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If you must invest in the overpriced Chinese market, go for one of the least glamorous sectors. Cement, for example.
Despite a huge pullback, the Chinese market is still expensive with a trailing P/E of 23, this article from Forbes notes. If one nevertheless seeks exposure to a clearly dynamic situation, the cement companies are a logical and relatively inexpensive way to play that market.
This and the following several articles continue our coverage of Forbes's invaluable 2008 International Investing Guide.
May's earthquake that killed perhaps 90,000 people in China was one of the world's worst of the last 100 years, but this human tragedy may quicken at least one positive trend: the overhaul of China's heavily polluting and inefficient cement business.
Investors can participate in this rebuilding by owning shares in companies that sell cement in China. It is one of the more conservative ways to get exposure to the feverish Chinese economy. Despite a sharp pullback in the last six months the Shanghai market trades at a pricey 23 times trailing earnings.
Many of the country's 5,000 cement plants date back to Maoist times, when local governments ran businesses and pursued self-sufficiency. The operations survived because of strong demand spurred by the country's spending on houses, factories and roads. In 2006 China consumed half the world's cement, 1.2 billion tons.
As part of a general industrial policy to push energy guzzlers and big polluters out of business, the central government wants to cut the number of cement suppliers to 3,000 by 2010, says Jay Zhou, who follows the industry at SinoPac Securities in Shanghai. Bigger companies get tax breaks for saving energy, and provinces have quotas to shut small companies. "Scale has a big effect on costs and competitiveness," says Zhou.
Such restructuring was under way even before the earthquake, but now demand for cement in China will grow by 61% by mid-2009 compared with an earlier prediction of 12%, says Deutsche Bank. Looking at the economic impact of reconstruction from previous earthquakes in Asia, Deutsche Bank edged up its forecast for China's GDP to 10.7% growth this year and 9.7% next.
Best positioned to benefit is Anhui Conch Cement, the country's largest cement producer, with 2007 sales of $2.7 billion. Its Hong Kong-traded shares are flat over the past 12 months. Another big producer is China National Building Material. Traded in Hong Kong, the majority-state-owned company has used cash from its March 2006 public listing to roll up smaller cement companies.
Several Taiwanese cement companies also stand to benefit from China's need for cement. The new Taiwanese government of Ma Ying-jeou is likely to lift long-standing restrictions on Taiwanese firms that want to invest in factories on the mainland. "Taiwan's market is very small compared to China. We are very competitive and hope to expand our business there greatly in the future," says Leslie Koo, Taiwan Cement's chief executive. In June TCC International Holdings, the group's Hong Kong-traded subsidiary, unveiled plans for $135 million of new capacity near Shanghai.
Other outsiders are active in China. Among them, Lafarge of France, the world's largest cement producer, which has 21 plants in China through a joint venture with Shui On Construction & Materials of Hong Kong. Billionaire Vincent Lo has a 57% stake in Shui On. In February Lafarge's European rival, Holcim, increased its stake in China-listed Huaxin Cement to 40% from 26%. About the same time, building materials supplier CRH of Ireland paid $306 million for 26% of Jilin Yatai Group, and it has an option on another 23%. Shui On is trading at six times projected 2008 profits. Taiwan Cement and Asia Cement (Taiwan) have estimated multiples in the teens.
Risks include the possibility that the interventionist-minded government of President Hu Jintao will backtrack on the move to a free-market economy and try to impose price controls to offset a shortage of cement. Also, authorities have been trying to cool gdp growth amid rising inflation, and the extra demand from reconstruction spending will peak next year, Deutsche Bank notes.
The article concludes with a table, subtitled "Beyond reconstruction, these companies should benefit from the rationalization of China's cement industry and the country's long-term prospects," which gives statistics on the stocks discussed above.
BUYING CHINA STOCKS IN THE U.S.
Investors were hungry for initial public offerings in the U.S. of Chinese companies.
Many Chinese companies are coming directly to the U.S. to raise capital. How have the stocks general done, post-IPO? This article tracks them.
In spite of the credit crunch last year, U.S. markets saw the largest number of IPOs, 273, and highest dollar volume, $60 billion, since 2000. Driving this market, according to Renaissance Capital, are Chinese companies looking for capital. As a group, these companies raised $5 billion in the U.S. over the past 12 months, and their stocks managed a 37% gain, versus a 10% loss for the S&P 500.
Excluding a few hot but tiny offerings, one of the best-performing Chinese new issues in the U.S. is Gushan Environmental Energy, which makes transportation fuel out of cooking oil. Biodiesel is at the moment a small business in China, but the government expects 15% of China's total energy to come from renewable sources by 2020. The government classifies biodiesel as an "encouraged industry," extending grants and interest-free loans to companies in this business. Gushan raised $173 million via its IPO in late December 2007, and its shares are up 18% from its first day's closing price. Last year Gushan generated $138 million in revenue.
Among the loser stocks: China Nepstar Chain Drugstore was profitable in 2007, on revenue of $268 million, but the new issue of this rapidly growing chain is down 36% since its first closing day, November 9.
The same oil prices roiling markets from California to Kolkata are flooding the Arabian Gulf with cash. You can buy into this boom.
It is hardly a secret or a surprise that the oil producing surplus nations are benefiting from current high prices of their primary export. Unlike the 1970s, those nations are reinvesting a lot of their sales take into their own economies instead of "recycling" into the bonds and econommies of their customers. Many companies will benefit from the resulting construction and development boom.
We find this to be a high-risk situation overall, what with memory still vivid from what happened post-the 1970s oil price spike. Essentially you are betting that oil prices will stay high, and there are other ways to make that bet that are easier to understand.
It is a Tuesday afternoon at Dubai International Financial Center's headquarters, a gleaming arch-shaped skyscraper known as The Gate. Inside, the soft hum of dealmaking hangs in the air. Men in traditional white dishdashas pad the halls. A trio of French-speaking suits huddle in the reception room, tapping BlackBerrys. By a wall of windows a DIFC executive, a tall, angular Brit, gestures broadly to a visitor at the smoggy horizon, littered with cranes, bridges and towers as far as the eye can see.
Dubai is the self-described financial hub of the Middle East and North Africa--or Mena--region, loosely defined as the Arab Middle Eastern countries plus Egypt and Morocco. The Gate is only partly occupied, but offices are filling fast. In the past two years eight U.S. financial service companies, including Standard & Poor's and Merrill Lynch (nyse: MER - news - people ), have set up shop here.
Why the rush? The greater Middle East, in particular the oil-producing Gulf countries (Saudi Arabia, United Arab Emirates, Kuwait, Bahrain, Oman and Qatar), is awash in oil money. The region's economy has grown at an annual 6% for the past five years. Last year every one of the region's market indexes posted gains of more than 25%. Combined with high liquidity (a regional fiscal surplus of $1 trillion), solid corporate earnings growth and a youthful population, Mena is "a not-to-be-missed opportunity," says Ziad Makkawi, chairman of Dubai investment bank Algebra Capital.
The IMF expects oil and gas exports to bring in $940 billion to the region this year. Gulf governments are now pouring those proceeds -- an estimated $225 billion over the next three years -- into infrastructure, finance and social sectors, like health care, to ready their economies for a post-oil era. So flush are these countries, says Makkawi, that oil could drop below $70 a barrel for the next 10 years and still there would be economic growth.
Private equity and hedge funders have been especially keen to tap the region's cash piles, but opportunities for U.S. retail investors are slowly becoming available as well. Joseph Rohm is a stock analyst at one of the newest offerings, the $853 million T. Rowe Price Africa & Middle East Fund. This fund has 85% of its assets invested in the Middle East, 61% of that in the Gulf, excluding Saudi Arabia, which is closed to foreign investors. The fund has returned 41% since its inception last September, twice that of its benchmark S&P IFCG Africa & Middle East Index.
Joseph Rohm sees other positives: "This market is uncorrelated with what is going on in the rest of the world right now. The region's banks all have loan-to-deposit ratios below 1.0 and are just not exposed." For a broad play on the region's strong macroeconomic growth Rohm likes commercial banking, noting that lenders are often the first to benefit in a fast-growing market. Commercial Bank of Qatar, for one, saw its latest quarterly earnings rise 64%. Loans grew 45% and nonperforming loans made up a mere 1% of its portfolio.
A little note: In the old days a loan-to-deposit ratio of, as we recall, about 2/3 or lower was considered prudent and conservative. That an analyst could impy that a ratio below 1.0 has an ample safety margin is another sign of the credit bubble times.
The building boom gripping the region has made construction and real estate an obvious investment choice. One of the fund's holdings is $4.8 billion (sales) Dubai real estate company Emaar Properties. Emaar is in the midst of constructing a 160-plus-story tower that, it hopes, will be the world's tallest upon completion. Lesser known but equally promising is $334 million Aldar Properties, the largest property developer in Abu Dhabi and the principal engine of the capital emirate's bid to outshine rival Dubai in touristy excess, beginning with its $40 billion Yas Island project, replete with water parks, 74 acres of shopping and a Ferrari theme park.
We hate to be a spoilsport -- and we may be wrong -- but those building über-skyscrapers usually come a cropper ... especially when the skyscraper sets a new height record. It has typically been a coincident indicator that a mania high is in the offing.
