Wealth International, Limited (trustprofessionals.com) : Where There’s W.I.L., There’s A Way

W.I.L. Finance Digest for Week of August 4, 2008

This Week’s Entries : This week’s W.I.L. Offshore News Digest is here.

August 4, 2008

Government throws gasoline onto the defaulting mortgages fire, turning a $5 trillion problem into a $10 trillion fiasco.

To no one's surprise, Peter Schiff is critical of the Freddie Mac/Fannie Mae bailout. Beyond the polemics one expects from Schiff is his sobering assessment of the consequences of the bailout. For example: "Paulson's Bazooka will be locked and loaded with enough fire power to blow what is left of our economy into the dustbin of history."

As Schiff points out, the bottom line is that trillions of dollars were borrowed and spent that will never be repaid. Those loans were once assets on someone's books and now have to be written down. The question is whose balance sheet ultimately gets to absorb the writedowns. Naturally the politically connected want to pawn their losses off on others, especially the ever-suffering public. Since politicians can never just honestly admit what they are doing they have to cover their crimes with some kind of "public interest" or "greater good" story. If the dissembling had no cost that would be one thing, but instead we get the spectacle of blowing $10 trillion in order to partially spare the unlucky and idiotic from $5 trillion in losses. Intelligence personified. A trillion here, a trillion there ... pretty soon you are talking real devastation.

With President Bush no longer threatening a veto, the subprime mortgage and Fannie and Freddie "bailout" bill is now sailing through Congress. In anticipation of its enactment, Congress had the foresight to raise the national debt limit to $10.6 trillion. Who says that politicians do not plan ahead?

Once signed into law, the budget busting legislation will hand the Administration a blank check to prop up the ailing home lenders. The ultimate cost is anybody's guess. I believe that the price tag will be higher than just about anyone imagines. Paulson's Bazooka will be locked and loaded with enough fire power to blow what is left of our economy into the dustbin of history. Though the government and Wall Street assure us that these bold moves will save the housing market, and the economy as a whole, from collapse, the reality is that the solution is far worse then the problem. As painful as the failure of Freddie and Fannie would have been, bailing them out will hurt even more. In other words, it is not the disease that will kill us but the cure.

Ironically, while government is rightly criticizing mortgage lenders for ditching lending standards during the boom (well after the horses had left the barn) the new law will actually encourage lenders to be even more reckless then before. By taking all of the risks out of mortgage lending (provided of course that the loans are conforming), the government is telling lenders not to worry about the loans they make, because if borrowers do not repay, the government will.

Since this bailout eliminates all market based deterrents to reckless lending for conforming loans, the only checks remaining will be those imposed by Freddie and Fannie themselves through the criteria they set for those loans. And although they have taken some steps over the past few months to tighten their minimal "standards", the political agenda behind the bailout will cause this nascent effort to lose steam. In essence, the government's main goal is to prop up home prices. Since American homes are still overvalued given the fundamentals, their prices can only be pushed up with reckless lending and inflation.

As a result of this bailout bill, the share of mortgages owned or insured by Freddie and Fannie will likely swell from near 50% today to over 80% within a year or two, turning a $5 trillion problem into a $10 trillion fiasco. If the government succeeds in keeping real estate prices propped up, it will only do so at the cost of sending all other prices through the roof. More likely, real estate prices will continue to decline despite government efforts to levitate them, compounding the problems and the losses.

The grim reality is that trillions of dollars were borrowed and spent that will never be repaid. No government program can alter that fact. Someone is going to have to pay the piper for all those granite counter tops and plasma TVs. The price tag is staggering and for all the bailouts and stimulus packages, all the government can do is exacerbate the losses and shift the burden through inflation. Nor can the government resurrect bubble home prices and the fantasy of real estate riches that went along with them. One way or another, rational home prices will be restored and the myths of our asset-based, consumption-dependent economy will be finally discredited.

CNBC once nicknamed me "Dr. Doom", but compared to what I see coming now, they should have then called me "Dr. Sunshine". [A]t a presentation I made back in November 2006, at the Western Regional Mortgage Bankers Conference ... are eight clips in total, and though the entire presentation is worth watching, most of the real estate comments begin with the 4th clip. [Links to the YouTube videos of the presentation are available on this page.] Every real estate prediction I made at that conference, which was considered outrageous at the time by those in attendance, has already come true. As confident as I was then about this impending crises, I am even more confident now that the government has just thrown gasoline onto the fire.

August 4, 2008

It is not certain that the dollar will deteriorate further and interest rates will rise, but it is a risk you should hedge against.

Steve Hanke is a professor of applied economics at Johns Hopkins, a Cato institutute fellow (his writings indicate that neither of these two positions should be held against him), and a regular Forbes columnist. He has been steadfastly critical of the Federal Reserve and U.S. government's weak dollar policy, and has pointed out that the whole idea of reducing a country's trade deficit by weakening its currency is so egregiously flawed that any advocates should be written off as quacks. Coming from a slightly different angle, he points out here how the Fed's policy of trying to boost the economy by inflating credit risks blowing up the whole works. Bottom line is buy more gold.

The U.S. dollar may be cyclically weak right now, but it remains the main vehicle for foreign exchange transactions, the leading international invoice currency and the most important medium for official reserves and interventions to influence exchange rates. In addition, it provides an anchor for many countries outside Europe to peg their currencies to, and for some countries like Panama, the dollar even serves as the official currency.

In short, the dollar rules, to the great benefit of the U.S. Could it lose its dominion? It could. Flabby monetary policy could bring on nasty inflation, a collapse in Treasury bond prices and the dollar and a lot of economic hardship.

Two worrisome signs are a flight of private money from the dollar and negative real interest rates. Private investors are starting to move their money to China and other countries with currencies they expect to appreciate. As a result China's foreign exchange reserves have increased rapidly while its trade surplus has begun to shrink. For real rates, compare the nominal return on short-term Treasury bills (less than 1.5%) with the rise in the consumer price index over the last year (5%). Someone sitting on cash in the form of T bills is seeing his wealth shrink (and this is before income tax is subtracted). Neither U.S. savers nor foreign central banks are willing to undertake this sacrifice forever.

