Schiff: The U.S. would not be afloat without help.
Peter Schiff, author of Crash Proof: How to Profit from the Coming Economic Collapse, returns to these pages after an extended absence. The title of his book is his message, and it has not changed since the book came out last year.
This interview with Barron's effectively synopsizes the thesis of Schiff's book, which we highly recommend. He is a good promoter of his world economic view, and thus of his services, so as usual one should do one's own thinking rather than adopt another's lock, stock and barrel. We happen to agree pretty much with all of his major points ... but that is us. And others may have good alternative investment ideas that are consistent with Schiff's big-picture thesis.
Peter D. Schiff is an extreme bear when it comes to investing in the U.S., and he has made a name for himself selling his point of view with considerable zeal, often on television but also in print. Schiff, 43, has contributed articles to Newsweek International and other publications, and he is the author of the recently published Crash Proof: How to Profit from the Coming Economic Collapse. Our own Alan Abelson cited his musings in a recent column.
However, comparing Schiff's performance with a benchmark is impossible because he does not run a fund. Instead, he recommends stocks for clients' brokerage accounts. Schiff, who holds a degree in finance and accounting from the University of California at Berkeley, is president and chief global strategist of Euro Pacific Capital, a brokerage he founded in the mid-1990s that emphasizes international stocks, preferably with dividends.
Not everybody is a fan. Schiff has been criticized for aggressively courting publicity to tout his doomsday message relating to U.S. equities and the domestic economy. But he has been right on several key calls, notably the weakening greenback and his emphasis on international stocks, and he has helped his clients make money. Barron's caught up with him recently.
Barron’s: When did you turn bearish on the U.S.?
Schiff: A long time ago I worked as a retail broker at Shearson Lehman Brothers and I was selling tech stocks, and I was generally bullish. I had difficulties with some of the problems in our economy, but I was recommending U.S. stocks. I left Lehman in 1991. In the mid-1990s, when I was working for a small broker-dealer in California and then for my own firm, I started getting concerned about the dollar. So I began getting some clients invested in some foreign stocks -- just to get out of the dollar a bit. The dollar had a big drop, and then it started to rally in the late-1990s, in conjunction with the tech bubble. It was all part of foreigners' efforts to try to participate in the Nasdaq's bubble.
What kinds of stocks did you like in those days?
Traditional value stocks with dividend yields. I also liked commodities, so I was buying international oil stocks back when oil was under $20 a barrel. The stocks I recommended were not doing very well in 1998 or 1999, especially after the Asian crisis, but they started doing better around 2000. I turned really, really bearish on the U.S. when I saw what the Federal Reserve was doing to prevent a recession in the early part of this decade, notably pumping a lot of liquidity into the system.
You continue to be very bearish on the U.S. But have not there been other times when there was lots of negative sentiment toward the U.S., only to see another era of prosperity emerge? Such as the late 1980s, when there was concern that Japan would take over the U.S. economy. Look at how that turned out.
Yes, but we have not been through anything like what we are going through now. The United States has really been living in a fool's paradise, or a phony economy, probably for more than 20 years. But our economy has been growing and getting bigger and bigger. We have been able to convince the world to lend us money and to provide us with goods that we do not produce and that we cannot afford to pay for with exports. And it has gotten to the point now where the problem is so big, especially since the real-estate bubble. We have now borrowed so much money from abroad. Our trade deficits are now very big, and our industrial base and our infrastructure have been allowed to decay for so long, that we are now at a point that we can only survive as an economy thanks to the charity of the rest of the world. They have provided us with all the goods that we can no longer produce because we lack the industrial capacity. And they have to lend us the money because we do not have any savings anymore.
What is your take on oil prices?
The Chinese currency will rise 5-fold against the dollar.
As oil prices are going up in the U.S., they are not rising nearly as fast in other countries because their currencies are strengthening. Ultimately, when currencies like the renminbi that are pegged to the dollar are allowed to float, I see the Chinese currency rising 5-fold against the dollar. That would make oil a lot cheaper in China relative to what it would cost in the U.S.
Speaking of China, how do you see things developing there and its impact on the U.S. economy?
The whole science of economics, as I see it, is how do you satisfy unlimited demand with limited resources? China has more than one billion people. It is not as if Americans are unique in wanting things. It is not as if the Chinese do not want dishwashers. The reason they do not have those possessions is because they do not have the purchasing power. But they do have that power; it is just that their government is taking it away from them and giving it to us. But it is Americans who cannot afford these goods, because we cannot produce them. So if the renminbi is allowed to rise, then Chinese factory workers will be able to afford the products they are producing instead of shipping them over here. That is going to be a major, major boon for their economy.
So it sounds as if the U.S. will be relegated to second- or third-tier status.
The U.S. is a post-industrial society, which is the same as a pre-industrial society.
The U.S. is in trouble. We are a post-industrial society, which is the same as a pre-industrial society. Our manufacturing base has disintegrated. It is not nonexistent. We still make some things and we are still competitive in some areas. But on the whole, as a nation we are not competitive. We are mainly a nation of a service sector and consumers, and that is going to have to change. Nor do we have the savings that we need to fund the transition.
What could go wrong with your scenario?
Somehow, the U.S. could buy itself some additional time. We could convince the world -- Europe and Asia -- that they need us, and that while propping up the U.S. economy is going to hurt them with more inflation, letting the U.S. collapse is going to be even worse. Of course, none of that is true. The truth, in my view, is that the cost of propping us up far exceeds the cost of letting the U.S. economy collapse. But I think we are already in a pretty severe recession.
But is there not an argument that once we clean up this housing mess -- along with the credit bubble, whenever that occurs -- the U.S. will be a lot closer to a bottom, where the outlook begins to improve?
I do not think that is true. The resolution to the housing problem is going to mean housing prices are going to be a lot lower than they are now, and most Americans are not going to have any home equity. It is going to mean that trillions of dollars will have been lost by the lenders. When the home equity is gone, Americans are broke, as they do not have any savings. All they had was their home equity. They were counting on their home equity, without which they will be unable to pay off their credit cards.
But don't U.S. companies that do business abroad benefit from all of the trends you have outlined?
Yes, they are going to benefit to the extent that they can generate higher sales abroad. But ultimately the shareholders are not necessarily benefiting just because a multinational company earns more dollars. If the dollars have less purchasing power, they are not necessarily better off. The way I see it, we are just putting our goods on sale to sell more of those goods. But if you want to look at U.S. corporate earnings in terms of euros, barrels of oil or gold bullion, these companies are not necessarily seeing a real increase in earnings.
Plenty of investors and financial advisers have decreased their allocations to U.S. stocks in recent years. Why not do that instead of completely writing off the world's largest economy?
The U.S. going forward will be like Japan in the 1990s.
Individuals can make their own decisions. I do not see a way for the U.S. economy to avoid a major retrenchment. There is no way that U.S. assets are not going to be marked down relative to foreign assets. Therefore, I would rather invest in the rest of the world. There are plenty of people who for the whole decade of the 1990s were investing everywhere but Japan, which is the second biggest economy in the world. Why were they excluding Japan? It was obvious that it was in decline. I am saying the same thing about the United States. I do not care if it is the biggest economy in the world; it is in decline. There are going to be a lot of losses in the United States, so why don't I avoid it? Worst-case scenario: I miss out on the U.S. market. But what are the odds that it is going to outperform all the other major markets that I am investing in? And I cannot see how the dollar is going to be moving up over time.
Why keep your business open here? Why not set up shop in Asia?
Right now my business is helping Americans to preserve their wealth from a collapse of the U.S. dollar. If I were to go to a different country, obviously I would have to come up with a different business. I do not think people in China need to protect their wealth. They are going to do great. My business works better here. I could try to run the business from overseas, say the Cayman Islands or Australia, but I have friends and family here. I am optimistic.
The cause of the U.S. economic collapse is too much government, not capitalism.
I have supported political candidates in the U.S., including Ron Paul, who ran for the Republican presidential nomination this year. I am not writing America off. But I am trying to educate people so that they understand that when this economy does collapse, it is not because of capitalism but that it is because of too much government.
What kinds of stocks do you look for?
The dividend is the most overlooked and important component of equity investing. Capital appreciation is great, but that is the icing. The cake is the dividend yield. I look for good dividend yields, but I want to get them in currencies that are gaining in value so that my clients can maintain their purchasing power here. These companies are playing into the growing purchasing power of the rest of the world -- not the shrinking purchasing power of the U.S. The rest of the world has been selling us goods and hoarding our Treasuries and mortgage-backed securities. They are not going to be doing that anymore. They are going to spend their earnings on themselves.
How about a few stocks that you like?