As locals embrace the boom, Rohm anticipates consumer spending, discretionary or not, to remain strong. Noting that more people are taking vacations, he likes Air Arabia, which he calls "the Ryanair of the Middle East." Largely owned by the government of emirate Sharjah, the low-cost airline flies to over 40 cities in the Middle East and southeast Asia -- ideal for expat Gulf residents -- and has few competitors. Another favorite is Cairo's Orascom Telecom, a $4.4 billion (sales) mobile provider, with 74 million subscribers and lucrative inroads into underpenetrated markets like Bangladesh, Zimbabwe and Iraq, countries where cell phone use is just gaining traction.
There will be more public companies where these came from. Over the next three years Dubai expects more than 100 offerings of stock in companies with at least 500 employees.
Inflation is climbing, exacerbated by the fact that all the Gulf currencies, except for Kuwait, are pegged to the dollar, which means low interest rates in the face of rampant growth. Rohm calls it the "key risk in the region" but says the countries' cash surpluses allow them to deal with it. "They have the money, they can raise wages and meet those inflationary expectations."
Ziad Makkawi even sees it as a bonus currency play. "These currencies are undervalued. If floated freely, they would instantly appreciate 15% to 20%. That is a 20% discount from, say, India or China." Unsurprisingly, Gulf treasuries are discussing depegging from the dollar but are considering the political ramifications and the effect on oil prices. Untethered currencies probably will not show up for at least two years.
Conflict scares off investors. The worst case would be a war between Iran and Israel, which would rattle the markets. Rohm, however, argues that the Gulf has benefited from its neighbors' turmoil. "There is a lot of money flow from Lebanon, Iran, Iraq and the Palestinian territories because the Gulf is very stable."
The T. Rowe Price fund is one of the few low-minimum funds available to U.S. investors. One option is to buy securities from a local brokerage, like efg-Hermes, a Cairo investment bank that provides online trading, in English, in both Egypt and the United Arab Emirates and broker-assisted trading in markets across the Mena region. The firm charges a commission of between 0.35% and 0.5% for online trading, depending on volume, plus 0.1% in other fees. Besides offering brokerage services, the firm boasts one of the most comprehensive market research houses in the Middle East.
More investment options are on the way. Both PowerShares and WisdomTree recently registered Mena-focused exchange-traded funds.
The article concludes with a table highlighting companies which could benefit from the Arabian Gulf developement boom.
One intrepid investor sees numerous value opportunities despite the continent’s turbulent politics.
"The Dark Continent" may warrant a look. Long known for third-rate economies and fourth-rate governments, Africa has several what look like first-rate companies. Whatever a country's and company's quality, price is the great equalizer. And some of the ideas presented look reasonable, but not necessarily too cheap not to buy. A lot of outside money in the last two years has sent African markets higher, so tread carefully.
Brutal dictators, civil wars and stolen elections tend to dominate the headlines Americans read about Africa. Less visible: cell phones, the spread of capitalism and World Bank-inspired debt forgiveness, all of which are driving down inflation and driving the boom in sub-Saharan Africa's stock markets.
So says Jonathan Auerbach, managing director of Auerbach Grayson, a cosmopolitan brokerage in New York City for institutional investors that have at least $100 million to commit. Last year it invested $850 million in Africa for these clients. His pitch: Most African countries, with the exception of Zimbabwe, have high rates of growth and millions of people aspiring to the middle class. Many who are already there are not visible in the official statistics because they are a part of the gray economy.
Outside of Johannesburg's, the stock markets are still small and illiquid but growing. Two decades ago there were 5 stock exchanges in sub-Saharan Africa. Today there are 18, with, among them, 1500 listings, according to the IMF. North American and European funds specializing in African stocks saw net inflows last year of $663 million, up from $82 million in 2006, says EPFR Global, a research firm that tracks funds worldwide. In a small market that modest sum was enough to send prices soaring. Excluding those in South Africa, African stocks have climbed at an annualized 43% since the end of 2006, according to S&P.
Auerbach, 65, began his career on Wall Street after graduating from Yale and spending two years tending ballistic missiles for the Army. He cofounded his present firm (with David Grayson) in 1993. He spends six weeks a year abroad, mostly to meet with business and political bigwigs. But he takes side trips into urban neighborhoods to get a feel for a country. A first-time visitor to Lagos, he says, could be terrified by the sight of the mass of humanity. But it is no different from the Lower East Side of New York a century ago: "Wagons, storefronts, stands, selling, buying -- and just as exciting."
Auerbach started putting money in Africa a decade ago, after the release of Nelson Mandela and the collapse of apartheid. He bought shares of companies in Botswana, Uganda and the Côte d'Ivoire. Yes, there was (and is) corruption. But there are also real economies -- and cheap shares. A price/earnings ratio of nine or less for a market leader is not uncommon.
"Anybody who takes their input from the New York Times on a daily basis," Auerbach says, will think of Africa as only "corruption, aids, starvation, disease, genocide." But he believes "this just isn't the case in Africa these days."
He points to working stock exchanges, enlightened new governments and significant amounts of capital going into the continent. His yardsticks are whether a country has a stock market, an acceptable legal framework, a custodian for his clients' stock and a local analyst who can send him reliable research.
When picking stocks Auerbach looks at ratios of price-to-book value and to earnings, rates of growth, rates of inflation and, most important, the purchasing power of the currency. "If the currency is undervalued and is strengthening to the dollar, it is a natural dollar hedge, an important consideration for my clients."
Kenya, he says, has a vibrant economy and is a leader in privatization. A favorite: Safaricom, the largest cell phone company there, with 10 million subscribers. In April, in the biggest offering so far this year in sub-Saharan Africa (and outside of South Africa), the Kenyan government cut its shareholding from 60% to 35%. It asked the big banks to provide lines of credit to anyone interested in investing, capped foreign investment at 15% and priced the new issue 10% cheaper for locals. "They realize the importance of creating an investor class," says Auerbach.
What about the postelection riots? "There were some nasty tribal confrontations," he says. "Now get over it and accept that this place works."
Auerbach sees potential even in the crisis-plagued nation of Zimbabwe. The despot Robert Mugabe will soon be gone. The populace is literate, and tourism will come back. He expects a new government to discard the worthless Zimbabwean dollar and peg a new currency to the U.S. dollar. His Zimbabwean picks include Delta Corp. and Kingdom Meikles Africa, the latter conglomerate with operations ranging from cultivating and marketing tea to financial services. Delta goes for nine times earnings and Meikles for seven times.
For a stake in Ghana's economy, Auerbach says, buy shares in a British outfit, Tullow Oil. Last year it discovered an offshore oilfield with proved reserves of 550 million barrels and unproven reserves of perhaps three times that. Tullow is also active in Uganda on Lake Albert. The stock will cost you 39 times earnings.
In Zambia Auerbach has invested in agriculture companies, including those producing animal feed, wheat, meat and dairy. The price of Zambeef Products, 28 times earnings, is merited by its top-line growth (50% year-to-year). From Zambia's copper belt he picks Canada-listed Equinox Minerals, which in Zambia owns one of the largest fully permitted copper projects in the world under construction.
Côte d'Ivoire ranks near the top of Auerbach's list of value anomalies. The key, he says, is the currency: This nation and the seven other members of the West African Central Bank have a currency pegged to the euro, but they also control their money supply by a formula that requires that it not exceed an amount equal to 50% of the region's exports. Higher commodity prices -- the country is rich in rubber, cocoa, palm oil and coffee -- enable the country to expand its money supply while keeping inflation limited to 3%. Auerbach also likes the Bolloré Group, run by billionaire Vincent Bolloré, as the French company controls most of the port facilities in Abidjan, the biggest port on the west coast of Africa and the delivery hub for exporting goods.
The article concludes with a table listing African company research candidates.
BANKING ON EUROPE
Looking to cash in on a banking recovery? Europe may just be the place.
We have counseled caution countless times when it comes to calling a bottom in U.S. financial stocks. The obvious subprime loan exposures and a deteriorating economy, combined with woefully insufficient loan loss reserving policies of the past decade-odd, make estimating values problematic. The value of many banks out there may well be zero.
In Europe the situation is not so tenuous, and the financial stocks warrant some attention. Earnings multiples and reasonable. Banks based in non-bubble economies such as Germany or France who did not get gulled into investing their capital in U.S. junk can hope to avoid massive hits to capital even if their respective primary economies do turn down. Those with strong balance sheets are in a position to scoop up clients and cheap assets from banks desperately trying to restore their capital.
Continental Europe is thousands of miles from the busted home loans in Miami and Las Vegas, but that has not spared its banks from the fallout. Swiss giant UBS has announced $38 billion in mortgage-related writedowns over the past year, has fired its chief executive and was forced to scrounge up $15 billion in fresh capital. Bank stocks likewise have taken big hits in Britain, which is suffering through its own U.S.-style housing crisis.
Elsewhere in Europe, however, many institutions are healthy, unencumbered by mortgage trouble and, more than anything, look like innocent victims of a panic that has investors fleeing bank shares worldwide. Many European banks have far less exposure to subprime loans than do U.S. banks and are far less likely to cut dividends. The high-flying euro also means they are positioned to buy assets from their cash-starved American counterparts at fire-sale prices.
"Europe's overall macroeconomic backdrop is better than in the U.S.," says Frank Crown, an international portfolio manager at Invesco Ltd. in Atlanta. "The U.K. has a lot of the same issues the U.S. does. But an export-oriented country like Germany is in much better shape."