Asian countries and the Gulf states are sitting on huge piles of dollars from being net exporters, and their central banks have been gathering up those dollars to maintain their link to the greenback and to keep their own money from appreciating too fast against it. They invest most of those reserves in U.S. government bonds. Foreign central banks purchase roughly 80% of all the new debt issued by the U.S. government.

The Fed's loose monetary policy and the resulting flight from the dollar have therefore paradoxically strengthened America's credit standing, as the greenback's weakness has induced foreign central banks to buy unwanted dollars and use them to purchase U.S. government bonds. This has drained new Treasurys from the market. Meanwhile, with the collapse of the housing bubble and the implosion of some hedge funds and special investment vehicles, private paper has gotten harder to use as collateral, so there has been a domestic flight to quality and Treasurys. All of which is why the prices of Treasurys remain elevated and their yields low.

The same weakness in the dollar has also pushed commodity prices up well beyond where they would otherwise be. By my calculation, approximately half the price increase in crude oil since 2003 and 55% of the increase in corn since 2001 can be accounted for by the dollar's decline. Federal Reserve Chairman Ben S. Bernanke does not concede this point. In Capitol Hill testimony on July 15, he declared that the weak dollar contributed in only a small way to the spike in oil prices. He is not, however, a disinterested witness.

In a speech on June 26 Fed Vice Chairman Donald Kohn also attempted to get the dollar off the hook for commodity inflation. He blamed foreign countries that link their currencies to the dollar and therefore import too-loose monetary policies from the U.S. He did not name the offenders, but China, other Asian countries and the Gulf states must have been on his mind. Kohn's conclusion: "Economies benefit from having independent monetary policies that provide room to respond flexibly to alternative configurations of economic and financial shocks. These benefits could be increased if exchange-rate flexibility were to become more widespread and monetary policies given greater latitude to respond to shocks wherever they originate."

By denying a direct link between the dollar and commodity prices, the Fed is signaling that it wants room to move interest rates and the dollar down if the economy sinks into an even deeper hole than it is in now. But by pushing the onus for high commodity prices onto countries that link their currencies to the dollar, the Fed is playing a dangerous game. If those countries abandon their links to our money, they will have much less reason to purchase dollar reserves and U.S. Treasurys. The dollar and U.S. government bonds will tumble, unleashing higher inflation at home and abroad.

It is not certain that the dollar will deteriorate further and interest rates will rise, but it is a risk you should hedge against. If you have not done so already, sell your nominal (i.e., non-inflation-indexed) U.S. government bonds and use the proceeds to add to the gold hedges I recommended back in May.

August 4, 2008

Contrarian/value money manager David Dreman, who is also an author and columnist, is not happy with the current market but would recommend staying put and not selling, all things considered. Two major reasons for doing this are: (1) Once out, the chances are you will miss a good part of the next bull market. (2) Stocks are one of the better inflation hedges over time, and inflation is something worth hedging against now. He recommends oil producers.

These are not happy times, but they are historic ones. The Dow Jones industrial average suffered its worst June since the Great Depression. In July it crossed the threshold into a bear market, dropping 22% from its October 2007 high.

The liquidity crisis continues to unfold, proving far worse than even the most pessimistic Wall Streeters expected. Several months ago most market savants thought the biggest banks had worked through the worst of their hits from bad mortgages and collateralized debt obligations, raising enough capital to make up the losses they were taking. Now a second wave of big writeoffs is occurring, along with markdowns by midsize banks with large burdens of construction and real estate loans. Financial and real estate stocks have dropped to new lows. The KBW Bank exchange-traded fund is down 59% from its February 2007 high. Financial institutions have raised capital 42 times since June 2007, almost always at large discounts to already depressed market prices -- and every one of those issues is now losing money for its investors.

The government is under intense pressure to avoid additional bailouts like the one of Bear Stearns, even if it has effectively guaranteed that it will keep Fannie Mae and Freddie Mac afloat. But benign neglect will not do. A run on an investment bank such as Lehman Brothers could lead to panic, as trillions of dollars in derivatives guaranteed by investment bankers, banks and hedge funds threatened to collapse. A single big investment bank's default might make its competitors seize up too, since nobody can unravel who owes what to whom.

Analysts' estimates are not helping. They tend to be well off the mark in the best of times, as I explained in my June 5, 2006 column, "Unpleasant Surprises." Right now they are too optimistic for both the second half of this year and the first half of next. They are predicting year-over-year earnings gains in both periods for the S&P 500, when in all probability there will be drops. In other words, if there is no further fall in stock prices, the price/ earnings ratio of the S&P is going to move higher. The index is currently trading at 14 times estimated earnings.

Finally, the Federal Reserve Board is in a bind. It cannot rescue an illiquid economy without boosting inflation, and inflation is already high. Prices for energy and industrial and agricultural commodities are rising faster than they have in a generation. The Fed cannot raise rates or it will risk making the liquidity crisis even worse, so it dares do nothing but jawbone, even though long-term Treasurys should be yielding at least one to two percentage points more than they are today.

Should you flee the market, given all this? It is a tough call, but I would not. For one thing, the Administration and Congress can play a much larger role in alleviating the liquidity crisis than they have up to now. This being an election year, I have a strong feeling we will see considerably more help from them in the next few months. Most likely the Fed will eventually move to fight inflation. Raising rates usually hurts the markets at first, but over time stocks have been one of the best inflation hedges you can find.

In these circumstances, I would not try to be too clever. You do not see market timers who own yachts. If you pack up now, chances are you will miss a good part of the next bull market. A large part of the gains are always made in the first few months of one, when market-timing investors are still on the sidelines.