One of the mining stocks that I have been buying, although it has pulled back a lot, is Oxiana [ticker: OXR.Australia]. Oxiana and Ziniflex, another Australian mining company, just merged. Another holding is an infrastructure play called Road King Infrastructure [1098.Hong Kong], which is listed in Hong Kong. It has also pulled back quite a bit. I also like Singapore Petroleum [SPC.Singapore]. Those are three names I have have been buying recently. One is a play on the growing infrastructure in China, while the other two are ways to invest in resources. A lot of people look at me and say, "Peter you are gloom and doom." I am not gloom and doom. [Chart of Schiff's stock picks here.]
Well, you are pretty gloomy on investing in the U.S.
I am very negative on the U.S. economy. But I am very optimistic on a lot of other economies. A lot of people tell me, "Peter, this does not make any sense. How can you be so dire and gloomy on the U.S. and yet so positive on the rest of the world?" That shows you I am not just gloom and doom. I recognize that contrary to popular opinion, the U.S. economy has been a drag on the global economy, and that when the rest of the world stops subsidizing us, growth abroad will actually improve as a result.
Surely you see some light at the end of the tunnel for the U.S.?
It is a long tunnel and the light is far away. But, yes, in the end I am still optimistic that we can one day dig ourselves out of this hole. Look at the Germans and Japanese. They lost World War II, but here they are. We did not lose a war, but in many respects we did in that our factories have been destroyed even though they were not bombed.
What is a reasonable plan for the U.S. to right the economic ship?
We are going to have to replenish our savings. We are going to have to rebuild our industry. We are going to have to repair our infrastructure. All of that is possible, though it is not easy. It is going to be very difficult given the current level of government we have, along with the types of taxation and regulations we have. To really rebuild the economy, we are going to need cooperation from government and the government is going to have to get out of the way and make itself a much smaller burden on society, which means major reductions in government spending, taxes and regulations.
Intervention Will Not Stop the Dollar’s Slide
Peter Schiff makes the obvious enough point that calls for intervention on behalf of the dollar ignores a major reality. After all, the countries with dollar-pegged currencies -- China, Hong Kong, Saudia Arabia et al -- have been massively staging such an intervention for years in order to hold their respective pegs. Countries without formal pegs but which wish to avoid significant appreciation of their currencies against the USD -- such as Japan, India, and Taiwan -- have also been part of the de facto coordinated dollar propping initiative. Any intervention now by the U.S. would be drop in the bucket.
This week [last Wednesday] the Federal Reserve took a step closer to acknowledging reality. Unfortunately it did not let that admission move it from a policy course firmly guided by fantasy. In its policy statement, Bernanke & Co. took the important step in noting that inflation expectations had taken hold in the country at large. However, in asserting that it expects inflation to moderate this year and next, the Fed gave no indications that these heightened expectations are gaining traction within the Open Market Committee itself. As a result, it signaled no likelihood that it was actually prepared to do something to fight a problem which it does not really believe exists in the first place.
In fact, by indicating that they expect inflation to moderate, the Fed is saying that elevated expectations are unwarranted. In other words, Bernanke claims that despite the fact that so many people are carry umbrellas, he still believes it will be a sunny day. The takeaway from the statement is that no rate hike is forthcoming. The markets saw this position for what it is ... capitulation to inflation and a weakening dollar. No surprise then that the gold responded with the biggest single day gain in more than 20 years!
With the ensuing carnage on Wall Street, many Thursday morning quarterbacks claimed the Fed missed an opportunity to reverse the dollar's slide by either talking tougher or perhaps actually raising rates a quarter point. If the Fed really believed it could talk the dollar up, or that a small rate hike would do the trick, they would have given it a try. I believe they chose a dovish route because of a greater fear of having their hawkish stance casually disregarded. Imagine what would happen if the Fed raised rates and the dollar kept falling? It would be like one of those horror movies where someone holds a cross up to a vampire, and the Count tosses it aside with nary a cringe.
Others claim that now is the time for coordinated central bank intervention to reverse the dollar's decline. Those who place their faith in such a plan, overlook the fact that Asian and Middle East central banks have been unsuccessfully intervening on the dollar's behalf for years. Those nations maintaining dollar pegs must constantly intervene in the foreign exchange markets by buying dollars to keep their own currencies from rising in value. Over the past few years the scope of this intervention has been unprecedented, with foreign central banks accumulating trillions of excess dollar reserves. Yet despite these Herculean and misguided efforts, the dollar has fallen drastically.
Intervention advocates must believe that if the ECB and a few other central banks joined the fray, that a better outcome would be achieved. However any additional efforts to artificially prop up the ailing dollar will be equally ineffective. Even if ECB intervention could slow the dollar's decent, what possible reason would they have for doing so? The ECB is already concerned about inflation and is preparing to raise rates as a result. Intervention to support the dollar will only worsen Europe's inflation problem and run counter to these efforts. This is because to buy dollars the ECB must increase its own money supply. That is exactly what is happening in countries like China and Saudi Arabia, which is why inflation in those nations is already much higher than it is in Europe.
Further, since the ECB is asking Europeans to endure higher interest rates to fight their inflation battle, why should they have to make additional sacrifices to help Americans fight their own inflation? Especially when our own central bank has held interest rates at the ridiculously low level of 2%, and has effectively excused Americans from the conflict.
Since we cannot count on any help from our friends, the only option would be for the Treasury to intervene unilaterally. However, the U.S. government should think twice about bringing a knife to a gunfight. The Treasury only has about $75 billion in foreign currency reserves with which to intervene. The war chest is just a spit in the ocean. To put this number in perspective, Poland has $77 billion, Turkey has $78 billion, and Libya has $79 billion.
On the other end of the spectrum, China has $1.7 trillion (not counting Honk Kong's $150 billion) Japan has $1 trillion, Russia has $550 billion, India and Taiwan each have about $300 billion. Singapore, a nation with fewer than 5 million people, has $175 billion. In fact, the U.S. holds just about 1% of the world's $7.6 trillion of foreign currency reserves, and our total position amounts to just 2.5% of the total daily volume of foreign exchange trading. Talk about Bambi vs. Godzilla! In other words, if the dollar is going to fall, the Treasury is completely powerless to do anything to stop it.
Jesse Livermore once was accused if "painting the tape" in order to manipulate onlookers into piling in a stock and taking out his position. He responded, "That only way I know to make a stock go up is to buy it." The only way to make the dollar go up is for the Fed to buy it in, which means decreasing the money supply. Raising interest rates and tactical interventions on the forex markets are all attempts to paint the tape, but have no substance unless money supply growth goes negative (or slows down, at least).
The Fed Unreserved
This Peter Schiff commentary is a devastating indictment on the Federal Reserve's performance since its creation, and especially in the last several decades. As he puts it, the U.S. loss in economic leadership and living standards in the last 50 years "may well qualify as the biggest economic choke in history." The Fed had some help, of course, but it was the straw that stirred the drink (as legendary baseball slugger and braggart Reggie Jackson asserted about himself).
Why did Schiff come out with this particular commentary when he did, when he could as well have written it just about any time? Because Treasury Secretary Paulson announced plans to give the Fed new powers to oversee and regulate the financial services industry.
Financial services industry participants did not cover themselves with glory during the recent credit bubble. Very far from it. But the situation is somewhat akin to this: Say some irresponsible parents put a stock of booze in a room where their their teenage son and his friends were having a party, and then left. The most prudent kids refrained from touching the stuff. Some drank a little. Others were less restrained and ended up destroying part of the house. And some got seriously sick. The kids get all the blame. The parents say that now they will have to monitor and regulate the kids' behavior more closely, but say nothing about the role that the past proximity of the alcohol and the partygoers played in the fiasco. Question: Do you trust the parents' judgement and oversight going forward? Paulson would say sure. After all, the parents are his buddies.
Throughout history, governments have always used crises to justify blatant power grabs. Often the crisis subsides, but the expanded government powers remain. In America this week [week of June 16], the tendency came into sharp focus. Congress signaled that it is preparing to perpetuate the Bush Administration's domestic wiretapping program, and has even abandoned the pretense that warrantless surveillance be confined to terrorism. Similarly, even though our financial crisis has yet to reach full flower, Treasury Secretary Paulson announced plans to give the Federal Reserve new and explicit powers to oversee and regulate the financial services industry. However, a sober look at his plan reveals that it is tantamount to giving the fox complete autonomy to guard the henhouse.
What few economic leaders have acknowledged is that the Fed itself is responsible for the real estate and credit bubbles, which are the source of our current troubles. By keeping interest rates too low for too long, the Fed ignited a speculative fever and engendered a disregard for risk management that pushed asset prices above rational levels. Should we blame the private sector for taking advantage of all the cheap credit, or the Federal Reserve for supplying it? If a kindergarten teacher passes out handfuls of Pixie Sticks [we think he is referring to those straws full of flavored, powdered sugar], and then leaves her classroom unattended for several hours, should we blame the five year olds for the hysteria that ensues?