Germany, the Continent's largest economy, is performing much better than you would expect, given the U.S. slowdown and rising global oil prices, says Jean Sassus, an analyst at Raymond James in Paris. German unemployment dropped in May, and last quarter the nation's economy grew at an annualized rate of 6%, the fastest in a decade.
Commerzbank recently halved its already modest $1.2 billion subprime mortgage portfolio. The remainder is "not enough to be a big trouble," says Sassus. The Frankfurt bank is expanding its retail network and could emerge as a suitor for Citigroup's German retail operation, which the equity-starved U.S. bank recently put on the block.
France's economy also appears to be on solid footing, and its real estate is reasonably priced. French banks are shopping for bargains among American assets. In June BNP Paribas paid Bank of America $300 million for its prime brokerage unit, which caters to hedge funds.
Commerzbank and BNP are cheap, with share prices off 34% and 23%, respectively, from last year's highs. Both banks have dividend yields of 4% and trade at less than 10 times earnings.
Compare JPMorgan at 13 times earnings and Wachovia at 10. BNP Paribas is trading at 0.3 times revenue and Commerzbank at 0.5. The U.S. banks are at 0.7 times revenue.
Spain's Banco Santander is down 13% from its 52-week high. Over the long term it should benefit from a strong domestic retail network and a presence in emerging markets like Mexico, Chile and Brazil. Santander's British subsidiary, Abbey National, largely avoided the mortgage loan debacle and is one of only a handful of U.K. banks in a strong position to keep lending. That should allow it to cherry-pick the best clients, says Sassus. In April Santander also picked up the consumer finance division from the beleaguered Royal Bank of Scotland.
With the possible exception of the circumspect HSBC and Lloyds TSB, the rest of Britain's banks merit the same caution as their U.S. counterparts. Some, like Barclays and Standard Chartered, are expanding abroad, but most remain highly exposed to bad loans at home. Are the Brits nearing the bottom? "I wouldn't take that bet right now," says Sassus.
DON’T FRET ABOUT THE FED
“Don’t worry, be happy,” says Ken Fisher.
About as reliably as Yellowstone's Old Faithful geyser spouts, Ken Fisher can be counted on to tell people not to panic and look around for bargains when the stock market is tanking. Here he makes the good point that Federal Reserve tightening is no cause for fear -- for the very good reason there is not statistical correlation between Fed tightening (or loosening) and stock returns. He also has some reasonably priced, large capitalization stocks to recommend.
There is a spreading fear that we are in for a period of tightening by the Federal Reserve Board. It has gotten to be obsessive. On a recent round of New York media interviews, I encountered two almost unanimous views: that the Fed would hike rates later this year, and that Barack Obama would be elected President. Both events are viewed as all but certain, and as all but certain to do great damage to the stock market.
Put aside your fears. The market will recover.
It is presumed that increases in the Fed's target rate for overnight loans are bad for stocks because high interest rates make the future earnings from corporations less valuable today. But the connection is not so neat.
Since 1970 there have been eight stretches in which the Fed was tightening and eight in which it was loosening. These periods ranged from 6 months to 56 months long. Recently I made two tables, one showing stock returns (as measured by the MSCI World Index) over various periods beginning at the starting points of the tightening periods, the other showing returns beginning at the starting points of the loosening periods. The periods covered 3, 6, 12 and 24 months. I have asked both large audiences and individuals to tell me which set of returns was for the tightening times and which for the loosening. They have been stumped. There is no pattern. They look almost identical.
For example, 24 months after tightenings started, returns averaged a cumulative 16.9%; 24 months after loosenings they averaged 19.7%. But look at medians instead of averages and the results flip-flop to 18.1% for tight money and 12.4% for loose money. You cannot find any pattern over shorter holding times, either. Despite what your gut tells you, central bank action holds no useful information about where stocks are going.
In my May 19 column I detailed why you need not worry about an Obama presidency. Another observation: U.S. stocks do better than foreign ones (in dollar terms) in the last five months before a presidential election. Since 1928 this has happened 3/4 of the time. The advantage to domestic stocks, averaged over all 20 elections beginning with Herbert Hoover's, is 9.1 percentage points. And when it has not happened, the other quarter of the time, U.S. stocks have not lagged by much. When they have led it has been by more than 13%. Simple explanation: Markets dislike uncertainty, and uncertainty declines as Election Day nears.
No guarantee the pattern will hold in 2008, but that is the way to bet. Here are some U.S. stocks I like right now:
Dow Chemical (35, DOW) is the superbly managed largest chemical company in the U.S. When I first studied Dow in the early 1970s, it was number four, behind DuPont, Union Carbide and Monsanto. I have no doubt it will someday overtake BASF to become the largest in the world, yet its market capitalization is half BASF's. It is incredible that a firm of this quality sells at 60% of revenue, 12 times 2008 earnings, with a 4.5% dividend yield -- and below its price of one, three or 10 years ago. ...
Franklin Resources (96, BEN) is a natural market play, because as stock prices rise so does Franklin's revenue base. It is often wrongly thought of as an American me-too mutual fund firm. It not only is not, but it is the world leader in mutual funds sold outside the U.S., where it has built an amazing base, totaling 26% percent of its $591 billion under management. It has a great, capable chief executive in Gregory Johnson. It should be selling at more than its 12.5 times 2008 earnings.
Ball Corp. (48, BLL) is America's leader in metal and plastic containers for beverages of all types. Growing by gaining market share in an otherwise slow-growth field, Ball has morphed itself steadily in the last decade to stay where the opportunities are. The stock moves very much with the market and should do well in a U.S. stock rally. It sells at 70% of annual revenue and 12 times 2008 earnings.
Merck (36, MRK) and Pfizer (17, PFE) are too cheap. Evidently the investing world presumes that Congress will find some way to put an end to the prescription drug industry. The presumption is not justified. These great firms sell at ten and seven times 2008 earnings.
COPING WITH INFLATION
Lisa Hess has a few interesting ideas vis a vis the title subject: A way by which retail investor can short Treasury notes and bonds, and a couple of stocks of companies which are service suppliers to commodity producers.
When I ask friends who are not professional investors what question they would most like answered in a Forbes column, they all say pretty much the same thing. Is the outlook really that dire? Should the talking heads really frighten me so? Most urgently, What should I do now?
Not only ordinary people, but also officers of institutions and members of investment committees are asking those questions. It is obvious that the vast majority of us are off stride. Portfolios, excepting those of commodities, are not maintaining their purchasing power. It is now clear that the prices of materials and the cost of living will both be going up for a long time throughout the world. The U.S. Producer Price Index for May was 1.4% ahead of April and 7.2% ahead of the previous May. European inflation is the highest in 16 years. The Consumer Price Index for the first quarter in Japan was the highest in 10 years. Central banks are gearing up to fight the fight, but they are in a real bind. How do they maintain their credibility as inflation battlers when higher rates may send a weakened U.S., Europe or Japan into a tailspin?
Rather than freeze like a deer caught in the headlights, we need to reposition our portfolios to take advantage of this new world of rising input prices, rising inflation and uncertain monetary policy. Stocks and bonds both do poorly at such a time -- bonds because their prices go down as inflation forces up interest rates, and stocks because corporations have a hard time keeping their selling prices ahead of rising input costs.
One way to cope with this unpleasant environment is to take a short position in U.S. Treasurys. Institutions can do that easily enough in the futures market, but individuals are better off seeking a fund as the vehicle. ProShares offers two funds with bearish positions in the bond market, both with 2-to-1 gearing (meaning for every 1% move up or down in Treasury prices, the fund goes down or up 2%). One, the UltraShort Lehman 20+ Year Treasury (71, TBT), bets against the prices of long-maturity (over 20 years) Treasurys. The other, UltraShort Lehman 7-10 Year Treasury (72, PST), does the same for the 7- to 10-year part of the yield curve. You are betting that interest rates will rise.
I think that is a good bet. Treasury yields are depressed at the moment, in part because market volatility and crazy oil prices have investors yearning for the safety of a triple-A credit. But at some point savers will realize that the 4.8% coupon on a long Treasury scarcely makes up for inflation, much less covers taxes or provides a real return. Both of the UltraShorts are exchange-traded funds with 0.95% expense ratios.
Another way to reposition is by investing in companies that profit from the rising demand for commodities. I find commodities themselves far too volatile for the individual investor. When you bet on them you are competing with the largest companies in the world, which have employees standing in cornfields and climatologists running supercomputers. I recommend investing instead in businesses that supply services or technologies that are necessary for meeting rising commodity demand.
One such supplier is Titan International (38, TWI), which makes huge tires for mining and agricultural machinery. I wrote about Titan in my column of May 7, 2007. Another is Hemisphere GPS (3.75, HEM CN), a manufacturer of GPS and steering systems for tractors. Hemisphere's devices significantly improve productivity by enabling the farmer to maneuver his tractor with precision and thus save money on seed, fuel and fertilizer. Hemisphere has a market capitalization of $210 million in Canadian dollars and trades on the Toronto exchange at 38 times trailing earnings. That sounds expensive, but I think its earnings could double in each of the next few years. The widespread adoption of GPS systems for large-scale farming is inevitable.