If the market slide continues, you will get opportunities to buy first-rate companies when they dip on negative news, such as an earnings miss that analysts and investors overreact to. When that happens, you should sell less-promising stocks to raise cash to buy the companies the market has panicked on.

If you do not already own any oil and gas explorers, buy some shares now. Some companies that have strong fossil fuel reserves are trading at multiples of their trailing earnings that are below the S&P's multiple of 15. The oil producers are also down from their highs of late May. Despite oil's price rise to $130, analysts are still basing their estimates on a price of $100 or so, which could cause some pleasant earnings surprises in the next quarter or two. Here are three oil stocks I would look at: Apache Corp. (114, APA), which is at 12 times earnings, Devon Energy (102, DVN), at 14 times, and Tesoro Corp. (16, TSO), at 6 times.

Bear markets are the hardest kind to invest in. But they can also be the most rewarding.

August 4, 2008

This may be the best time in years to scoop up Chinese shares.

Jim Oberweis is a growth stock money manager and has recently become a Forbes financial columnist. Here he expresses the opinion that Chinese stocks are now interesting, having undergone a severe correction since last fall, and recommends some small companies operating out of China that are very typical of the kind of stocks Oberweis likes. People who get dizzy at the sight of high multiples need not apply. But the ideas are interesting. They kind of remind us of U.S. dot-com boom stocks.

People who have invested in Chinese stocks are either smiling or crying right now, depending on when they got in. Those who got in at the beginning of 2005 and have tracked Morgan Stanley Capital International's China Index are up, as of now, 167% in dollar terms. The ones who got in last October, near the peak, are down 40%.

The recent crash is not simply a consequence of irrational exuberance in the Chinese market. It results in large part from the economic problems of the United States. China's red-hot growth still relies heavily on exports, and it will likely be further tempered by America's slowdown. Moreover, inflation is accelerating in China, and it is unclear how long companies will be able to pass on increases in commodity and energy prices to their end customers.

Despite these risks and the roller-coaster stock market, this may be the best time in years to scoop up Chinese shares. The forward price/earnings ratio of the MSCI China Index has tumbled to 14, about the same as in October 2006, before the big rally there got up a full head of steam. The country has one of the fastest-growing economies in the world, with near-term real GDP growth estimated at 9% to 10% a year. It is not a stretch to say Chinese equities are undervalued.

The country's most interesting opportunities lie in high-growth companies with small market capitalizations. These are often entrepreneurial companies with no state ownership. They are underfollowed and underowned by big institutions, so there are undiscovered gems among them. I and the portfolio managers I work with look for rapidly growing businesses with significant ownership, typically 15% or more, by their management. We also look for barriers to entry that keep competitors at bay.

Many of our investments stand to profit from the Chinese consumer's increasing spending power. Over the next decade wages in China will rise, and the emerging middle class will spend more on middle-class goods and services. Chinese advertising, education and entertainment firms will be among the beneficiaries. These four have American Depositary Receipts that trade on U.S. exchanges. ...

It is not often that you can buy shares in rapidly growing companies at reasonable prices, but that opportunity does exist today. If you can handle the bumpy road, China's little dragons will take you down it, to very attractive returns.

The four companies are: (1) VisionChina Media (15, VISN) is an advertising company in Beijing that operates a network of 45,000 digital TVs on buses. It has a forward P/E of 23. VisionChina earned 29 cents a share over the past year. (2) New Oriental Education & Technology Group (62, EDU) provides foreign-language training and college test preparation courses. It has been showing yearly enrollment growth of 30% to 40%, and trades at 32 times his forward earnings estimate of $2 a share. (3) ATA (11, ATAI) is China's leader in computer-based testing. It has a market share of 30%, and its biggest clients include several Chinese government agencies. It trades at 23 times Oberweis's forward estimate. And (4) Sohu (71, SOHU) operates China's 3rd-largest internet portal (a concept that has been largely discredited in the U.S.). Its forward P/E of 24.

August 4, 2008

Fannie and Freddie as key linchpins for a historic credit bubble along the lines of John Law’s 18th-century Mississippi Bubble.

Behind every great bubble is some kind of credit instrument, which people accept is interchangeable with money while the mania is in progress. We find the most fascinating one of all to be the Kuwait Souk al-Manakh Stock Bubble of the early 1980s. In that case stock buyers were allowed to pay for stock purchases with post-dated checks, a default of which would allegedly "violate the tradition of trust" and "caused a loss of face upon the entire family." Naturally as the mania progressed, speculators started to assume that capital gains were a sure thing, and that they would be able to cover all their checks by selling the stock positions the checks were used to purchase. The whole thing came to a grinding halt when a (female) speculator pressed one of the most prolific of the check writers (who passed off $14 billion worth all by himself!) for payment on a check ahead of its due date. He was unable to honor the check and the implosion was virtually instantaneous.

A couple of interesting elements from the episode: (1) The underlying companies being speculated on were worthless or of nominal value -- only a few cement and clinker plants, a slaughter house or two, and quite a few shell games. (2) At the peak of the market, tiny Kuwait's market capitalization was #3 in the world, behind only the U.S. and Japan. (3) Everyone assumed the government would come in and bail out everyone if things got dicey. (4) Skeptics were dismissed with the usual "It is different this time" or "People have been predicting a crash for years and they have been wrong" arguments. (5) The Souk al-Manakh's decline was so instantaneous and dramatic that it could not even be considered a crash. "One cannot quite say it declined or it crashed; it has just stopped trading," said one participant (who apparently escaped undamaged).

The Kuwait government did not end up bailing out all the speculators. (We have no doubt that the best connected were granted a favor or two.) The Kuwait Ministry of Finance called in all dubious checks for clearance, tallying the value of worthless checks at $91 billion -- equivalent to $90,000 for every Kuwait man, woman and child. Commerce slowed to a trickle but, of course, they had a fair quantity of that black stuff in the ground to ease the pain. What about all the violated trust and loss of family face? We can only assume that when everyone is in the same predicament -- like being without clothes in a nudist colony -- the sense of shame is mitigated.