The reality is that we should be restricting, rather than expanding, the powers given to the Federal Reserve. Since Greenspan, Bernanke and company have already inflicted so much damage with the weapons already in their arsenal, why provide them with heavier artillery? Only in Washington do those who screw up get rewarded for doing so.
As Will Rogers once asked: If stupidity got us into this mess, then why can't it get us out? He was of course asking in jest, but government seems to take his idea seriously. Or as he also said, "With Congress, every time they make a joke it's a law, and every time they make a law it's a joke."
Since the Fed has demonstrated complete incompetence at setting interest rates, why not return that function to the market? Instead of allowing the Fed to inflict unbridled havoc on our economy, why not re-impose some discipline? Instead of looking for new ways to regulate Wall Street, why not find an old way to regulate the Fed? Actually there is a simple answer to all of these questions. It is called the gold standard
In his speech outlining these proposals, Paulson stated that during the past 50 years the performance of the U.S. economy has been second to none. I do not know what planet Paulson has been living on these past 50 years, but it is certainly not Earth. If Paulson were referring to the prior 50 year period, from 1908-1958, his statement would have been correct. But from 1958 to 2008, the U.S. economy has blown a lead even greater than the one the Lakers enjoyed over the Celtics in game four of the just concluded NBA Finals. [The Celtics overcame the largest deficit ever in an NBA Finals game in game four.] In fact, it may well qualify as the biggest economic choke in history.
In 1958 the U.S. enjoyed a standard of living so unmatched that the rest of the world still lived in the Stone Age by comparison. Our per capita income was so far ahead of our nearest rival that it seemed impossible that any other nation would ever catch up. Today not only is per capita income in the U.S. barely in the top 10, but we are being rapidly overtaken by countries that up until a few years ago were barely discernable in our rear-view mirrors. When it comes to economic performance during the past 150 years, the U.S. is the Big Brown of economies. 1858-1908 was the Kentucky Derby, 1908-1958 was the Preakness, and 1958-2008 was the Belmont Stakes.
Big Brown won the Derby and the Preakness, the came in last at the Belmont after going into the race a prohibitive 1-4 favorite. Big Brown was so far behind at the finish that they did not bother to calculate his margin of defeat. Darn apt analogy.
Not only did the U.S. surrender a substantial lead, but in many respects our current standard of living is lower than the one our grandparents enjoyed. Sure we have a few more gadgets, larger televisions and more prevalent air conditioning, but the quality of life has actually declined. In the 1950's, the average man earned enough money to fully support a wife and four kids, all while saving for retirement and paying off his mortgage. Today the average man can barely support himself. It takes two bread winners in most families to make ends meet, and that is assuming only two children. Even with both parents working, the typical mortgage on the family home will never be paid off and retirement is now a pipe dream. Flush with high pay, low debt, and a strong currency, the Ugly American in the 1950's could vacation in Europe like a king. Now he can now barely afford the gas for a day trip to a Six Flags theme park.
If Paulson can be so completely clueless regarding the Fed's role in the current debacle and in America's economic stumbles over the past two generations, why would anyone place any faith in his proposed remedies? In fact, an unaccountable and unelected Federal Reserve, which nonetheless has lately proven to be as politically craven as any two-bit politician, does not hold the keys to our economic revival. However, with its increased willingness to rescue the big financial firms from their own excesses, perhaps Paulson sees an expanded Fed as the best way to ensure the continued prosperity of his former pals on Wall Street.
The Fed chairman is in the impossible position of trying to raise the price of real estate while lowering the costs of food and fuel.
Nicholas von Hoffman is a gadfly leftist-type who routinely attacks modern corporate capitalism in a predictable but somewhat intelligent and perceptive manner. His book Capitalist Fools: Tales of American Business, from Carnegie to Forbes to the Milken Gang (short review here) pays some authentic tribute to genuine value-creators among big businessmen. He used to be a columnist in arch-mouthpiece of the ruling class, the Washington Post; but late publisher Katharine Graham wrote "My life would have been a lot simpler had Nicholas von Hoffman not appeared in the paper." Like most people, he seems to think the solution to our problems is to have the right guys with their hands on the levers of power. Predictable.
Here he shares a highly readable background piece on the dilemma confronting the Fed: It wants to keep housing prices from falling further while keeping basic consumer goods prices from rising further. It is doing neither one successfully, but doing both is impossible. But, as von Hoffman explains, the Fed has no choice but to try something/anything.
You may be able to go up the down escalator or you may be able to go down the up escalator, but until now nobody has been able to do both at the same time, which is what the U.S. is attempting.
The United States is struggling to hold down the price of gasoline and bread as it uses its artifices and devices to lift the price of housing, not to mention propping up the stock market. The greatest of prestidigitators would be hard pressed to deflate and inflate the same balloon simultaneously, and such accomplished masters of legerdemain are seldom found running the major financial organs of the U.S. government.
Even when there is no inflation or deflation, prices fluctuate. Under those circumstances, prices, taken together, would be flat on average even as the prices of individual goods and services bobbed up and down. But what is going on today is no tame bobbing. We are looking at an economy at war with itself. On one side is an inflationary cyclone propelled by oil prices. On the other, a deflationary hurricane making money vanish by the billions as it roars downward into a chasm whose bottom we cannot see. Tried and true remedies seem to intensify the storm. The measures taken in hopes of stemming the housing rout supercharge inflation, and the measures needed to stop rising prices intensify the mortgage market calamity.
The downward struggle is at its fiercest over mortgage foreclosures. The more foreclosures, the more the price of housing drops. And the more home prices fall, the less the bonds issued to pay for the mortgages are worth, and the closer the nation's distressed financial institutions come to bankruptcy. Hence Ben Bernanke, the chairman of the Federal Reserve Board, speaks of "the foreclosure crisis."
Crisis is not a word that trips lightly off the tongue of a Fed chairman. In the highly spookable world of money, Fed chairmen, secretaries of the Treasury, and such are given to soothing murmurs, as though they were horse-whispering into the ear of a skittish Kentucky Derby winner. These guys do not shout fire even when the barn is ablaze.
The cause of Mr. Bernanke's fear is obvious when he lays out the salient facts as he knows them:
About one quarter of subprime adjustable-rate mortgages are currently 90 days or more delinquent or in foreclosure. Delinquency rates also have increased in the prime and near-prime segments of the mortgage market, although not nearly so much as in the subprime sector. As a consequence of rising delinquencies, foreclosure proceedings were initiated on some 1.5 million U.S. homes during 2007, up 53% from 2006, and the rate of foreclosure starts looks likely to be yet higher in 2008.
Should foreclosures continue to grow at the same rate as last year, 3 million properties will be going under the auctioneer's hammer before 2008 is over. Not all of them will be owner-occupied, but the dumping of that many houses on a real-estate market already heavily overhung with inventory must push prices below today's levels.
So even some of those who look on people who default on mortgages as cheats or losers believe they have an immediate material interest in having the government prevent foreclosures, if that is what it takes to stabilize real-estate prices and start pushing them back to a point where the debt on residential housing is no longer greater than what houses are worth on the open market
To drive those prices back up, the Fed and other government entities have been resorting to a variety of tricks, none of which has worked spectacularly well so far. Price control or price manipulation has a mixed record to say the least.
Price controls are associated with keeping prices down, but it is price control nevertheless when the object is to stop prices from falling. The single most concerted attempt to do that can be found in the passage of the National Recovery Act of 1933. The bill, reluctantly signed into law by Franklin Roosevelt, but backed at that desperate moment by almost everyone, authorized the creation of industry councils that had the power to set the minimum price at which something could be sold. The results were an ungodly mess from which the Supreme Court mercifully delivered the country.
More recently, Alan Greenspan, Fed chairman emeritus and archetypical idiot savant, was seized with a premonition in the first years of this decade that prices were collapsing under a deflationary riptide. Rushing to the rescue with interest-rate cuts and large quantities of new money, he successfully triggered what became the explosive housing bubble of 2007.
Greenspan's successor, Ben Bernanke, has discovered that nothing is automatic. Employing the tools his predecessor used to lift prices and other tools of his own invention, Bernanke is finding out that, though he is contributing to the vertical take off in oil prices, he has had no luck with housing or the stock market. No method has yet been devised to manipulate markets so that you get to pick what goes up and what goes down.