A final idea would be to buy shares of American Commercial Lines (11, ACLI), a barge manufacturer. Besides making boats, it operates 2,700 of them, moving grain, coal, steel and chemicals along 1,500 miles of inland waterways. Flooding in the Midwest is a horror story for the barge transport business, with grains not getting to market and earnings taking a short-term hit. ACLI is selling at its 52-week low, having declined by 54% this year. Its market cap is $562 million, which is 13 times trailing earnings. Its enterprise value (market cap plus debt minus cash) is 7.5 times operating income (EBITDA, that is). Near-term earnings will undoubtedly be under pressure, so you need some patience. But still, the company is selling for less than the probable liquidation value of those boats. Sam Zell owns a quarter of it. He is patient.
TROUBLE IN JUNK LAND
Fixed-income money manager Marilyn Cohen does not understand why junk bonds currently trade at such a small premium to risk free (so called, anyway) Treasury bonds, given the macroeconomic outlook and the recent rise in bankruptcies. For those who insist on engagin in the search for higher yields, he does have a couple of ideas.
I am flummoxed. here we are, in an economic slowdown. Interest rates are heading up, bankers who lend are as scarce as hen's teeth and already there have been more corporate defaults than in all of 2007: Standard & Poor's counts 27 U.S. corporations defaulting on their publicly traded debt so far this year, versus 22 for all of last year. Many companies are struggling to make their payments, and several are covering their interest obligations by issuing additional bonds, so as to preserve their cash. Not a good sign.
Despite all of this, the spread between junk bond yields and Treasurys remains narrow. Look at either the Merrill Lynch High Yield Index or the KDP High Yield Index and you find a spread over 10-year Treasurys of 5.75 percentage points. That is slim recompense for the risk of participating in the next default. Corporations whose businesses are struggling have been on a slippery slope ever since the credit crisis began, with banks less interested in making loans than in fixing their balance sheets after suffering more than $396 billion in mortgage-related losses.
As if all that were not bad enough, consider how hard it will be to refinance the $13 billion in junk bond debt that matures this year, the $28 billion that matures in 2009 and the $45 billion in 2010. Markets can and do climb out of pits of worry, but getting out of this pit will not be easy. There is lender angst and buyer strain out there in junk bond land. That is why I think default rates will rise, putting pressure on long-term junk bonds and junk bond funds.
If you own exchange-traded funds in junk bonds, such as SPDR Lehman High Yield Bond (JNK), iShares iBoxx High Yield Corporate Bond (HYG) or PowerShares High Yield Corporate Bond (PHB), sell them. As for open-end junk funds, look at your funds' performance during previous high-default-rate periods -- 2001 to 2002 and 1990 to 1991. If they did well then, hang on. If there is doubt, get out.
I know full well that the hunt for high yields must continue. For those of you who demand extra yield and spread over Treasurys or government agency bonds, take a look at the following short-term bond recommendations. Be fully apprised of the underlying business problems and credit quality.
Ford Motor Credit (FCJ) 5.8% bonds, due Jan. 12, 2009: These junk bonds are rated B by Standard & Poor's and are on the precipice of a downgrade to B--. Ford Motor Credit has some risk, given its loan delinquencies and deteriorating profitability. In the first quarter it earned a measly $24 million, down from $193 million in the first quarter of 2007. Ford Motor's chief executive, Alan Mulally, recently confessed that the parent company's turnaround had hit some speed bumps and will not be done in 2009, as previously planned. That is bad news for the finance company, which has said it will not be profitable in 2008. Rising gas prices, rising steel costs and limbo-low consumer confidence have all landed blows.
If you can live with the negative news headlines, this short-term bond generates the extra yield you may be looking for. Priced at 97.50, it yields 10.74% to maturity. That is 8.67 percentage points more than the Jan. 15, 2009 Treasury bond. The $2.8 billion issue is large and liquid, and I believe both Ford and Ford Motor Credit will still be limping along in January, all the while making their interest and principal payments.
You may want to pop nitroglycerine for this next one, the General Motors 6.85%, due Oct. 15, 2008: The company is burning through roughly $2 billion a month; its losses appear never ending; its market share continues to deteriorate; its shares are at a 30-year low. Still, I believe you will get your money back in October. These bonds are rated B by Standard & Poor's and are at risk of a downgrade. They trade at 98.80 for a 10.94% yield.
My final recommendation is SLM Corp. 4%, due Jan. 15, 2009. SLM, the student loan company formerly known as Sallie Mae, has had its own set of credit headaches. It has been hurt by problems raising capital and cuts in federal loan subsidies. But it appears to be one of the survivors. The bonds, rated BBB by Standard & Poor's, are priced at 98.75 for a 6.24% yield to maturity. The issue size is $1 billion, so trading is liquid.
If you disagree with me and believe default rates will stay relatively low, then by all means stick it out with your junk bond funds. But after such a long period of lax lending standards, I think deteriorating prices are inevitable.
Investors who want the ultimate in safety should buy Treasurys. I would aim to buy Treasurys between three and five years in maturity, whose yields are between 3.25% and 3.55% -- not the highest yields, but certainly the highest credit quality.
BENCHMARK MORTGAGE BACKED SECURITIES AND THE SEC
Writing flood insurance at premiums insufficient to compensate for the risk works fine ... until the floods actually arrive. Similarly, it has been clear all along to anyone with an ounce of sense that making of low-downpayment mortgages and speculating in the derivatives created therefrom would only work as long as housing prices kept rising -- analogous to the rains staying away above. But that game is obviously over. And now, staying with the analogy, the rains have been coming hard enough, long enough that the houses above the historical flood plain high water mark are at risk. Quite a change.
Major losses are thus inevitable. The question is how they will be allocated. With no government interference the losses would be incurred by the home owner/equity holders and the mortgagor/debt holders. Of course without government interference this mess would never have occurred in the first place, so we are talking fantasy-land there. The sucker public will have some large percentage of the losses palmed off on it via taxes and inflation. Thank goodness for the SEC, whose contribution to the matter is to forbid the weather services from forecasting anything but sun.
This week [ending July 18] benchmark Fannie Mae MBS yields jumped 31 basis points, to an 11–month high of 6.15%. Spreads versus treasuries widened 18 bps to the widest level (206 bps) since the height of the crisis in March. Also this week, the SEC took an extraordinary step to tighten the rules for shorting the large financial stocks. These developments are not unrelated.
In JPMorgan Chase's and Citigroup's earnings conference calls, both major lenders this week noted deterioration in prime mortgages. This provides additional confirmation that the mortgage crisis is now reaching the bedrock of our nation's mortgage credit system. And particularly with the mortgage insurers, the Government Sponsored Enterprises, and the leveraged speculating community having come under varying degrees of stress, a tightening in "conventional" mortgages will now significantly exacerbate the mortgage/housing/financial/economic crisis.
In years past, I have occasionally used my fictional "town by the river" analogy to demonstrate how the introduction of inexpensive flood insurance and a resulting speculative boom in writing this protection fostered a building boom along the river. The financial (insurance, lending and speculation) and economic (building, asset inflation, and spending) aspects of the boom were interrelated and reinforcing. In my fictional account, the booms were further spurred by a drought that both inflated the profitability of writing risk insurance (attracting throngs of speculative players) and buoyed complacency for those living, building, and spending freely near the water's edge.
These dynamics set the stage for the inevitable dislocation in the flood insurance market. With the arrival of the first torrential rains, there was a panic as the thinly capitalized "insurers" rushed in a futile attempt to reinsure their risk of potentially catastrophic losses in the event of a flood along what had become a highly overdeveloped river bank. Few in the insurance market had built reserves, as most speculators simply planned on hedging flood risk in what was, at least during the time of the boom/drought, a highly liquid insurance marketplace. Worse yet, over time the pricing of flood protection had become grossly inadequate with respect to the mounting ("bubble") risks that had developed over the life of the financial and economic booms. Any reinsurance available during the crisis was priced prohibitively.
Back in 1990, when I first began working on the short side, there was an estimated $50 billion to $60 billion in the hedge fund community. The few of us actually shorting stocks were primarily focused on diligent fundamental company "micro" research and analysis. It was not until some years later that "market neutral" and "quant" strategies took the financial world by storm. And back in the early '90s the OTC (over-the-counter) derivatives industry was just starting to take hold. Today's Wild West CDS (credit default swap) marketplace did not even exist.
Nowadays, the "leveraged speculating community" is measured in the multi-$trillions. The derivatives market in the hundreds of $trillions. The scope of players and sophisticated strategies utilizing short-selling is unlike anything previously experienced in the markets. And similar to how drought magnified the boom along the river, it was the boom in leveraged speculation and derivatives that played the instrumental role in fueling self-reinforcing credit expansion and the resulting credit, asset price and economic bubbles. But those bubbles are bursting -- the torrential rains are falling and there is today extraordinary and overwhelming impetus to "reinsure" -- to offload -- the various risks that ballooned over the life of the protracted boom.
Many writing the multitude of types of market insurance incorporate "dynamic hedging" strategies. This means that few hold little in the way of actual "reserves" to pay in the event of major losses. Instead, they rely on "shorting" various securities that, in a declining market, will provide the necessary cash-flow to satisfy any insurance obligations. This all worked wonderfully in theory, and the basic premise of modern day risk hedging capabilities was supported by the nature of highly liquid boom-time financial markets. But "torrential rains" have a way of rapidly and dramatically altering marketplace liquidity. The reality is that entire markets cannot insure themselves again declines. Any attempt by a large swath of the marketplace to hedge exposure will be problematic. Selling will either immediately overwhelm the market or the "put options" accumulated as protection will create acute market vulnerability to self-reinforcing selling pressure and market dislocation.