Now anyone who does not see a strong resemblance to the bubble in U.S. mortgages and deriviatives created therefrom has simply not been paying close enough attention. The biggest difference would appear to be that the U.S. government is going to try to bail out the speculators. Lucky us.

What has been the equivalent of the post-dated checks that fueled the Kuwait bubble? Credit Bubble Bulletin's Doug Nolan nominates all the paper issued by Fannie Mae and Freddie Mac. The debt of these "Government Sponsored Enterprises" has always been assumed to be -- nudge nudge, wink wink, say no more -- "backed by the full faith and credit" of the U.S. government if push ever came to shove. The GSE's were "too big to fail" and Uncle Sam would have no choice. This implicit backing granted Fannie and Freddie the ability to basically create money at will -- their own private printing presses. Of course the credit issied fueled property prices primarily, but it also spilled over to the other financial markets and the real economy. One might say it messed up the later royally. The problem was that this "money" would be accepted at face value only as such as long as the property values backing it remained intact. Segue to today's mess.

The odd thing is that even though the U.S. government backing of the twins has now been made explicit, the market does not quite believe it. Their debt not only trades at a notable premium to Treasuries, but this premium has not shrunken since the explicit backing was instituted. The market is evidently suffering a loss in "faith" in the USG's "credit."

On more than a few occasions over the years I have been accused of having an obsession with the GSEs. For some time I have viewed these institutions as the key linchpins for a historic credit bubble along the lines of John Law's 18th-century Mississippi Bubble. The GSEs, with their implied government backing, forged a fundamental -- and momentous -- change in the nature of contemporary "money" and credit. Their financial and economic impact has expanded exponentially since their initial foray into system liquidity backstop operations back with their 1994 bond market/hedge fund "bailout." I am left to scoff at the CBO's $25 billion estimate for the likely eventual cost to the American taxpayer.

Fannie's and Freddie's combined total assets ended 1991 at $194 billion, only to about double in four years before ending the 1990s at $962 billion. After several years of aggressive growth, Fannie's and Freddie's combined Books of Business (retained holdings and Mortgage Backed Security guarantees) began 1999 at about $1.60 trillion. In May of this year they exceeded an incredible $5.20 trillion and have so far this year expanded at near y-t-d double-digit rates. Over the past 12 months (through May), Fannie and Freddie's combined Book of Business had expanded $627 billion, or 13.7%.

This is bubble-creation fuel alright.

When I read the various estimates of the GSEs' additional capital requirements, I again reflect back to one of the great flaws in economic historical revisionism with respect to the Great Depression. Conventional ("revisionist") thinking today has it that if the Fed had simply "printed" $5 billion and replenished lost banking system capital in the early 1930s, the worst effects of the depression would have been avoided. But then, as is the case today, the size of lost financial sector "capital" was not the critical issue. Instead, financial sector losses pale in comparison to the huge scope of additional credit creation necessary to sustain deeply maladjusted financial and economic structures -- and the impossibility of sustaining credit bubble excess in the face of escalating risk intermediation losses and resulting tightened financial conditions, sinking asset prices, acute financial system impairment, investor and speculator revulsion, de-leveraging, major changes from boom-time spending patterns and economic downturn.

Although there is no denying the slippery-slope nature of intervention, and keeping in mind that there is nothing so permanent as a temporary solution, it seems fair to say that if during the 1930s the Fed had extended temporary lines of credit to solvent (emphasis there) but illiquid (due to a run) banks that some misery would have been avoided.

Treasury and the Fed could today easily "cut" Fannie and Freddie (and the FHLB!) a $20 billion check or, OK, $50 billion. Yet the reality of the situation is that GSE "Books of Business" must expand at least $600 billion this year and then as much next year and the year after that ... or very serious problems will unfold throughout the conventional mortgage marketplace. There are Minskian "Ponzi Finance" dynamics at work here, as there were in subprime, "private-label" MBS, CDO, auction-rate and other markets. Only the stakes of a conventional mortgage bust are much greater.

Without the GSEs, there is no way total U.S. mortgage debt would have doubled in the six years 2001-2006. Without the GSEs, it would have been impossible for broker/dealer assets to have ballooned from $455 billion to begin 1995 to $3.10 trillion to end 2007. And I believe very strongly that without the GSEs the leveraged speculating community would be but a fraction of its current unfathomable size.

Many view the GSEs in an ideological context. To me, it has always been at its core a financial, economic and political issue -- one of the most important issues of our day that Washington and the Fed have left in complete shambles. With the GSEs' quasi-governmental status, the markets have merrily assumed GSE obligations would be, if necessary, backed by the full faith and credit of the U.S. government. It remains an irrepressible bubble.

Washington (Democratic and Republican administrations, Congress, and the Federal Reserve) and Wall Street were happy to live/thrive with the grey area of the markets' acceptance of implied government backing. Importantly, this market perception granted the GSEs the extraordinary capacity to create at will contemporary "money" (financial instruments perceived as being safe and liquid) and (extraordinarily appealing) credit. This "moneyness" of GSE obligations played an instrumental role in profound changes experienced throughout the financial and economic world over the past 15 years. Never in history has an inflationary mechanism enjoyed such capacity to issue endless quantities of "money-like" instruments with nary a public protest or market backlash (at least as long as asset prices were inflating). And even recently, despite heightened market concerns, Freddie was not impeded from expanding its retained portfolio $21 billion during June, or 33% annualized.

The markets' enthusiastic embrace of massive issuance during bouts of financial market tumult encompassed the greatest danger inherent in GSE obligation "moneyness". GSE assets expanded 15% ($115 billion ) during the 1994 crisis, 28% ($305 billion ) during tumultuous 1998, 23% ($317 billion ) during 1999, and another 18% ($344 billion ) during the corporate credit crisis of 2001. And keep in mind that Fannie's and Freddie's combined Books of Business have ballooned more than $3.1 trillion so far this decade.