Not that Congress is not trying. The air on Capitol Hill is heavy with proposals to, if not ameliorate the price of oil, at least reduce voter ire. Gas-tax holidays and the suspension of oil purchases for the Strategic Petroleum Reserve may give constituents the impression that Congress is about the work of lowering oil prices, but they will not see results at the pump. Republicans have renewed the endless argument about drilling in the Alaska National Wildlife Refuge, where there may or may not be a large amount of oil and, in any case, it would be years before it found its way to filling stations. The debate serves to underscore congressional powerlessness to control prices by measures short of rationing, a method last used 60 years ago during the Second World War.
The contradiction facing those who seek to lower prices is that the more money Bernanke puts out to fight off the collapse of housing prices, the more he weakens the purchasing power of the dollar, which in turn results in higher prices for oil -- and a lot of other things.
And reduces the amount of income left for everyone to buy housing, thus hurting that market further. The whole exercise is one in futility.
Bernanke knows this. He is not a perversely obdurate man, but one who is terrified at what might happen if housing prices continue to drop, since so many financial instruments are directly or indirectly affected by what happens with those mortgages, both the prime and not so prime. Entities as distant as drudgy, dependable municipal bonds can rise or fall on what happens with housing. ... But municipal bonds are not keeping Bernanke up at night. He is looking at the monsters of the Wall Street depths -- financial arrangements with ugly names like credit default swap.
This kind of swap is a form of insurance dreamt up in the early 1990s for real-estate bond buyers to ensure that they got their money back in the event that the bonds defaulted. The market for credit default swaps now exceeds $45 trillion, more than the combined value of every residence in the United States. What started out as a sensible insurance mechanism has turned into speculation dwarfing the annual handle of all the casinos in the world.
Hanging in the air over lower Manhattan is what may happen if housing prices continue to fall, the bonds backing the mortgages on the foreclosed housing go into default, and those who sold the swaps are not able to come up with enough money to cover the losses. Maybe the trillions of dollars in commitments get worked out some way or another, or maybe, faster than the Fed chairman can get to his office to stop it, the system implodes into something the size of a billiard ball.
Neither Bernanke nor anyone else knows if the swaps -- or other financial instruments similar in size and risk -- will collapse. Bernanke is a long-time student of the 1929-1934 catastrophe, when the absolute worst did happen. To forestall a repetition, he has taken a number of actions the legality of which some people question. But if not he, who? And if not that, what?
For all it has done in the face of the crisis, Congress might as well be a bathtub toy boat with a broken rudder. The White House has more important business to take care of, which leaves Bernanke and the Fed.
What he has done so far may work out. If it does not, we shall all know soon enough. In the meantime, no one else has a plan. Everybody senses the danger, and no one can say how to escape it. Escape it we may, but if we do, it will be by luck and muddle.
WHEN CENTRAL BANKERS CLASH, STOCK MARKETS CAN CRASH
Gary "Sir Charts A Lot" Dorsch gives us an up close and personal perpective on recent policies pursued by the world's central banks. The smaller central banks whose currencies have been pegged to the U.S. dollar, either formally or de facto, are all finding themselves fighting raging imported U.S. inflation. Several important ones are all at least in the early stages of tightening.
The big story, however, is in the differing policies of the ECB and U.S. Fed. The ECB is more concerned with inflation getting out of control, while the Fed seemingly is so concerned with the imploding banking system that it is willing to risk hyperinflation. Such conflicts can make for more excitement than one might wish. The main service of this article is to document that the conflict exists rather than to predict an outcome.
Hyper-inflation in the commodities markets is rivaling the U.S. housing collapse and the global banking crisis, as the biggest threat to the world economy. Finance ministers from the United States, Canada, Japan, France, Germany, Italy, Britain, and Russia, have expressed their alarm over the doubling of agricultural, energy, and key raw material prices from a year ago, which is pushing inflation rates around the world, to their highest in three decades.
Crude oil briefly touched $140 a barrel, and the price of corn, used to make ethanol, hit $8 a bushel. [See chart.] Chinese steelmakers agreed to pay 96% more for Iron ore from Australian miner Rio Tinto, a 5-fold increase since 2003. Steel prices have soared almost 50%, this year, as coal and iron ore prices continue to climb and global demand shows little sign of abating. Dow Chemical is raising prices on a wide range of its products by 25%, due to sharply higher energy and raw material costs.
Sharply higher shipping costs, driven by rising oil prices, have increased the cost of transporting a standard 40-foot container from Shanghai to the east coast of the U.S. from $3,000 when oil was priced at $20 per barrel, to $8,000 today, with crude oil around $135, according to CIBC World Markets analysts Jeff Rubin and Benjamin Tal. The Baltic Dry Index, which monitors merchant shipping costs on forty major export routes for dry commodities, is 50% higher from a year ago.
South Korea's President Lee Myung-bak noted on June 16th, that inflation was the biggest challenge the global economy has faced in 30-years. "It is no overstatement to say that the world is faced with the gravest crisis since the oil shock of the 1970's, with oil, food and raw materials prices skyrocketing," he said. A week later, Myung-bak switched his government's top policy goal to fighting inflation, and within hours, the Bank of Korea (BoK) sold US$1 billion from its foreign currency stash to bolster the Korean won against the dollar, to help keep import costs down.
Smaller tier central banks are already moving to combat inflation pressures, with tougher monetary policies. The Reserve Bank of India (RBI) raised its key lending rate by a half-point to 8.50%, its highest in six years, and increased the ratio of deposits banks keep with it by 50 basis points to 8.75%, to fight inflation, now raging at 11%. The Bombay Sensex index fell below 14,000 points for the first time in 10 months, after the RBI tightened it monetary policy. The Indian stock market has lost more than 30% in 2008, one of the worst performing Asian indices this year.
Beijing lifted retail gasoline and diesel prices by 18% last week, the first hike in eight months and biggest ever one-off rise, which could push the overall inflation rate to 9% next month. A week earlier, the People's Bank of China (PBoC) hiked the bank reserve ratio by a full percent to 17.5%, soaking up 422 billion yuan, and knocked the Shanghai stock market 14% lower over the next four-days. "Surely higher energy prices will put some pressure on the CPI, so we may need a stronger policy against inflation," warned PBoC chief Zhou Xiaochuan on June 20th.
Brazil's central bank hiked its overnight Selic rate by a half-point rate to 12.25% on June 5th, to bring inflation down from a two-year high in Latin America's commodity powerhouse. The latest half-point rate hike pushes the real interest rate, adjusted for inflation, to 7.25%, the highest among the world's 52-leading economies. On June 19th, Brazil's central bank chief Henrique Meirelles signaled a 3rd rate hike, to bring inflation down from a 2-year high in Latin America's largest economy.
Futures contracts in Sao Paulo project a 1% Selic rate hike to 13.25% by year's end. "It is necessary to slow domestic demand in order to balance the whole equation and to avoid the pass-through of the wholesale price increases as a result of the raw materials component to retail prices," Meirelles warned. Inflation in Brazil climbed from an 8-year low of 3% in March 2007 to 5.9% in the 12 months to mid-June, and above the bank's 4.5% upper target for a sixth month.
Brazil's central bank expects the inflation rate will accelerate further to 6.3% in the third quarter of 2008. The Brazilian real strengthened to 1.591 to the $U.S., a 9-year high, and is +9% higher this year, the biggest advance among the 16 most-traded currencies against the dollar. The central bank is utilizing a stronger currency to hold down import price inflation, and appears to be adjusting its overnight loan rate in reaction to trends in global commodity markets.
South Africa's central bank hiked its overnight repo rate by 50-basis point to 12%, to counter surging inflation, extending a tightening cycle that has lifted the lending rate 500-basis points higher since June 2006, to a 5-year high. South Africa's CPIX inflation hit 10.4% year-on-year in April, and producer prices are 12% higher. Eskom, the electric utility, is raising electricity rates by 27% due to a doubling of coal prices from a year ago. RBSA chief Tito Mboweni is warning the markets of higher interest rates ahead, and "Yes, it will be painful," he said on June 23rd.
ECB and Fed in Game of high Stakes Poker
Central bankers of fast-growing emerging economies are navigating through the stormy seas of commodity inflation by tightening monetary policies. But the "Group of Seven" central bankers have acted in a different fashion. The British, Canadian, and U.S. central banks are focused on the global banking crisis, and the slide in U.S. home prices, and have lowered their interest rates, while the Bank of Japan has stood motionless. But the European Central Bank was moving in the opposite direction, and guided Euro-zone money market rates to their highest in 7-years.
And when powerful central bankers clash -- moving interest rates in opposite directions -- nasty accidents can happen in the global stock markets. Tighter monetary policies in the emerging economies is an interesting side-show, but what is really rattling the global stock markets these days, is the looming battle of wits between the two most powerful central banks, the Fed and the ECB, which hold diametrically different views over how to cope with the twin-evils of the "Stagflation" trap.