Today, there is little liquidity in the securitization or corporate bond markets. So, the multi-trillions of strategies relying on shorting securities for hedging and speculating purposes have gravitated to the relative liquidity of U.S. equities. And, when it comes to hedging against or seeking profits from heightened systemic risk, one can these days see rather clearly how incredible selling pressure can come down hard on the 19 largest U.S. financial institutions. And when one considers the scope of derivative strategies that incorporate "delta hedging" trading dynamics -- where the amount of selling/shorting increases as the market declines (systemic risk increases) -- one recognizes the possibility of a marketplace dislocation along the lines -- but significantly more systemic -- than the "portfolio insurance" fiasco that fueled the 1987 stock market crash.
Importantly, this issue of acute systemic risk has taken a turn for the worst with the recent deterioration in the conventional mortgage market. The highly exposed GSEs, mortgage insurers, and leveraged speculators are positioned poorly to withstand a bust in prime mortgages. The fate of the U.S. bubble economy today rests on the ongoing supply of low-cost "prime" mortgages. Any meaningful tightening in conventional mortgage credit -- including the lack of availability of mortgage insurance, required larger down payments, and/or tougher credit standards -- would have a major impact on credit availability for core housing markets throughout the country (many that have thus far held together fairly well). Such a tightening would put significant additional downward pressure on prices, exacerbating already escalating problems for the GSEs, credit insurers, and speculators.
A TALE OF TWO DOWNTURNS
Not only is it easy to see how the British economy could sink into a recession much deeper than in the U.S., it is difficult to see how it can emerge from that recession to renewed prosperity.
While British commentators have been tut-tutting over the aftermath of the U.S. bubble party, they appear to not have been looking out their own windows. The British economic bubble was every bit as excessive as the U.S.'s, and has even less capacity to regenerate (believe it or not) some sort of dynamism. This is in part due to the fact that Britain's economy is even more (again, believe it or not) dependent on the financial industry than the U.S.'s. Martin Hutchinson explains, and also provides an interesting summary assessment of Margaret Thatcher's legacy.
British observers have in the last year indulged in a considerable amount of schadenfreude about the U.S. subprime crisis, the excessively expansionary monetary policy of Fed Chairman Ben Bernanke and the substantial recession that appears impending. They should be less eager to gloat. The recession into which Britain is heading is likely to be considerably more serious than its US counterpart, and the way out less certain.
One reason for Britain suffering a deeper recession than the U.S. is that its house prices got more out of line. Whereas in the United States, the house price to income ratio peaked at 4.5 times, against a long term average of about 3.2, in Britain in 2006 the house price to income ratio peaked around 5.5 times. Housing is more tax advantaged in the U.S., since mortgage interest payments are tax deductible unlike in Britain. Hence the equilibrium British house price to income ratio would appear to be about 3 times, marginally above the 2.7 times level of 1970, when the British housing market was close to equilibrium. That implies that an average fall in real British house pieces of 45% is needed to bring the market back into equilibrium, considerably larger than the 29% drop needed to bring the U.S. market into equilibrium.
Those figures may seem startlingly high but remember: The average Tokyo house price dropped by no less than 70% between 1990 and 2005, as Japan's 1980s stock and real estate bubble deflated. Thus a 45% drop is perfectly within the bounds of possibility. The U.S. housing market appears well on its way to the necessary 29% correction, with the Case-Shiller house price index already down 18% since late 2006. Conversely, the British market has only just begun to drop in price, with current national average prices down by no more than 5%. Hence the future economic effect of the housing downturn is likely to be considerably more pronounced in Britain than in the U.S.
There are however other reasons for believing that Britain is likely to have a deeper recession than the U.S., the principal of which is the different structure of the British economy. Not only is it more finance-oriented than that of the U.S., but its finance sector appears considerably more vulnerable, largely because of the lack of locally-controlled institutions involved in it.
One of Shakespeare's better-remembered lines, from Julius Caesar is:
“The evil that men do lives after them
The good is oft interred with their bones.”
For almost no political leader has this been so true as for Margaret Thatcher, thankfully still with us but surely watching in horror as the positive parts of her legacy disintegrate while her few mistakes return to haunt us in ever more terrible form. She cut back the size of the bloated British public sector -- but it is today larger in terms of GDPt than when she came to power. She brought a new assertiveness to Britain's relations with the EU -- but today the EU is forcing through a treaty that would be rejected by an overwhelming majority of the British people. With Ronald Reagan, she brought about the fall of Communism -- but today Vladimir Putin's Russia is as threatening to the West as any Soviet regime since Josef Stalin died, and we cannot even rely on the inherent contradictions in its economic management to weaken it. She brought a new self-discipline and self-respect to the British people -- but today the British people are as wayward and feckless as they have ever been. She more or less invented privatization -- but today that technique of extracting assets from the dead hand of government is little used, and the net British and global trend appears to be towards more state control, not less. She defeated the Trades Unions, an achievement that still stands -- but maybe they would have been defeated anyway by the forces of globalization and the disintegration of the British manufacturing sector.
As for her mistakes, we have been given a stark reminder this week of her first major political blunder, the 1979-80 Lancaster House settlement of Rhodesia/Zimbabwe. When she came to power, an internal settlement for that country had been achieved and a majority-population prime minister, the moderate and respected Bishop Abel Muzorewa, had come to power through elections agreed by international observers to be free and fair. All she had to do was ratify the process that had produced Muzorewa, regularize Rhodesia-Zimbabwe's independence, and provide a certain amount of aid and investment, and Zimbabwe would have become a beacon of relative prosperity in the continent and a staunch British ally.
Instead Thatcher succumbed to the politically-correct machinations of her feeble Foreign Secretary Peter, Lord Carrington and the incorrigibly-leftist Foreign Office, and forced a settlement that deprived the elected incumbent government of office and allowed the Marxist terrorist Robert Mugabe to intimidate his way to power. Mugabe has been there ever since, representing no sort of democracy and driving his terrorized populace into ever greater misery and penury. Seldom if ever has political feebleness brought such catastrophic results -- none of which have accrued to the prime minister responsible or the electorate that chose her expecting better.
Thatcher's reorganization of the City of London by the Financial Services Act of 1986 is likely to produce fewer actual fatalities but in the long run may be even more damaging, at least economically. It was designed on a wholly fallacious theory that London's financial "playing field" should be leveled, in order to produce a more competitive marketplace. It abolished market structures that had worked well for close on 300 years, replacing them with an inferior copy of the structures prevalent in New York. It was implemented shortly after a decade in which the British merchant banks had been devastated by recession and near-hyperinflation, so that in real terms they were a quarter the relative size they had been in 1970. The result of removing the market mechanisms with which local houses had been familiar and subjecting them to fierce competition from much larger foreign banks (who themselves remained protected in their domestic markets) was inevitable. Within 15 years of the Act's passage the London merchant banks were not merely foreign-owned but non-existent. It was the most suicidal British economic legislation since the 1846 Repeal of the Corn Laws.
The long-term damage to Britain's economy caused by the 1986 Act has been a generation in arriving, but appears now to be upon us. At the 20th anniversary of the Act's implementation in November 2006 there was much bien-pensant rejoicing, with declarations that the City and Britain in general were incomparably more cosmopolitan and better off as a result of it. As we now know, that rejoicing was premature, since the anniversary coincided almost precisely with the apogee of the financial services bubble that has since so damagingly begun to implode. The fancy bonuses achieved by the remaining British bankers, kowtowing vigorously to their masters in Frankfurt, Paris, Zurich or New York, are unlikely to be matched again for at least a couple of decades, if ever.
It seems most likely that the financial services industry, which approximately doubled its share of world value added between 1980 and 2006, will shrink back to somewhere close to its original size. Many of its "innovations" such as securitization turn out to have had fatal flaws in their incentives design that produced aberrant and in some cases criminal behavior by participants. Global overcapacity in the sector is likely to reduce both individual remuneration and the fees charged by financial institutions. The multi-tiered investment management business, in which many funds were distinguished solely by the splendor of their fee structures, is likely to shrink back to a modest economic activity that competes mostly on price. A return to much tighter monetary policy and real interest rates well above zero will greatly reduce the amount of loose money sloshing around the world looking for a home.
Britain is likely to be more deeply affected than the U.S. by a prolonged implosion in the financial services business for three reasons. First, and most simply, it is a more important part of the British economy, and its decline will cause more difficulties in the London real estate market, up-market retailing etc. than will the equivalent decline in New York. Second, Britain has more or less hollowed out its manufacturing industry. We are already seeing some of the effect of U.S. resilience this year: As the financial services business gets into greater difficulty and the dollar declines, manufacturing companies such as John Deere are able to take advantage of the weaker dollar and high commodity prices to expand their businesses at a rapid rate. Britain has few such opportunities.
Finally, Britain will suffer an additional recessionary effect from the "branch-plant" nature of its remaining financial services business. Asian finance is already moving increasingly to Asia, since London is in reality little more convenient than New York to carry it out. U.S. finance, to the extent it has migrated to London, will migrate back to New York, since skilled staff will be available there in profusion as the business shrinks. Only the slow-growing EU and maybe some Middle East business will remain in London. However, other European financial centers and Dubai are keen competitors in those areas. To the extent the Middle East remains a viable economic region once oil prices decline, it will probably want to carry out its own financing, and the same will be true of the other major European countries. With few significant domestic institutions, London's global market share is thus headed sharply downwards, reducing employment opportunities and revenues even beyond the effect of the shrinkage in the financial business generally.