Enjoying unlimited access to borrowings during periods of systemic stress, the GSEs evolved into the powerful liquidity backstop for the leveraged speculating community and the securities markets generally. Like clockwork, the Greenspan Fed would aggressively cut rates and the GSEs would aggressively expand credit. [The "Greenspan Put."] And without the GSEs as buyers eager to pay top dollar for mortgages and MBS -- especially in the event of marketplace disruption -- the hedge funds, Wall Street proprietary trading desks, and others would never have had the gumption to accumulate highly leveraged positions throughout the mortgage and debt securities marketplace. Speculator profits would not have been as spectacular and certainly not consistently so. The unrelenting fund flows feeding the speculator community bubble would have been a trickle or perhaps a stream as opposed to what evolved into a historic flood. Today's massive and destabilizing global pool of speculative finance owes its existence to the GSEs.

If it were not for the GSE's, the 1998 LTCM crisis would have burst a number of fledgling bubbles, certainly those gaining momentum in technology stocks and telecom debt and most likely in securitizations more generally. The year 1999 would have been a recession year, rather than one noted for spectacular stock market gains. The GSEs again played a major role in ensuring that the 2001/02 recession was short and shallow -- that unfolding excesses and imbalances were validated rather than corrected [emphasis added]. The GSEs, along with their Wall Street comrades, ensured that each year would bring only greater amounts of system credit and resulting higher asset prices higher than the year before. Resulting economic and asset market "resiliency" spurred an increasing variety of credit instruments and channels -- mostly "AAA" -- that provided more than sufficient fuel for the U.S. bubble economy.

I have repeatedly expounded the view that the most problematic systemic damage over this protracted credit boom has been inflicted upon the underlying structure of the U.S. economy. It is my view that only through the interplay of GSE and Wall Street "structured finance" bubble dynamics has our massive current account deficit been sustainable. It was this credit apparatus that created much of the "money-like" financial claims that our economy has for too long traded for imported energy and goods. And each year that foreigners eagerly accepted these claims brought deeper mal-investment and structural impairment. The GSEs provided a "backstop bid" to the speculators and foreign central banks provided a "backstop bid" for the $trillions of agency instruments and dollar financial claims more generally. U.S. and global imbalances went to unprecedented extremes. Most regrettably, the evolution to our finance-driven, "services," asset and consumption-based economy has been a direct byproduct of the GSE/Wall Street credit boom.

As the credit bust has broadened and worsened, GSE solvency has become a critical marketplace issue. Today, with the specter of acute GSE financial fragility, the "moneyness" of GSE obligations now rests 100% with unlimited federal government backing. Treasury has few options than the game it is playing (Bill Gross used "sham"). The hope is that with Congress providing Treasury with blank check discretion to recapitalize the GSEs, agency obligations will retain the confidence of the marketplace. It worked somewhat this week, as agency debt spreads narrowed significantly. But why, then, are agency MBS spreads remaining so wide? [See chart.]

Mortgages have traditionally been a rather unattractive investment instrument. Real estate markets are traditionally highly cyclical, with risk under-pricing during the boom and credit losses exploding in subsequent downturns. Moreover, there is major interest rate risk. When rates decline, homeowners rush to refinance and the holders of these mortgages suffer prepayment risk (must reinvest proceeds at lower rates). When interest rates rise, homeowners hold onto their attractive mortgages longer -- and the holder gets stuck with longer duration.

Yet despite these less than enticing attributes, mortgages became only more coveted during each year throughout the life of the credit bubble -- with, of course, the booms in the GSE and Wall Street finance playing an instrumental role in the newfound status of this asset class. A strong case can be made today that the dynamics of this asset class have changed once again -- and profoundly. Mortgages are poised to be unappealing for years to come.

Capital raising notwithstanding, the GSEs will now be indefinitely and severely equity capital constrained (at best). Their days of mortgage/MBS "buyers of first and last resort" will be drawing to a conclusion. Capital requirements for guaranteeing MBS are significantly less onerous, so Fannie and Freddie will have little alternative than to rein in balance sheet growth (MBS retention) while continuing to guarantee massive agency MBS issuance ("insurer of last resort"). This cannot be a comforting dynamic for those that have had been making a nice living leveraging in MBS. Meanwhile, the "private-label" MBS market is an unmitigated bust and even bank "prime" mortgage lending appears to have tightened meaningfully, further restraining mortgage credit growth and placing ongoing downward pressure on home prices and the general economy. This credit bust dynamic greatly exacerbates GSE portfolio credit risk, while leaving them with no alternative than to continue to aggressively expand their MBS guarantee business (to the tune of $600 billion plus annually in the face of an escalating housing and economic bust).

The GSEs are now trapped in a precarious riptide where they must swim incredibly hard to barely tread water. This is an extremely tenuous position for the conventional mortgage marketplace, not to mention the increasingly credit-starved U.S. bubble economy.

The Uppers
August 4, 2008

The probabilities are now high that GDP turns decisively negative during the second half.

While the subprime mortgage issuance boom was a poster child for an out-of-control credit mania, a question is: What was the extent of the distortions it introduced into the economy? No doubt they were a, if not the, major contributor to elevated housing prices, which certainly engendered excessive investment in the housing stock. Now all the subprime loan losses must be dealt with and worked through but, again, what was the actual damage subprime loans inflicted on the real economy (the part of the economy involved in the production of goods and services)?

A "bubble economy" is one characterized by an excessive portion of GDP being devoted to consumption, an insufficient part to capital investment, and the ongoing requirement for outside support -- as reflected, e.g., in trade deficits -- to keep the game going. When an economy has been in bubble-mode for long enough a deeply ingrained set of distortions are introduced, with companies and whole economic sectors springing up to service the artifically well-off consumers. Savings and reinvestment are neglected, and industries that produce real goods are "hollowed out." When the outside support plug is finally pulled, the extent of the "malinvestments" -- as the Austrian economists call them -- are revealed.