"The world has been staging a run on the greenback, with damaging results if it continues," warned former Fed chief Paul Volcker on April 9th. "Concerns about recession are rife, and the Fed will be tempted to subordinate the fundamental need to maintain a reliable currency, to the impulse to shore up a flagging economy. The danger is that you lose both battles, as in the 1970's, and wind up with "Stagflation," Volcker said, referring to the twin-evils of a stagnating economy plagued by high and rising inflation.
Since the sub-prime mortgage debt crisis erupted into full bloom last summer, the Fed has chosen to counter the "Stag" part of the equation, by slashing the fed funds rate 325 basis points to 2%, and far below the inflation rate. American consumer confidence has plunged to a 16-year low in June, largely due to a 18% erosion in home prices since the middle of 2006, which has slashed $4 trillion in household wealth, or more than $50,000 for each U.S. homeowner.
However, facing a similar set of circumstances, the ECB was not fazed by a plunging Euro-Stoxx banking sector, and instead, stayed focused on fighting commodity inflation and held its repo lending rate steady at 4.00% for the past 12-months, showing no sympathy for the meltdown in EuroStoxx banking shares. Focused on fighting inflation, the ECB guided the 3-month Euro Libor rate to 4.95%, its highest in 7 years, a clandestine tightening stance. The ECB is utlizing higher interest rates, to buoy the Euro above $1.540, in order to shield the Euro zone from the full blast of the "Commodity Super Cycle," which is now wrecking havoc in the U.S.-dollar linked economies from Hong Kong, the Persian Gulf, and to the United States.
Meanwhile, the Fed's aggressive rate cuts could not stop the bleeding in the U.S. banking sector, nor end the slide in U.S. home prices. The Fed's money printing spree is bound to fail in the long-run, in the opinion of the ECB, because "price stability and a sound currency" are the bedrock for a healthy economy. "Challenging as the present global economy may be, the rules for monetary policy-making are not altered," said ECB chief Jean Claude Trichet on June 3rd. "Inflation is a monetary phenomenon in the long term and price stability is the responsibility of the monetary authorities."
"In demanding times of significant market correction and turbulences, it is the responsibility of the central bank to solidly anchor inflation expectations to avoid additional volatility, in already highly volatile markets," Trichet said on Jan 23rd. "In this new financial landscape, monetary policy has a stability dimension that central banks simply can no longer ignore," said Bank of Italy chief Mario Draghi on June 11th. "Central banks need to consider persistently rapid growth of money and credit aggregates as early warnings of financial imbalances, and thus to monitor a wider set of indicators, and not just inflation statistics," Draghi declared.
Is the ECB Hijacking Fed policy?
Crude oil prices have multiplied 7-fold since 2001, and surged 40% since January, to now stand above $135 a barrel. Yet the hyperinflationists at the Bernanke Fed and U.S. Treasury -- the "Plunge Protection Team," did not recognize that their cheap dollar policy was backfiring on the U.S. economy and stock market, until crude oil prices jumped $16 per barrel in two-days, on June 5-6th.
The "crude oil vigilantes" are energized on heavy dosages of steroids, flexing their muscles, and ready to jack-up oil prices, whenever the Bernanke Fed shows a willingness to devalue the U.S. dollar. Recognizing that the devaluation game had run its course, Fed chief Bernanke shocked the markets, and quickly made a 180-degree turn on June 3rd, vowing to defend the U.S. dollar at all costs, as Mr. Volcker had advised nearly 2-months earlier.
"We are attentive to the implications of changes in the value of the dollar for inflation and inflation expectations," Bernanke told the International Monetary Conference in Barcelona, Spain, and a worldwide television audience. "The Fed's commitment to price stability and maximum employment will be key factors insuring that the dollar remains a strong and stable currency," he said, signaling an end to the Fed's rate cutting campaign at 2%.
However, the ECB hawks seized upon Bernanke's vow to defend the U.S. dollar, to telegraph a baby-step 0.25% rate hike to 4.25%. The ECB hawks have been itching for months to lift the repo rate, anxious to combat inflation, which is raging at a +4% annual clip in the Euro zone, its fastest in 16 years. "We could decide to move our rates a small amount in our next meeting in order to secure the solid anchoring of inflation expectations," said ECB chief Trichet on June 5th.
"The ECB is not split, we have sent a clear message to the markets about what to expect in the near future, we have to let deeds follow words," said Bundesbank chief Axel Weber on June 5th. The benchmark 2-year German schatz yield soared by 80-basis points to a 7-year high of 4.80%, after Weber's warning, and snuffed out the German DAX rally at the 7,200-level. The ECB is not afraid to pay the price of weaker Euro-zone stock markets, in order to keep inflation under control.
The ECB's rate hike signal jolted the German 10-year bund market, which plunged into a free-fall to its lowest levels since July 2007, lifting its yield to 4.65%. Given the close synchronization in the G-7 bond markets these days, the tremors erupting in the Frankfurt are also felt in Tokyo and New York, where government bond markets came under attack by the global inflation vigilantes.
The downward spiral in the German bund market widened the Euro's interest rate advantage over the U.S. dollar, leaving the greenback on shaky ground and vulnerable to speculative attack. Bernanke would be under heavy pressure to match a second ECB rate hike to 4.50%, to defend the value of the dollar. In essence, the ECB could hijack U.S. monetary policy, and force the Fed to guide the federal funds rate higher, in order to shake out speculators in the crude oil and commodities markets.
The U.S. Treasury's "Plunge Protection Team" (PPT) has fought a relentless campaign to prevent a bear market from materializing in the Dow Jones Industrials. The PPT's unleashed its total arsenal -- the largest Fed rate cuts in 25 years, negative (real) interest rates, swapping Treasuries for risky mortgages, $165 billion in tax rebates, and intervention in stock index futures. The PPT also convinced the Bank of Canada and England, to lower their lending rates, to provide artificial life support for the U.S. dollar against the Loonie and the British pound.
But the PPT's safety-net for the Dow Jones Industrials was ripped wide-open by the ECB hawks, who "jawboned" German schatz yeilds to their highest level in 7 years, rattling stock markets worldwide. U.S. 2-year T-Note yields jumped 65 basis point to 3.05% the following week, tracking German yields, for the largest weekly increase in 26-years. To put out the fire, secret agents at the Fed leaked word to syndicated columnist Robert Novak on June 16th that Bernanke would not be bullied into rate hikes by the ECB. "Speculation that the Fed is about to begin inflation-fighting interest rate increases appears to be dead wrong. Bernanke disagrees more with the European position than is reflected by his public statements," Novak wrote.
Furthermore, the "Fed chairman feels high oil and gasoline prices threaten contraction more than inflation. The depressing impact on the oil-driven American economy is especially menacing in his view," Novak added. Yet sky-high energy prices can inflict much more damage to the U.S. economy and the stock market, than a few baby-step Fed rate hikes to stabilize the greenback.
The point of maximum stress could unfold if the ECB carries out a second rate hike to 4.50% in September. That would put enormous pressure on Bernanke to hike U.S. interest rates to defend the dollar. On June 13th, the godfather of the U.S. sub-prime debt crisis, "Easy" Al Greenspan said, "If you are going to keep inflation rates down, the Fed is going to have to put increasing pressure on the money supply and reserves, and as a result we are going to see interest rates rising."
On June 25th, Trichet held his cards close to the vest. "I didn't say that we envisage a series of rate increases. That being said, of course, we never pre-commit. The observers in the market know that pretty well." However, the central bank chief of the Netherlands, Nout Weilink said tackling inflation must take precedence over slowing growth. "It is way too early to judge on what should happen in the second half of this year. This means all options should be kept open," he said.
Bank of Japan is Inflating the Crude Oil “Bubble”
Venezuela's energy minister Rafael Ramirez and OPEC chief Abdullah al-Badri agree that oil markets are well-supplied, and that sky-high oil prices have nothing to do with global production levels. "The U.S. economy is in a crisis that is devaluing the dollar and boosting the price of oil and food around the world. Financial speculators are migrating to futures contracts, which are considered safer than other investments," Ramirez explained.
While the weak dollar against the Euro gets most of the blame for the sky-high price of crude oil, the dollar's strength against the Japanese yen is also elevating the energy markets these days. The Bank of Japan (BoJ) has kept its overnight loan rate pegged at 0.50% for 16 months, which is nurturing inflation worldwide. Global "carry traders" are borrowing Japanese yen at 1% or less, and converting the yen into U.S. dollars, in order to purchase energy futures in New York.