Not only is it easy to see how the British economy could sink into a recession much deeper than in the U.S., it is difficult to see how it can emerge from that recession to renewed prosperity. Certainly a revival of London's historic position as a financial services entrepot seems highly unlikely.
That historic position was based on a financial dominance that has, of course, long since passed. In the end it is hard to see why London's financial position should be much larger than, e.g., Germany's.
Infrastructure rehabilitation has been mentioned as an investment theme multiple times on these pages over the years. The deteriorated state of U.S. infrastructure is indeed obvious, but that state is no accident. It gets financed publically and thus is subject to the vagaries of the political process. Martin Hutchinson, in his typically erudite manner, explains the issue in detail. We would hazzard that infrustructure will become a priority in the same way that all government priorities get set: It will get attention when there is a crisis, and otherwise be ignored as long as possible.
Both the Economist and the Washington Post have recently denounced the poor state of U.S. infrastructure. It is obviously becoming fashionable to do so. However, much of their criticism is ill-founded. Infrastructure failures are inevitable because infrastructure decisions have become politicized and suffer from the results of that politicization. Infrastructure investment has thus become a particularly economically inefficient area, the reform of which would add greatly to national and global wealth.
When the Duke of Bridgewater built the Bridgewater canal in 1758 to transport coal from his mines at Worsley to newly industrial Manchester, he did not need political permission to do so. Neither did he raise outside capital. The canal was financed out of his own resources. Hence his own entrepreneurial judgment that money could be made from the canal was the sole factor in his decision. His investment was spectacularly successful. The price of coal at Manchester dropped by 3/4 within a year after the canal was completed in 1763. The canal operation remained a profitable independent company until being sold to the Manchester Ship Canal (also private) in 1885 -- the canal itself remains active to this day.
Since around 1900, most infrastructure investment has been financed by the public sector. This has introduced a number of additional complications that the Duke of Bridgewater did not need to consider. Politicians are elected on a short term electoral cycle, so long-term projects have little appeal -- even the modest-scale Bridgewater canal took 5 years from conception to completion, longer than most electoral cycles. Much of their power comes locally, so projects that benefit several jurisdictions are difficult to get off the ground and small projects benefiting only the immediate community are preferred.
Politicians are also almost entirely ruled by popular fashion. Thus in periods when infrastructure is fashionable, say 1920-1960, it is built in great profusion (think for example of the complex spaghetti of poorly planned, poorly integrated and environmentally destructive highways built by New York's Robert Moses during that period). Conversely in periods such as that since 1970 in which environmentalist and "not in my backyard" [NIMBY] objections have been given priority, infrastructure spending is neglected.
As an example of how this works, consider the state of Connecticut. Connecticut benefited enormously from the first wave of suburbanization. It already had the New Haven Railroad in place and no state income tax, so until 1980 it filled up rapidly with the more affluent toilers in the New York metroplex. The Hudson Valley had equally good infrastructure, in the form of the local rail line, but its towns of Ossining, Peekskill, Beacon and Poughkeepsie were blighted by the remnants of earlier industrial development; and in any case it did not offer wealthy New Yorkers the same tax benefits as Connecticut.
The downside of having no income tax was that the state was always short of money, and so built infrastructure less aggressively than New York. It also made the mistake of attracting financial services company headquarters to Stamford, and then building no road infrastructure to support them -- in the 1980s, when the major influx occurred, it still had no state income tax, and was attempting to maintain a Massachusetts level of social services on a New Hampshire tax base.
Connecticut voters foolishly elected Lowell Weicker, a leftist independent as Governor in 1990, and as a result they were saddled with a state income tax but no improvement in infrastructure. (The Democrats had been terrified of introducing a state income tax themselves for fear of facing the wrath of the voters.) Nevertheless, Connecticut's state income tax remained lower than New York's, and its suburbs of Greenwich and Westport in particular were highly fashionable, so in the late 1990s and onward it attracted large numbers of hedge fund managers, who found they could carry out their nefarious but profitable activities from the comfort of Connecticut, without the bother of commuting into Manhattan.
The result of economic growth without infrastructure provision has been gridlock, more or less permanent except at 5:00 a.m. Sundays, on the Connecticut Turnpike between Greenwich and New Haven, a distance of 45 miles. Even outside the rush hour, it can take about 2 1/2 hours to navigate the Turnpike, which now runs at over 200% of "capacity." There are few alternatives available, since Connecticut has built a maze of small highways that may serve local voters but do not go anywhere and relieve little if any of the congestion in East-West traffic. The cost of this gridlock is immense, not only in the time of drivers but in the additional environmental damage caused by hundreds of thousands of vehicles proceeding in low gear for several hours.
The solution is simple if you look at a map. Indeed it was contemplated by Moses half a century ago, even before the Connecticut Turnpike was completed, when he built the Sunken Meadow State Parkway across Long Island with a spur facing Connecticut. However even Moses, a Yale graduate born in New Haven, could not get the Connecticut state government to cooperate, so he doubtless ground his teeth in frustration and proceeded to demolishing more of the South Bronx. Connecticut needs to be connected to Long Island by a bridge, and connecting highways and another bridge need to be built linking Long Island to New Jersey.
The principal purpose of such construction would be to allow traffic to move from New England to the Mid-Atlantic states without having to drive 270 degrees round New York, a city that is particularly awkwardly situated for modern road traffic. A bridge could be built west of New London to the tip of Long Island, crossing 12 miles of water, from East Haven, crossing 20 miles of water (but connecting conveniently with Connecticut's meager north-south road network) or from Fairfield to Moses's Sunken Meadow State Parkway, covering 14 miles of water. At the New Jersey end of Long Island, a bridge from Rockaway Point to Sandy Hook would cross only 8 miles of water. Short links would connect the Connecticut bridge terminus to the Connecticut Turnpike, the New Jersey terminus to the Garden State Parkway (or a longer link to the New Jersey Turnpike) and the Long Island termini to the island's extensive road network.
Constructing such bridges would not be particularly difficult or expensive -- the waters to be crossed are much shorter than that crossed by the Chesapeake Bay Bridge-Tunnel, completed in 1965, let alone the Channel or Seikan tunnels. As well as removing the 110 mile New York circuit for long distance north-south travelers, the bridges would relieve the Connecticut Turnpike of most long-distance traffic, allowing the remaining locals to enjoy their gridlock in peace. They would also free Long Islanders from long-term imprisonment, allowing them to visit the rest of the United States without driving through New York.
Such a project would be dear to the heart of the Duke of Bridgewater. However it is unlikely to proceed because it cuts across the jurisdictions of three different states, would take a decade to build and would run into enormous opposition from various local interests, as well as from environmentalists who would have six different court systems and five appeals courts in which to harass it. Senator Barack Obama has proposed a $60 billion infrastructure fund at the federal level. This project would be an obvious candidate for such a fund, but is unlikely to fare well there because of the diffuse nature of its beneficiaries -- even at the federal level it is easier to fund "pork" in a single district, so the local Congressman gets the benefit.
The other and better way to fund infrastructure is through the private sector. This only began to be squeezed out by public sector financing with the success of the Erie Canal, financed by New York State guaranteed bonds in 1817-25. From roughly 1930 to 1980, public sector financing was assumed for all major infrastructure projects, since the state was able to borrow more cheaply than the private sector. In addition, private sector finance, which had focused largely on debt through the 19th century, from the 1920s onwards focused increasingly on equity, a very expensive means of financing infrastructure needs. However after 1980 the increasing popularity of the private sector and budgetary constraints in the public sector swung the pendulum back towards private finance.
The ideal infrastructure finance involves both debt and equity, with the equity used as a cushion to provide assurance that the debt will be repaid. That should be readily available in a universe that includes junk bonds. The problem is that infrastructure brings only long term returns, which are generally fairly low but very secure. In addition, political harassment can hugely increase the cost of even the simplest infrastructure project, primarily by delaying it.
The Eurotunnel project, which ran so far over its cost estimates it was eventually forced to declare bankruptcy, is a prime example of an infrastructure financing gone wrong. It required agreement on even small details between two governments and two public sector rail operators. Its form, a rail-only tunnel, was chosen for political reasons when a road bridge was clearly economically preferable. Finally, it was selected through the kind of public sector bidding process that almost always results in costs running astronomically over the heavily massaged estimates that win the bid.
Even with the relevant governments lined up, private finance for infrastructure today is questionable, because of the excessively short-term orientation of most financiers. The infrastructure specialist Macquarie Bank's approach, in which the project arranger extracts a high return quickly through financial engineering, works only when the investor takes over existing infrastructure in return for an up-front payment to the seller. The Macquarie structure can be very attractive to local governments with aging infrastructure and urgent budgetary needs. It is no solution when more than minimal new construction is involved.
There is however a natural match between the long term modest but fairly certain returns of infrastructure projects and the long term investment requirements of life assurance companies and pension funds, which have a need to diversify their assets beyond stock and bond markets. Rather than investing fiduciary money in fly-by-night short term operators in hedge funds and private equity funds, such institutions should form consortia to hire engineers and undertake infrastructure projects directly. As representatives of thousands or even millions of life policyholders or pensioners, they would have the political clout to deal with recalcitrant local governments. For them, infrastructure projects would provide that ultimate diversification: long term returns that were inflation-protected and independent of stock and bond markets, though not of the economy overall.