In a followup to the article above, Doug Nolan asserts that subprime mortgages were not a critical source of finance for the overall U.S. bubble economy (there are plenty of other "bubble economies" in the world as well). Rather, it was the "upper-middle" to "upper" ends -- "The Uppers" of the article headline -- where loose finance "encouraged many to stretch to buy the expensive home, to lease the luxury vehicle, and to finance the upscale lifestyle -- credit creation that then further stoked the overall economy and asset markets." What looked like a virtuous circle of increasing asset prices, borrowing, and consumption is now rapidly unraveling and turning vicious, Noland believes. It is a sobering read.

The U.S. Bubble Economy has burst. I sympathize with those who would argue this is old news. But the probabilities are now high that GDP turns decisively negative during the second half -- if it has not already. Instead of the year-long credit crisis showing signs of improvement or even stabilization, a further tightening of credit availability is taking hold broadly throughout the economy.

The so-called "subprime" crisis has, of late, invaded "prime" and "conventional" mortgages. This is a major additional blow for home prices and the economic support provided from built-up home equity. The securitization markets remain in shambles. Even corporate debt issuance dropped to a 5-year low in July. Meanwhile, the increasingly impaired banking system has sharply curtailed lending virtually across the board -- to households, to students, and to businesses both small and large. Bank credit is basically unchanged over the past nine weeks. And without sufficient credit creation, the finance-driven U.S. "services" economy is an unmitigated bust. It is my view that this bust has over the past few weeks gained critical -- and self-reinforcing -- mass.

The subprime mortgage fiasco provides a convenient poster child for this boom's egregious excesses. I would argue, however, that its role in fueling the boom was much less than presumed. It actually was not a critical source of finance for the overall bubble economy. Or, stated differently, the relative brief period of subprime excess was not a major factor in the protracted period of financial excess that spurred imbalances and deep structural economic impairment. Likewise, last year's subprime bust was not a decisive development for the bubble economy generally. Its overall impact on system employment and incomes was not great -- its effect on tax receipts only marginal.

I tend to view subprime as chiefly a "lower end" issue with respect to the real economy. And it is my view that the greatest -- as well as least appreciated -- bubble economy excesses were at the "upper-middle" to "upper-end." It is in the upper-ends where years of credit excess had the most pronounced effects on incomes, household net-worth, spending, and government revenues.

It was the at the "Uppers" where loose finance encouraged many to stretch to buy the expensive home, to lease the luxury vehicle, and to finance the upscale lifestyle -- credit creation that then further stoked the overall economy and asset markets. And it was The Uppers that enjoyed spectacular gains in income and financial wealth. It was the momentous changes in Uppers' spending patterns that spurred enormous real economy investments in a multitude of new businesses and services -- a great deal of this spending of the discretionary and luxury variety. It was The Uppers' windfalls that encouraged state, local and federal governments to rapidly boost spending. These were the inflationary distortions that had a profound impact on the underlying economic structure -- over years spurring the transformation to a "services"-based bubble economy.

It is my view that The Uppers are now in the process of being hit with rapidly tightening Financial Conditions. This year will see a historic decline in financial sector compensation, led by collapsing Wall Street bonuses and unprecedented layoffs throughout the financial services industry. This week also saw the announcement of major "white collar" job losses at General Motors, an employment trend that I expect to spread throughout the real economy. Many companies and industries must today respond to collapsing profitability (as financial conditions tighten and spending patterns and levels adjust), and there will be no alternative than to shrink "upper-end" employment and compensation.

This week also saw evidence of a significant tightening of credit availability for The Uppers. BMW, GM, Ford and Chrysler all announced that major changes in vehicle leasing terms are in the offing -- especially for SUVs. BMW apparently has recognized that it is problematic that 60% of its U.S. unit sales have been leases. Surging gas prices and other economic worries have hit used vehicle residual values hard, turning the leasing business into a losing proposition. Leasing terms are now being tightened significantly -- a dynamic that will further depress used vehicle prices. It is worth noting that July new vehicle sales were reported at the lowest level since 1992. They will most certainly go lower.

This week also saw higher rates and additional withdrawal from the jumbo mortgage marketplace. At 7.56%, 30-year fixed jumbo borrowing rates this week were almost 100 bps higher than a year ago. And one can assume that lending standards continue to tighten, with downpayment requirements putting many buyers out of the market for "upper-end" homes in neighborhoods throughout the country. And keep in mind that, to this point, home prices have actually held up reasonably well in many locations, a dynamic that will likely not withstand a further tightening of credit in prime jumbo and conventional mortgages. A more broad-based downturn in housing prices will spur a more broad-based decline in spending -- especially for discretionary purchases by The Uppers.

This [last] week was also notable for bankruptcy announcements from a few national restaurant and retail chains. Increasingly, the post-boom adjustment in spending patterns is challenging the profitability of scores of businesses. This dynamic is poised to feed on itself, as more business closures and layoffs severely impinge incomes. And what I expect to be rapidly deteriorating business credit conditions will surely worsen the financial crisis.

For years now, the leveraged speculating community has profited handsomely from taking leveraged positions in higher-yielding business loans. Borrowing from Wall Street was easy, and it was just as easy during the boom to extend credit to profitable (or at least cash flow positive) businesses. But this dynamic is changing profoundly. With business and economic prospects now deteriorating rapidly, I would expect significant tumult to unfold in the corporate credit market. And a reversal of speculative flows away from leveraged business lending would be a major blow to both corporate credit availability and the vulnerable leveraged speculating community, a dynamic with negative ramifications for The Uppers.

And when it comes to states with huge exposure to Uppers, California and New York sit at the top of the list. Not surprisingly, both states are today in the grips of intense fiscal pressure. And with my expectation that economic prospects are now worsening by the week, it is not at all clear how California, New York and other states will deal with ballooning deficits. Drastic spending cuts and tax increases are inevitable to get budgets back somewhat in line with post-boom receipts. And this will prove one more problematic dynamic for the bursting U.S. bubble economy.