In his first major blunder, rookie BoJ chief Masaaki Shirakawa scrapped his predecessor's policy of gradually raising Japan's borrowing costs, and signaled a green light for "carry traders" to bid oil prices higher. "The outlook for economic activity and prices is highly uncertain. It is not appropriate to predetermine the direction of future monetary policy. We need to pay utmost attention to the downside risks to the economy," he said on May 12th -- switching to a neutral policy.
Now the BoJ's super-low interest rates are boomeranging on the Japanese economy. Wholesale prices for petroleum, coal, and gasoline prices are up 28% from a year earlier. Japan's oil import bill soared 53% to $12 billion in May, and soaring steel and iron ore prices are hammering Japanese carmakers, such as Honda and Nissan, whose operating profit might drop 32% this year. Japan's total import bill is up 12% from a year ago, narrowing its trade surplus by 46% to ¥485 billion ($4.7 billion). A half-point BoJ rate hike to 1% is necessary to shake-out the "yen carry" traders in the energy markets. Do not count on it anytime soon.
Can the ECB Subdue the Gold market?
On June 25th, Warren Buffett told CNBC television viewers that "inflation in the U.S. is exploding and really picking up. Whether it is steel or oil, we see it everyplace," he said. A few hours later, the Fed halted its aggressive rate cutting campaign, leaving the Fed Funds rate unchanged at 2%, but signaled it is in no hurry to rein-in hyperinflation. "Uncertainty about the inflation outlook remains high." However, "the FOMC expects inflation to moderate later this year and next year."
The Fed is admitting that its hands are tied by the banking crisis and the slide in housing, and is afraid to lift the Fed Funds rate ahead of the U.S. elections. The Fed thinks the "Commodity Super Cycle" is a speculative bubble ready to burst under its own weight. Therefore, corrective action by the central bank is not required. The Fed is letting inflation seep deeper into the economy in order to support Wall Street bankers, and has squandered the last ounce of its anti-inflation credibility.
That is good news for gold bugs, who put were on the defensive by Bernanke's bluff about defending the dollar. The Bernanke Fed is holding the fed funds rate far below inflation. In the 1970s, this condition stoked hyperinflation, and the Bernanke Fed is repeating the same blunder. Still, a psychological barrier that is blocking a spirited gold rally is the ECB's move to ratchet German interest rates higher.
The ECB is the solo inflation fighter within the G-7 clique. The ECB has guided the German schatz yield to 7-year highs, but so far, has only knocked the European gold market about 8% lower. The ECB's anti-inflation efforts are thwarted by the "super easy" money policies of the BoJ and the Fed, while the Bank of Canada and England show no inclination to reverse their rate cuts anytime soon. However, the ECB is starting to get some backup support in the battle against inflation from central banks in the emerging world.
However, geopolitical events can overtake the ECB's battle with the simmering gold market. U.S. military chief Admiral Michael Mullen is expected in Israel this week [article was published on 6-26], amid speculation of a possible aerial strike aimed at Tehran's nuclear weapons program. ... Speculation about a possible Israeli strike heated up this week after former UN ambassador John Bolton told London's Daily Telegraph that Israel could strike Iran's nuclear sites between the November 4th election and January. ..
Gold prices jumped by $30 amid a perfect storm, in early New York trading on June 26th, with investors attracted to the yellow metal's "safe haven" status. Citigroup shares fell to their lowest level in nearly a decade after Goldman Sachs said the largest U.S. bank might take $8.9 billion of write-downs in the second quarter. OPEC chief Chakib Khelil predicted, "Oil prices will probably be between $150-170 during this summer. The devaluation of the dollar against the Euro will probably generate an $8 rise in the price of oil," he told France 24 television.
STOCKS FOR A SEASON OF CAUTION
An interview with Harry Cohen and Scott Glasser: In a brutal market, this Legg Mason team is focusing on good stocks with limited downsides.
Unlike fellow Legg Mason fund manager Bill Miller, whose reputation as a value man is belied by his substantial positions in the likes of Amazon and Yahoo, Harry Cohen and Scott Glasser look and sound like the real McCoy. Cohen, the senior of the two, started managing the fund in 1979, so the extended bear market of the 1970s (the 1973/74 leg was the worst bear market since the 1930s) is living history to him.
They wisely have avoided the value-trap of overweighting in seemingly cheap financials, although they did take their hits in that sector from Freddie Mac and GE. Their performance over the past year has been just barely down (before this past week), which we think is pretty good for someone who has used a diversified value stock picking approach.
Harry "Hersh" Cohen started running the Legg Mason Partners Appreciation Fund when Jimmy Carter was president, although in those days it was part of Shearson. So for Cohen, 67, who took over the fund in 1979, the bear market of the 1970s is not an abstraction from the history books. A value investor who tries to take a longer view of stocks, Cohen has a doctorate in psychology from Tufts University. Scott Glasser, 42, joined him as a co-portfolio manager at the very end of 1995. They have guided the fund (ticker: SHAPX) to a solid long-term record, besting the S&P 500 over 10, 5 and 3 years. Over the past year, even though Legg Mason Partners Appreciation is down about 0.69%, it has trounced the market by more than nine percentage points and has acquitted itself well in its Morningstar peer group. Barron's recently caught up with Cohen and Glasser at their Manhattan office.
Barron’s: How does this market look to you?
Cohen: The time to be really bearish was a year ago when the credit crisis started. Since then, we have morphed from being bearish to just plain cautious.
Cohen: We have had a big decline already, particularly in financials, where the biggest leveraging and risks were, and we do not know if that is over. Looking ahead, we do not see the financials leading the market. There are still going to be issues for those companies, including write-downs and capital raises. Whether those stocks have declined enough we do not know -- but we do not think we have reached a durable bottom for the overall market.
The long delay between the first definite signs of the credit crisis last summer and the major declines in financial stocks and the market in general is at utter odds with the Efficient Market Hypothesis. It goes to show you that a little common sense and independent thinking can go a long way in the investing world.
People thought there had to be some end in sight to the credit crisis, and that it had peaked with the collapse of Bear Stearns in March. And yet, you keep getting these bombshells, almost on a daily basis. So we do not even know if the credit crisis has peaked. We also need to see how deep and how long this recession will be. We had believed, and still believe, we are in a recession and that it probably started in November, when retail sales began to fall off a cliff. There are still people who do not even think we are in a recession. We expect that corporate earnings will be impacted for some indefinite period.
How does this market differ from, say, what happened in the early part of this decade?
Cohen: Valuations are not as expensive as they were in the beginning of the bear market of 2000 and at the beginning of the bear market in 1969. But they are not as cheap, either, as they were at the end of the bear market. They are not giving stocks away here like they were in early 2003 and in 1974. We are not seeing a lot of screaming bargains, but we are not seeing a lot of overpriced stocks. But with corporate earnings uncertain, we are being cautious.
Glasser: It is our belief, looking at the second half of the year and 2009, that expectations are way too high. Earnings estimates have come down significantly in the areas where you would expect to see them, notably financials, retailing and consumer discretionary. But we probably need to see them come down further in other sectors as well.
The real question (i.e., what would Buffett and Munger ask?) is whether expectations for the these sectors' sustainable earnings levels are too high. We suspect yes.
Your portfolio has done well in recent years, particularly relative to your peers. How have you managed to avoid the carnage?
Cohen: For starters, it tells you how tough this market has been. Our performance is more or less flat over the past year. It is a brutal market. A key factor that has helped us is that we avoided most of the toxic stocks. We got bearish on financials well over a year ago and cut back materially. On the positive side, we had a pretty good position in domestic energy, both E&P [exploration & production] companies and drillers, including Nabors Industries [NBR]. We had some good individual holdings, including Wal-Mart [WMT] and IBM [IBM], both of which are top-10 positions.
What stocks have not worked as well for you this year?
Cohen: General Electric [GE] is down about 20% this year, and Berkshire Hathaway [BRK.A] is off about 10%. For every good stock that you have, you have another one that is not working.
Glasser: Look at what has worked and what has not worked in this market. The leadership has been very narrow. It has been momentum-oriented and, therefore, anyone with a diversified portfolio has had both the pluses and the minuses. Even the rallies we have had have been very narrow. For the market to get a healthy rally, it must get broader in terms of which stocks are working.
What about General Electric, which you lightened in April after the company missed earnings badly?
Cohen: We are upset about the stock price, and we probably should have been more alert. We thought about the impact of the financial division on the entire company. But the indications from them were that they were managing through this. It is a non-transparent portfolio, so how do you know? I guess our judgment was erroneous in thinking that they could be different from others in managing their way through this. And I do not think anybody really knows how difficult their financial portfolio is. It was our first- or second-biggest position. When the earnings came out in April -- we do not usually do what we did then -- we sold some of the stock. But we still think 75% of GE is really good.