To build better infrastructure, we need superb engineers and sober, long term oriented, moderately paid fiduciaries. Not expensive fast-buck financiers and not governments. The problem is one of U.S. economic structure, and it urgently needs to be solved.
Fast-buck financiers and governments are one thing the U.S. has in abundance, and the demand for them on the export market is modest despite the cheap dollar. Thus we see the problem.
CRUDE OIL: DRILLING FOR OPPORTUNITY
On July 11, a perfect fundamental bullish storm SHOULD HAVE sent crude prices to the moon. Instead ...
Just as the oil market looked like it was going to the moon it broke down. Why? Internal market dynamics are the only reason, say the Elliott Wave International analysts. Whether this is a sharp correction or the end of the mania is a subject for another day.
July 11, 2008 was the unofficial D-Day for the Crude Oil market. "D" -- as in, DOWN. From that most recent peak, oil prices have plummeted more than $20, to a two-month low -- a severe sell-off that has also included the steepest drop in dollar terms since the Gulf War (circa 1991).
However, the most shocking incident of July 11, 2008 was not its launch of crude's latest slide. It was the fact that on that particular date, a perfect bullish fundamental storm blew in over the oil market that should have -- by all mainstream logic -- sent the energy market soaring to the moon.
Off the top are these memorable July 11, 2008 events:
Not to mention escalating tensions with Iran AND the onset of the 2008 Hurricane Season with tropical storm Bertha. YET -- instead of rocketing into outer space, crude oil has fallen back to earth.
- The Dow Jones Industrial Average plunged below the psychologically important 11,000 level for the first time in two years.
- The U.S. Dollar skated south to a 3-month low before hitting bottom on July 15.
- Gold prices (Oil's alleged "safe-haven" partner) rocketed above $940-, $960-, and $980 per ounce before turning down on July 15.
- And, two powerful blows pummeled the U.S. economy -- i.e., the largest regulated thrift to fail in U.S. history (IndyMac Bancorp) and the downgrades of Fannie Mae and Freddie Mac.
Elliott wave analysts know that NO single outside factor will change the internal course of a financial market's major trend. And, on the very day of Crude Oil's recent slide, the July 11 Daily Futures Junctures "Weekly Wrap Up" segment went on high alert to the market’s downside potential via the following price chart. (Some Elliott wave labels have been removed for this publication)
The action since then speaks for itself.
CHIPOTLE MEXICAN GRILL: BEWARE THE VALUE TRAP
The general idea of a "value trap" occurs when a stock falls substantially and looks cheap, except that earnings and other supporters of value are falling as well, making the stock not so cheap after all. Part of the implication is that the stock was substantially overvalued before, relative to now-revealed sustainable sustainable earnings levels, so all the price decline has done is bring it out of the stratosphere rather than into value territory. Moreover, value is value and should not be confused with price. So if one simply ignores a stock's price history one is far less likely to fall into this "trap."
The area the concept applies most clearly to now is with financial stocks. They have taken a severe tumble. The price-to-book value ratios start to look a lot more reasonable versus before ... except that with loan value writeoffs those book values are falling -- and sometimes collapsing, as one can see from the resulting news about bankruptcies, closures, and bank failures. Less dramatically, many companies who depended on discretionary consumer spending are finding that previous sales and earnings are not sustainable. A recent report by Morgan Stanley outlined concerns for the entire retail industry, and cited Chipotle Mexican Grill among a "fading five" stocks which it though destined to fall further in price. Now the stock has already fallen from a (ridiculous) high of 155 to below 80 currently. This is arch-typical Wall Street: Where were they then!? But the writer of this piece agrees it has further to fall. In fact he has put his money where his mouth is. He has a short position in the stock.
Shares of Chipotle Mexican Grill, Inc. (CMG) continue to trade lower as prospects for the overall economy become dim. The most recent catalyst for a lower stock price was a report offered by Morgan Stanley, which outlined concerns for the entire retail industry. In the report, Morgan named five stocks dubbed its "fading five" which were likely to see lower stock prices. The five names were Abercrombie & Fitch Co. (ANF), Nordstrom, Inc. (JWN), Chipotle Mexican Grill, Inc. (CMG), Sears Holding Corporation (SHLD), and Best Buy Co., Inc. (BBY).
One of the temptations during a bear market is to find beaten up stocks that are good values. The problem is that often good values become even better values as prices continue to drop due to investor fear, declining earnings, and sharply lower equity multiples. This scenario is often referred to as a "value trap" in which unscrupulous buyers become convinced that lower prices are indeed better values for companies they wish to own.
While a bear market is certainly an excellent time to pick up stocks [cheap], good timing can make the difference between the "trade of a lifetime" and slow, frustrating financial death. Besides timing, leverage is also a very important factor. If you want to get the most bang for your buck, it is very easy to rationalize buying a depressed growth stock on margin (borrowing half of the value of your purchase). However, this is a recipe for disaster as even a 20% loss in the stock will cut out almost half of your capital and likely trigger ugly margin calls. If you are correct in picking up a stock at the low, it is probably not necessary to use margin as the returns on the stock by itself will likely be very strong. The danger far outweighs the additional benefit.
CMG strikes me as a name that is likely to suck in bargain buyers. I have felt tempted myself as gains from being short the name have accumulated. Out of discipline, I have covered a portion of my short sale to book some profits, but more than half of the short position still remains on my books. Food inflation still remains a significant factor as the company struggles to keep its costs under control. The employment picture in the U.S. is not pretty and that causes less in the way of discretionary spending.
These factors alone are concern enough, but with CMG trading at more than 20 times estimates for 2009, the stock seems to be pricing in an overly optimistic picture for the restaurant company. I would caution growth stock buyers to steer clear of this name until the multiple is much more of a bargain, and the earnings picture becomes clearer.
Simply and reasonably stated. There are many other stocks out there to which the same logic could be applied.
LEHMAN: THE END GAME
Back to financials ... Lehman Brothers' stock price has fallen from 68 or so to below 20, which is way below its official book value. But that book value is largely fictitious, with the company being tremendously leveraged and many of its assets consisting of credit bubble detritus whose value is closer to zero than current nominal accounting value. This article, another short sale idea, goes into detail.
But note that with short sales timing isn't everything ... it's the only thing. The stock subsequently spiked up 50% from the price at time of publication -- perhaps on its way to zero, but that is a lot of short term pain if the timing was off and the capital committed large. Behind the spike was the commencement of an SEC inquiry seeking to discover who contributing to the collapse of Bear Stearns and the huge drop in Lehman Brothers' stock price.
One wonders whether this piece of analysis by a speculator (and the cited analysis of well-known short seller David Einhorn) who is short Lehman will be on the SEC's no-no list in the future. After all, does it not hurt "confidence" in the financial markets? Truth is no defense when it conflicts with the state's agenda.
What is the market telling us about the outlook for Lehman Brothers (LEH)?
On the credit markets, the company's CDS [credit default swap] spreads for its senior debt was trading last week at around 400 bps, very close to the peak reached during the Bear Stearns (BSC) crisis and trending higher. This is indicative of "stress," although not yet of extreme distress (i.e., elevated likelihood of default). Clearly, if it were not for Lehman's access to the Fed's discount window, these spreads would have been much wider, or, quite possibly, LEH could have failed by now.
The equity market is sending a different message: The stock, at about $12.4, results in a P/B of 0.36, which probably indicates that the firm is beyond the point of no return. The equity market is telling us that LEH will likely not be able to continue as a going concern.
In Roger Lowenstein's excellent book When Genius Failed, he recounts an incident when John Meriwether disclosed to a friend that LTCM was down 50%, and his friend told him, "You are finished" -- the friend's argument being that, if a fund has gone down that much, people believe it can go down all the way. Trust is gone, margins will be called, redemptions will come in, and it becomes a self-fulfilling prophecy. The same principle holds true for a financial institution, and that is the predicament that Lehman Brothers is in today, even with access to the discount window.
Joining the credit picture and the equity picture, it emerges that the market does not seem to be incorporating an imminent collapse, but that likely there is no medium-term viability for the firm as a going concern. In other words, the expectations seem to anticipate that there will be an orderly, gradual unwinding of Lehman Brothers supported by the Fed promise (or actual supply) of liquidity, where shareholders likely get wiped out (or close to it), and senior lenders are likely to recover most of their money.
I certainly believe more in what the market is saying about LEH than what Dick Fuld, Bernanke, or Paulson are saying. In Lehman's case, I am, however, more pessimistic than the market. I think there is a good chance that the unwind might be less orderly and end up with a classic run on the bank and bankruptcy for the institution (with a 60% likelihood).
In my view, the lack of viability is clear from these factors:
More importantly, there is the embarrassing loss of face from management mistakes and the revelation of lack of candor and questionable accounting practices from the firm's management. This is really what has wounded the institution mortally. There is no recovery from this.
- the very low price-to-book value of 0.36
- the 83% fall in price since October
- the fact that it is the smallest of the bulge-bracket investment banks
- the fact that they have the most relative exposure to domestic fixed-income markets of the bulge market firms in general and residential mortgages in particular (with about $60 billion of commercial and residential real estate, as of May 30, 2008, including about $12 billion of Alt-A toxic garbage -- a business they got into in the late 1990s with the acquisition of BNC), and the most absolute dollar exposure to commercial real estate
- recklessly high levels of leverage (even after finally reducing leverage in the last quarter to about 25 to 1, which is still way too much), as all other such firms have, and a lot of assets in Level III, valued at over 1.7 times equity
Consider the following:
What could tip Lehman over?