August 6, 2008

An interview with Nouriel Roubini: Maybe now somebody will listen.

One of the recurring routines from the classic 1960s television comedy Get Smart would go something like this (totally made up scene, but serving just fine as an illustration): Man runs up to bumbling secret agent Maxwell Smart and claims his life is in great danger ... Max: "You expect me to believe that?" ... Shots ring out and man slumps to the ground ... Max: "Now I believe you."

NYU economics professor Nouriel Roubini -- who claims to be "a pretty mainstream economist" -- is emblematic of those who have been warning that something like the current mess was bound to happen for time immemorial, and fits into the role of the pursed man to the political and financial establishment's Maxwell Smart in the above scene pretty darn well. Barron's interviews Roubini about what has gone on and what is next. Maybe now everyone will believe him. Distilled to essentials, he is bearish on the U.S. and bullish on most of the rest of the world.

Like the exhortations of Jeremiah to the nation of Israel before the first temple's destruction, the warnings of economist Nouriel Roubini fell on deaf ears. For the past two years Roubini, a professor at New York University, has cautioned about a huge housing bubble whose bursting would lead to a 20% drop in home prices, a collapse in subprime mortgages, a severe banking crisis and credit crunch, the near-failure of Fannie Mae and Freddie Mac, and a U.S. recession of a magnitude not seen since the Great Depression. So far, this latter-day prophet of doom has been on the mark, though time will tell about the recession part.

A Turkish native who grew up in Italy, Roubini trained at Harvard and later advised the Clinton White House, after his blog on the Asian financial crisis attracted the attention of Washington's economic and political elite. Roubini still publishes the blog -- the RGE Monitor -- and teaches economics at NYU's Stern School of Business. We caught up with him recently at his offices in lower Manhattan, and continued the conversation at Barron's. For his latest predictions, please read on.

Barron’s: Unfortunately for the rest of us, you have a pretty good track record. How much more misery lies ahead?

Roubini: We are in the second inning of a severe, protracted recession, which started in the first quarter of this year and is going to last at least 18 months, through the middle of next year. A systemic banking crisis will go on for awhile, with hundreds of banks going belly up.

Which banks, specifically, will fail?

I do not want to name names, but many, given the housing bust, will become insolvent. Their losses are mounting because they have written down only their subprime loans so far. They have not started writing down most of their consumer-credit losses, and reserves for losses are much less than they should have been. The banks are playing all sorts of accounting gimmicks not to recognize them. There are hundreds of millions of dollars outstanding in home-equity loans that eventually could be worth zero, too.

So far, we have seen no recession in the technical sense: two consecutive quarters of negative growth in real GDP. Why not?

The definition of a recession is not only two consecutive quarters of negative growth. The NBER (National Bureau of Economic Research) puts a lot of emphasis on things like employment, and employment has already fallen for seven months in a row. It also emphasizes income and retail and wholesale sales. Many of these things are declining.

Maybe the recession started in January. If you look at the data on gross domestic product on a monthly basis between February and April, GDP was falling. Saying this is not a recession is just a joke. Maybe instead of a "U" recession and recovery, it will be a "W", with a rebound in the second quarter. But by the third quarter, the effect of the government's tax rebates is totally gone, because other forces on the consumer are more persistent and negative.

Which forces, for instance?

The U.S. consumer is shopped out and saving less. Debt to disposable income has risen to 140% from 100% in 2000. Hit by falling home prices, the consumer no longer can use his house as an ATM machine. The stock market is falling and (issuance of) home-equity loans (has) collapsed. We have a credit crunch in mortgages, and gas is around $4 a gallon. Everyone says, "Yeah, that's true, but as long as there is job generation there is going to be income generation and people are going to spend." But for seven months in a row, employment in the private sector has fallen.

The most worrisome thing is that in spite of the rebates, retail sales in June were up only 0.1%. In real terms, they were down. If people were not spending their rebate checks in June, what will happen when there are no more checks?

Good question. How do you think Federal Reserve Chairman Ben Bernanke has handled the crisis so far?

The Fed's performance has been poor. More than a year ago the Fed said the housing slump would end, but it has not. They kept repeating this was a subprime-debt problem only, whereas the problems of excessive credit involve subprime, near-prime, prime, commercial real estate, credit cards, auto loans, student loans, home-equity loans, leveraged loans, muni bonds, corporate loans -- you name it.

The Fed's other mistake was to believe the collapse of the housing market would have no effect on the rest of the economy, when housing accounted for a third of all job creation in the past few years. When the proverbial stuff started to hit the fan last summer, the Fed went into aggressive easing mode. But it has always been kind of catching up.

What should Bernanke have done a year ago, or even prior to that?

The damage was done earlier, beginning when the Greenspan Fed lowered interest rates in 2001 after the bust of the technology bubble, and kept them too low for too long. They kept cutting the federal funds rate all the way to 1% through 2004, and then raised it gradually instead of quickly. This fed the credit and housing bubble.

Also, the Fed and other regulators took a reckless approach to regulating the financial sector. It was the laissez-faire approach of the Bush administration, and (tantamount to) self-regulation, which really means no regulation and a lack of market discipline. The banks' and brokers' risk-management models did not make sense because no one listens to the risk managers in good times. As Chuck Prince (the deposed CEO of Citigroup) said, "When the music plays you have to dance."

Now the regulators are attempting to make up for lost time. What do you think of their efforts?

The paradox is they are going to the opposite pole. They are overregulating, bailing out troubled participants and intervening in every market. The Securities and Exchange Commission has accused others of trying to manipulate stocks, but the government itself is now the manipulator. The regulators should investigate themselves for bailing out Fannie Mae (FNM) and Freddie Mac (FRE), the creditors of Bear Stearns and the financial system with new lending facilities. They have swapped U.S. Treasury bonds for toxic securities. It is privatizing the gains and profits, and socializing the losses, as usual. This is socialism for Wall Street and the rich.