Probably nobody, including GE's management, knows exactly how "difficult" its financial portfolio is. And, this is true of almost every financial stock.
They missed earnings by seven cents a share and said they expect the rest of this year to be sluggish. Not the best quarter they have ever had.
Glasser: It was a significant miss for a company that is not known for missing. What was alarming was the magnitude of the miss, and we realized that we were not comfortable with the transparency of their financial portfolio. Hence, it made some sense to cut some back. But it is still a significant holding for us.
Cohen: Longer-term, they will work their way out of this, and they are still the leader in many industrial areas. That is part of their leadership going forward. But for now, it is a show-me stock.
Which sectors do you see taking a leadership role in the market as signs of an economic recovery take hold?
Cohen: There has been a change in leadership from financials, which had the wind at their back for 15 years. That has passed to energy, industrials, agricultural firms and materials. Some of those stocks might need to correct before this bear market ends, but that is probably where the leadership is going to continue to be.
Glasser: As far as the financials go, maybe we have started to see the first signs of capitulation. But there are still too many investors, primarily long-only, who are thinking in relative terms. In other words, what happens if the financials turn or for some other reason I need to reassess their weighting [in my portfolio]? Until these investors start thinking in terms of absolute losses and really get scared, it is unlikely you will see a bottom for the financials.
How are you approaching technology stocks?
Glasser: There has been a clear divergence in terms of the performance of tech stocks. The better performance has been driven by the higher-quality companies. Another factor that differentiates these companies is their international exposure. The incremental growth in technology has been overseas. But one of the risks going forward would be if emerging markets start to slow. Then one of the pillars of the tech story starts to erode.
Cohen: We love technology stocks, but they have to be regarded as cyclical stories, for the most part. Even though technology is a long-term, secular story, these stocks seem to have a strong cyclical component. But we have had good success recently with Cisco [CSCO], IBM and Qualcomm [QCOM].
If you could have one stock selection back from the last year, which one would it be?
Cohen: Freddie Mac [FRE], which we bought in November, thinking that the worst of the housing situation that was over. We thought Freddie Mac would be part of the solution, not part of the problem, and we just underestimated how severe their write-downs would be. We still own a relatively small position.
Let's hear about some holdings that you like.
Cohen: Two are The Travelers Cos. [TRV] and Newfield Exploration [NFX]. We also hold a group of companies -- Kimberly-Clark [KMB], DuPont [DD], PPG Industries [PPG] and Kraft Foods [KFT] -- that have characteristics in common. They all face headwinds, which they will overcome and become good stocks. No one of those four may necessarily be exciting, but as a group they are pretty reasonable holdings. In the meantime, we think their downside is limited.
What do you like about Travelers, whose shares have been under pressure?
Cohen: Travelers trades at about 1.1 times book value. They have what we consider to be the best management in the property-and-casualty insurance business. They have a pristine balance sheet and, unlike many other financial firms, they have not been dinged by any exposure to subprime mortgages. And their chief executive, Jay Fishman, understands how to price risk. First of all, he will not take outsize risks, relative to what kind of premiums they are getting. And, No. 2, they will not cut prices dramatically just to capture more market share. In a better market environment the stock trades at 1.5 times book. And Travelers is increasing its book value every year.
Glasser: It is one of the few financials where you can believe that the book value is real and that the earnings are real. There is a greater sense of confidence as you go forward, owing to the quality of the balance sheet.
And what about Newfield?
Glasser: Newfield Exploration is a company that we have added to over the course of the past year. We have a lot of confidence in it. Performance has been good. But we think there is a large part of the story that is not appreciated by the Street. It is close to its 52-week high of around 70. It has gained about 30% for the year, which is good. But it has lagged a number of other energy and E&P companies, because it is a story about a company that is transforming. ...
How do you go about valuing this company?
Glasser: We look at it on a net asset basis, using various commodity prices. We try to make conservative judgments about the reserves they have and the reserves they are likely to have and what the final development costs are going to be. It also depends on your assumptions in terms of natural gas. If you were using an $11.50 per Mcf [thousand cubic feet] gas price, the upside price potential over a multi-year period is double its current price of about 67. If you put a $7 per Mcf price on natural gas, there is modest downside. Currently, natural gas is at about $13 per Mcf.
Cohen: One other point about E&P companies in general and why we own several of them ... it is a thesis put forth by our colleague Rich Freeman, who manages the Legg Mason Partners Aggressive Growth Fund [SHRAX). With a change in [presidential] administrations in the U.S., it is going to be very tough for energy companies to do deals after the beginning of 2009. Therefore, we think M&A activity by the majors could and should heat up over the next six months, though we are not banking on it. If you look at ExxonMobil [XOM], which is having trouble replacing its reserves at the same level it used to, it can buy a company for less than it would cost them to find new reserves right now.
Let us move on to PPG, Kraft, DuPont and Kimberly-Clark. Where is the upside?
Cohen: They all have good or improving management teams, and they all have growing dividends. Kraft has just become an independent company, and it has already raised its dividend. Kimberly-Clark has a long history of dividend increases. PPG has raised its dividend every year for 35 or 36 years. DuPont just raised its dividend for the first time in a number of years. On the other hand, these companies have a lot of businesses that are sensitive to commodity prices.
They are all fighting headwinds with raw material prices, energy costs, and transportation costs. But we think they are managing their way through these issues pretty effectively.
But there are only so many price increases these companies can pass along, right?
Cohen: These are not stories for tomorrow.
Glasser: We see these companies in the same way we saw Wal-Mart a year ago, namely a low-expectation story with some kind of transformational change going on at the company. The valuation was low, things were likely to get better, though we did not know when. But we thought the downside was limited.
Cohen: Kimberly-Clark is innovative in its products. They have strong international sales, and they have had top-notch management over the past couple of years.
Glasser: And they have done a much better job allocating capital, putting more emphasis on buying back shares. I would also say that Kimberly-Clark is more of an execution story fighting headwinds than a story about a company transforming itself.
What about DuPont?
Cohen: DuPont has been a really disappointing stock. But the company has shed some slower-growing businesses and focused on higher-growth areas, including agriculture. It has also done better with share buybacks and increased its dividend.
Glasser: It was a much more cyclical company several years ago. And now the majority of its business is in coatings. They have moved toward having higher margins and more consistent earnings, and they have done a good job of returning capital to shareholders. They are facing some headwinds, with exposure to housing and automobiles, but they have enough positive things going to offset that.
What about Kraft?
Cohen: We always love great companies that are dominant franchises, especially when expectations are low. There is lots of room for margin improvement at Kraft. There is room for asset sales. There is room for dividend increases. And there is room for stock buybacks.
Thanks very much, gentlemen.
A table of Cohen and Glasser's picks is here. All have declined somewhat since the table was published, in line with the overall stock market selloff since then. Travelers, Kimberly-Clark, DuPont, and PPG are reasonable large capitalization value stocks, with low teens multiples and an average dividend yield in the 3-4% range. Kraft has a P/E of 18 but also has a nice yield of 3.8%. Newfield has no dividend and no accounting earnings to speak of. This is a defensive set of stocks, consistent with the interviewees' enunciated philosophy and claim above.
CLEAN UP AND RETHINK YOUR PORTFOLIO DURING VACATION
Some useful mid-year advice from Stephen T. McClellan, author of Full of Bull.
I is almost the Fourth of July and vacation time beckons ... When I think vacation, I think of distance or a relaxing change of venue like a beach resort. But when you are not inundated by everyday distractions, that is the perfect opportunity to ponder your investment holdings. Reassessment and review in a disciplined manner is especially critical in December in order to make year-end investment changes that have tax implications. But on vacation this summer, along with my book Full of Bull (your required reading!), take your monthly brokerage statement and mull it over at the pool with a piña colada.
Rethink your overall strategy or themes and shake off any emotional paralysis that has locked you into certain stock positions. Maybe your theme is stale; are there newly emerging trends to begin investing in? A market analyst I respect, Ray DeVoe Jr., terms this "liberation from the prison of past decisions."
Some stocks may have attained too heavy a weighting for your peace of mind. However, this is where I disagree with most "experts" who advise periodic rebalancing by trimming back oversized positions. Your biggest winners that become the outsized positions in your portfolio are probably the last things you should contemplate selling. I prefer a higher weighting in my best investments rather than just a normal position. If you believe that prospects remain favorable for one of your most sizeable stock positions, buy more, if anything, rather than cutting back.