- Until the Bear Stearns crisis in March, the firm seemed to be weathering the crisis well, like Goldman Sachs. This was surprising, considering their high domestic fixed-income and mortgage exposure. This could be driven by (1) excellent risk management or (2) being less than forthcoming in writing down assets. It would have been easier for Lehman's management to pull off the latter than at Citi, UBS, Merrill, or Morgan Stanley, because its CEO has been on the job for over 20 years and had much more leverage over the board and any internal checks and balances than the CEO's in the other institutions. In the other institutions, particularly the ones where the CEO was eventually replaced, the new CEO has all the incentives, for obvious reasons, to write down bad assets as soon as possible and seek to move on. The suspicion increased with the tremendous lack of quality of Lehman's Q1 2008 earnings, where substantial gains resulted from marking to market its liabilities (a bizarre result of a rule that allows a firm to recognize accounting gains resulting from a deterioration in its credit profile); and (so it seems), where they have not appropriately written down sub-investment-grade structured securities; and where they, inappropriately it seems, wrote up Level III assets. Only under extreme scrutiny of their statements by a short seller with a strong reputation, David Einhorn, the company admitted that it needed to raise more capital and recorded its first-ever loss since its IPO over 20 years ago.
- The company was increasing its leverage all the way up until the Bear Stearns collapse. For example, in the first quarter Lehman added over $80 billion in assets, and, amid falling mortgage markets, it increased by about $2 billion its holdings of Alt-A loans (mortgages made to borrowers who are less than prime and cannot provide evidence of their income). "We saw a great opportunity," Lehman's then-CFO Erin Callan said on March 18. This is a clear sign that they completely misread the markets and thought that doubling down and window dressing would get them through this crisis.
- The firm increased its dividend when it needed to bolster its capital position at the beginning of the year. By this time, they must have known better. Was this was an attempt to show defiance and mislead the market? Again, a serious misread of the severity of the crisis: They did not seem to realize that this was the real McCoy.
- Lehman was aggressive in tapping the Fed's "lender of last resort" facility for broker dealers. In fact, Lehman was so "creative," that in March they created a $2.8 billion "Freedom CLO" out of leveraged loans that could not be readily sold to investors ... for the express purpose of meeting the Fed rating requirements for collateral. That the Fed went along and accepted this junk as high investment-grade collateral is shocking.
- Last month, at the same time it admitted that it will likely need to raise new capital, Lehman decided to use precious capital to (in my opinion) manipulate its stock price by buying its own shares. Some analysts in the market saw this as a positive sign. This is unbelievable. It is very easy to show "confidence" in the future of the firm with other people's money. If Dick Fuld were to step up and put a substantial portion of his net worth in the stock of the company, then I would agree that that would be a positive indication; however, he has not done so.
- At a time when it needed to conserve capital, Lehman very recently invested $1 billion in R3, a hedge fund started by employees who departed the firm to form it, which is based at Lehman Brothers' facilities, and which has bought $4 billion of assets from Lehman. This is eerily reminiscent of Enron. If all of these are arms-length transactions, how can Lehman justify investing $1 billion in a hedge fund under its current conditions?
- It seems that the firm may have employed deplorable tactics last month, doing what appeared to be selective disclosure of material information through the leaking of an "internal memo" about its reduction of leverage. Such practice would be against SEC regulations.
At this point, Lehman has no option but to continue to deleverage itself, although this raises doubts about the assets that were not sold. Is this an approach of selling what they can and keep what they cannot sell?
Lehman has no real trade-sale alternatives: Band of America and JPMorgan have already done large and potentially disastrous acquisitions. Goldman is too smart to fall for it.
It is also very doubtful that Lehman would be able now to tap into the equity markets, with investors having poured over $300 billion into financials and licking their wounds. The New Jersey investments division, which was one of the key investors in Lehman's most recent, $6 billion, equity injection, closed last month, has lost well over 50% of its investment (they came in at $28).
I have great intellectual respect for Bill Gross of PIMCO, so I was surprised last week when he apparently indicated that there were no concerns about Lehman's solvency as long as the Fed window is made available. The problem is that the Fed window is not unconditional and may be withdrawn. The company does have substantial liquidity, but solvency is a different question. The fact that the Fed has opened the discount window does nothing for Lehman's solvency, which only exists if the market value of assets exceeds the market value of liabilities.
The collapse of IndyMac (IMB), which was a federally insured savings bank, and therefore had access to the discount window, proves that even with this access, a collapse is possible. The Fed, in theory, should only provide liquidity to solvent entities. If it becomes obvious that the company is insolvent (for example, because of a bank run, as was the case with IndyMac), the Fed may stop throwing money at a black hole. Nouriel Roubini recently, brilliantly, explained how such a collapse could happen (read his 6/27 piece, "The delusional complacency that the 'worst is behind us' is rapidly melting away ... and the risk of another run against systemically important broker dealers"). If LEH counterparties believe that the company is insolvent, then they should fear that the Fed could stop providing the "last resort" loans.
Ironically, as the authorities work on rules to handle the liquidation of large or systemic broker dealers and work to bring the credit derivative market under a clearing house mechanism, this could increase the likelihood of a Lehman failure as the financial system will be better ready to withstand it.
The Fed and particularly the Treasury have been indicating concern with moral hazards and may soon be ready to have a sacrificial lamb to establish their hawkish credentials.
At the end of James Thurber's, well, Thurberesque, short story "If Grant Had Been Drunk at Appomattox," Grant actually ends up surrendering to Lee, with words something like (this is strictly from memory): "Well we almost licked you. And if I had been sober we would have licked you."
Down the line from now we might be saying, "Well Lehman almost failed. And if the authorities had been sober, it would have failed." The government has a lot riding on keeping Wall Street Finance, as Doug Noland calls it, around in some form -- not the least its own funding stream. This might involve propping up Lehman, and rubbing the short sellers' faces in the mud in the process. This, to us, is the biggest danger in committing real capital in line with this piece's analysis.
TWO SCHOOLS OF THOUGHT
There are two ways of studying economic theory: the academic theoretical way and the right way.
Academics of the academy and acting in policy advisory capacities, as exemplified by Federal Reserve Chairman Ben Bernanke, almost uniformly failed to anticipate the current troubles. Economic historians, which include the largely non-quantitative Austrian economists, all foresaw that the current problems not only likely at some point, but virtually inevitable. William Rees-Moog points out that this is the difference between theory and experience -- not unlike the difference between an adolescent and an old man.
There are two ways of studying economic theory. One approach is mathematical, and has been much enhanced by the computing power available to the individual economist. The other is historical and relies on the accumulated understanding of economic theory and practice.
The events of 2007 and 2008 have shown the limitations of the mathematical method. The credit crunch was not foreseen by anyone that I read, but it came as a shock to the number crunchers -- it took them completely by surprise.
It did not come as a shock to the economic historians, who happily settled down to discuss the resemblances between this credit crisis and earlier ones, going back to the South Sea Scheme in 1720 or the Wall Street Panic of 1907. The economic historians know that similar events had happened before, and had also learned, often by painful experience, that such events are quite common.
Neither group foresaw the actual events of August 2007, but the historians were quite able to put the credit crisis in a context of other crises. Even though both groups were taken by surprise, it was the mathematicians whose previous forecasts were stood on their heads.
By and large, historical economists, who follow the example of major English economists such as Maynard Keynes or W.S. Jevons, do not regard timing as any more predictable for economic shocks than for earthquakes.
One can say that there is a build up of stress in the system that will eventually have to be released. One cannot say that the release of pressure will occur next Tuesday or next August or even next century.
Some say the big earthquake will happen along the San Andreas Fault in California. It may come tomorrow; it may come before 2050; it may not happen for 500 years. We can usefully predict what and where, but we can very seldom predict when. This makes expectation difficult to quantify, though all markets are based on expectations.
What we do know from economic history is that there is a cycle of debt that has to be relieved. In 20th century history the war debts of the first war played their malign part in the European depression of the 1920s and eventually in the Great Depression of the 1930s. The Austrian School of Economics, and particularly Friedrich von Hayek, developed the Debt-Deflation theory of the business cycles. Hayek indeed foresaw the risk of a deflationary crisis as early as 1927.
Keynesian economics, as expounded in his General Theory, 1936, were criticized at the time for an inadequate appreciation of the negative aspects of excessive debt. Bankers of the Gold Standard era attached great importance to the balance sheet rather than the profit and loss account. I get the impression nowadays that people read the current account much more carefully than they do the capital account -- partly because they think that off balance sheet financing has reduced the transparency of the balance sheet itself.
As a result, government balance sheets, bank balance sheets, corporate balance sheets and personal balance sheets have all deteriorated. Finance ultimately depends on the security of capital, and weak balance sheets, at any level, are exposed to risk and to problems of opportunity cost.
An old-fashioned banker would now be calling for strengthening of balance sheets at every level. But the liquidation of debt takes years to accomplish and diverts fund from current consumption. The 2007 credit crunch calls for liquidation of debt, but that is bound to have a deflationary effect.
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