Other stocks you own may have lagged for so long, it is time to give up. Ask yourself, what is your comfort level or enthusiasm with each individual stock in my portfolio? There are tax considerations when taking gains. Maybe there are losers to be used as an offset. A reticence to sell stocks that have not worked out -- that is, to admit mistakes -- is normal. But by not selling your losers and moving on, you commit another mistake. Accept your failures, step up to the plate, and dump your junk so you can start afresh. It only hurts for a bit, and then you feel liberated.
After returning from vacation and if you have been out of touch with the stock market, financial news and the price changes in your holdings, do not pull the trigger on any portfolio transactions on your first day back. First get up to speed and familiarize yourself with any investment news that you missed. Then if it still seems appropriate, orchestrate the needed portfolio shifts. This may be none or possibly one or two actions.
Always remember, you are an investor for the long term. The fewer transactions ... the better. Do not feel compelled to "do something." The best decision is usually "do nothing." For more on this topic, check out my book ...
THREE EASY STEPS FOR PICKING STOCKS
Wayne Mulligan, who runs the TickerHound website, neatly summarizes the stock-finding approach that almost all fundamental, systematic investors use in one form or another.
Someone just e-mailed me ... How exactly do you go about finding stocks to buy? And after I read it, I really began to think about how my investing process works. How do I go about identifying, researching and ultimately buying a stock?
For many investors the process has evolved so much for them that it is tough to tell what their exact methodology or framework is anymore. So after reading that question, I decided to pull out my yellow legal pad and literally write down my investing methodology ... and here it is (the abridged version):
Here is the process in a nutshell: First, find a list of companies with strong financial characteristics and make sure you really study the industry and who else is operating in it. Finally, figure out what the business is worth and make sure you do not overpay for it.
- Stock Screen & Filter
This part of the process is not set in stone but it is what I find myself doing when I am searching for stocks that are not on my radar yet. But many times I will simply find companies due to overall macro trends that I am following (e.g., wireless, China, etc.) and then I will just skip this first step.
But in the event that I am looking for new companies, what I will typically do is use one of the free stock screeners out there (Yahoo! Finance has a great Java app for screening stocks). Here are some of the criteria I will use:
- Market Cap: Depending on which types of stocks I am looking for (large-cap, small-cap, etc.) I will tweak this setting accordingly.
- Return on Equity (ROE): This is an extremely important metric in determining the overall health of a business and how competent management is. Anything above 15% is a healthy ROE number.
- Earnings Yield: This is a number many people do not look at but it is very helpful in quickly screening for potential investments. The Earnings Yield is basically the inverse of the P/E ratio -- Earnings divided by Price.Think about it this way, if you could get a 5% yield on a government bond (a risk free investment), then would not you want more out of a company you are investing in? I will typically look for companies with earnings yields north of 6%, but the higher the better.
- Look Out For Debt: While I would ideally like a company with zero long-term debt, some debt is OK as long as it is not breaking the company's back. So make sure the company is able to comfortably meet interest payments (interest coverage ratio) and that long-term debt does not make up the majority of its capital structure.
- It is All Business
After you get your list of stocks, the next step is to filter it down further but this time you will need to look a bit deeper than the numbers. For me, I will only invest in a stock if I really understand the business behind it. I will want to know exactly how the company makes money and what makes it a better company than its competitors, etc.
So you would never see me invest in a chemical company because I just do not know enough about the industry to say which company has a real advantage over another. So make sure the business you are investing in is one you are familiar with and understand.
- What Is It Worth and Is the Price Right?
OK, so now we are back to the numbers -- and here is where it gets tricky ...
Let us say we are looking at a stock with a $500 million market cap. How do we know it is not really worth $100 million? How do we know it is not worth $5 billion?
The answer is tricky in that there is no single "correct" way to determine the value of a business. Everybody uses their own metrics and equations.
But what I can tell you is that nobody will ever come up with the exact value of a company. It is impossible to be right about something as dynamic as a business. There are just too many different variables and moving parts. So what is an investor to do?
For this topic I will default to the kings of value investing: Benjamin Graham and Warren Buffett. To be clear, Graham was the one who came up with the concept I am about to discuss, but Buffett's success in applying it makes it worth including his name here as well.
And the concept I am referring to is, "Margin of Safety."
For example, if you think a stock is worth $1 billion, then you should only buy it when it is trading for $500 million. Meaning, you should require a Margin of Safety of 50% or more on every investment you make.
This way you eliminate a lot of the uncertainty and the risk involved in trying to accurately value a company. If you get nothing else out of this article, then I hope that the concept of Margin of Safety really sticks and you use it in all of your investing operations.
I am obviously oversimplifying here, but I know if you stick to a regimented system, whether you are buying a large cap tech stock or small cap alternative energy company, you will consistently outperform the market.
If you would like to read about how other investors pick stocks or submit your own ideas then click here now.
A Troubling View From The Top
This Barron's article is accessible by subscribers only, but the preview is interesting enough. The article description (in the metatags) says: "One leading institutional broker suggests that the credit squeeze and falling stock prices aren't going away soon."
The most important asset in any market is information. As the head of a top institutional brokerage, GFI Group (GFIG), Mickey Gooch has a lot of information about a lot of assets.
GFI, which he founded and leads, operates at the intersection of the credit, equity, and commodities markets. As a so-called inter-dealer broker, GFI helps its institutional clients, including some of the largest investment banks in the country, trade assets including derivatives on assets such as energy and precious metals, currencies, stocks and credit.
So what is Mickey seeing from his rarified vantage point that can help the rest ...
The Coming Depression?
From LewRockwell.com writer and blogger Bill Anderson:
There is only one reason the Great Depression became a decade of high unemployment and low output and that is because of government intervention into the economy. I have no doubt that the credit-filled boom will continue to morph into the credit-crunch bust, but there is no good reason as to why this has to turn into another Great Depression.
The ONLY thing that can make this current slowdown into a depression is government intervention and government spending. Paul Krugman continually calls for another "New Deal," which means he wants government to create cartels, limit output, and block the creation of wealth. If the government follows his advice, we WILL have another depression.
One wishes that the powers-that-be would listen to Ron Paul. However, a severe contraction also will mean that the politicians will have even more dictatorial powers, so it is in their best interest to make sure the economy tanks -- all the while blaming business for the whole thing.
Shanghai Cliff Diving
So it looks like the Chinese stock market was a bubble after all.
The Shanghai SSE composite index is ... now below 2700 for the first time since early 2007. The index is off 54% from the peak. [See graph.] This is some serious cliff diving.
Timber ETFs Are Lacking in Timber
Two timber ETFs -- newcomer iShares S&P Global Timber & Forestry Index Fund (WOOD) and established rival Claymore/Clear Global Timber Index ETF (CUT) -- could be good ways to get exposure to an attractive asset class ... if only they owned some timber.
The second timber ETF in America launched on June 25th, reflecting the growing popularity of these vehicles among investors. However, I think both existing timber ETFs are bound to disappoint shareholders and will ultimately fade into obscurity.
To be sure, I believe the enthusiasm for the asset class of timber is fully justified. Here is a factoid that will shock most investors: research shows timber has delivered higher risk-adjusted returns than stocks, bonds, or commodities over the past several decades (as noted in this article from another Seeking Alpha writer). Additionally, timber provides a partial hedge against inflation and is an excellent portfolio diversifier due to returns that are not highly correlated with the returns of stocks and bonds.
But here is the catch: These timber ETFs offer no direct access -- and only a smidgen of indirect access -- to this asset class. These ETFs have been portrayed as viable timber plays by numerous reporters and financial gurus, but I will explain why this conventional wisdom is wrong.
Vanguard’s Patent Keeps Other Mutual Fund Companies from Introducing ETF Alternatives
What keeps mutual fund families from introducing ETF alternatives? One -- perhaps the major -- concern is that the lower ETF fees would eat into the profits from the main product. The other is the Vanguard fund company has this patent ... which provides further evidence that the patent system is broken. But what do you expect from a government run system?
Vanguard is the only company that can launch an ETF as a share class of an existing mutual fund. They came up with the idea a while back and by-golly, they patented it. So far, I do not think anyone has licensed that patent, although Vanguard has spoken with a few firms about it. The share class structure could make sense for an active shop, if Vanguard would let them do it -- and if they got around the transparency issue.
Let us say, for instance, that you ran an actively managed fund that had been around for a few years. Let us also say that the fund had produced strong returns over the past few years, and some of the stocks it owned were bought at much lower levels. That could come back to haunt shareholders if you ever decided to sell, because the capital gains would be passed through to the fund's shareholders. But if you had an ETF share class, you could use the ETF to get rid of those high-cost shares, thereby improving the tax efficiency of the fund as a whole. It could be interesting for an active shop.
In the end, though, I think ... it is all about the money. And the money tells the active fund managers to stick with funds.
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