So the government should have let Bear Stearns fail, not to mention Fannie and Freddie?

If you let Bear Stearns fail you can have a run on the entire banking system. But there are ways to manage Bear or Fannie and Freddie in a fairer way. If public money is to be put at stake, first all the shareholders of these companies have to be wiped out. Management has to be wiped out, and the creditors of Bear should have taken a hit. Why did the Fed buy $29 billion of the most toxic securities, and essentially bail out JPMorgan Chase (JPM), which bought Bear Stearns?

Because JPMorgan was a counter-party?

Exactly. The government bailed out everyone. Even the unsecured creditors of Fannie and Freddie should have taken a hit. Sometimes it is necessary to use public money to rescue institutions, but you do it in a way in which you are not bailing out those who made the mistakes. In each one of these episodes the government bailed out the shareholders, the bondholders and to some degree, management.

At what point does the government run out of money to lend to troubled banks?

Many public institutions are themselves going bankrupt. The FDIC (Federal Deposit Insurance Corporation) has only $53 billion of funds, and has already committed almost 15% of it to bail out depositors of IndyMac. The FDIC's deposit-insurance premiums were not high enough, and now it is asking Congress to raise them. Plus, the agency claims only nine institutions are on its watch list. IndyMac was not on the watch list until June, the month before it collapsed. Studies done by experts in banking suggest that at least 8% of U.S. banks are in big trouble. Eight percent of the roughly 8,500 that the FDIC essentially is insuring equals about 700 banks. Another 8% to 16% also are shaky, so some 700 potentially are going bust and another 700 eventually could join them. Yet the FDIC is watching only nine institutions. It is a joke.

What recourse will the taxpayer have?

The taxpayer's bill is going to be huge. I estimate this financial crisis will lead to credit losses of at least $1 trillion and most likely closer to $2 trillion. When I made this analysis in February everybody thought I was a lunatic. But a few weeks later the International Monetary Fund came out with an estimate of $945 billion, Goldman Sachs (GS) estimated $1.1 trillion and UBS (UBS) $1 trillion. Hedge-fund manager John Paulson recently estimated the losses would be $1.3 trillion, and late last month Bridgewater Associates came up with an estimate of $1.6 trillion. So, at this point $1 trillion is not a ceiling, it is a floor. And the banks, as I have said, have written down only about $300 billion of subprime debt.

Peter Schiff thought (see above) there would be $5 trillion in losses even before the Fannie/Freddie bailout created a moral hazzard that will elevate losses further.

How long will it take for the collapse in the banking sector to play out?

It is happening in real time. Many smaller banks are going bust already. More than 200 subprime mortgage lenders have gone bust in the past year alone. And many community banks will go bankrupt. Community banks usually finance everything: the homes, the stores, the downtown, the commercial real estate, the shopping center. If you are in a town or a municipality where there is a housing bust, the bank is gone. Of three dozen or so medium-sized regional banks, a good third are in distress. That includes the Wachovias and Washington Mutuals of the world. Half of this group might go bankrupt. Even some of the majors could end up technically insolvent, though they might be deemed too big to fail.

Take Citigroup. In 1991 there was a small real estate bust, though the quarterly fall in home prices was only 4%, based on the S&P/Case-Shiller indices. Citi was effectively bankrupt and signed a memorandum of understanding with the Fed that allowed the government to give the bank regulatory forbearance. Citi was allowed to ride it out and try to recapitalize in a few years, and thereby avoid bankruptcy protection. This time around the S&P/Case-Shiller indices indicate home prices already have fallen 18%. The decline could be as much as 30%, because the excess supply is huge.

Nouriel, have you always been so negative about everything?

No. I am actually a pretty mainstream economist. I was trained first in Italy and then in the U.S. and earned my Ph.D. at Harvard. My interests are in international market economics and international finance, and I am not a "perma-bear" on the stock market nor an eternal pessimist.

Leaving aside the fact that we are going to have a pretty nasty recession and international crisis, the global economy is going to grow at a sustained rate once this downturn is over. There are significant financial and economic problems in the U.S., and that is why I am bearish about the U.S. But the emergence of China and India and other powers is going to shift global economics and politics radically, and the world is going to be more balanced in the future, rather than relying on one engine, which has been the U.S. There are big issues ahead: How do you integrate the 2.2 billion Chinese and Indians into the global economy? There will be transitional costs and the displacement of workers, both blue-collar and white, in the advanced economies. But I am quite bullish about the state of the global economy, and I am positive about the medium and long term.

That's a relief. Thank you.

August 5, 2008

Successful structures show their limits; strong gains face “comeuppance month.”

Hedge funds -- a compensation scheme rather than an asset class, according to Warren Buffett -- are such a huge and amorphous universe of investment approaches that no general characterizations are meaningful. Nevertheless, the fact that many can take highly leveraged positions and easily undertake short sales gives them a certain gun-slinging reputation, accurate or not. Most hedge funds are less constrained by the value/growth, large-cap/small-cap styles box compared with more conventional (and regulated) mutual funds and money managers, and are also not forced to meet certain diversification criteria, so in theory they have more flexibility when it comes to rolling with the markets' punches.

Now it looks like the capacity to leverage and/or concentrate their bets has come back to bite certain hedge funds. U.S. stocks are mediocre performers? Fine ... bet on commodities, natural resource stocks, overseas stocks, or sell the plummeting financial stocks short. Except that did not work well this past month either. As noted here, several managers are down more than 20% for the year. The S&P 500 is down 14%, so down 20% is not horrible on principle. But when you pay a 2% of assets plus 20% of realized profits as a management fee, you probably expect better.

In the world of hedge funds, it is harder to hide from the financial crunch. Since the crunch began, these elite money managers have generated strong returns by focusing on areas such as commodities, emerging-market stocks, or betting against troubled banks.

But as hedge funds as a group look set to turn in their worst monthly performance since July 2002, even those investment strategies that had been doing well have run into trouble. Some previously highflying funds are sustaining declines in the double digits. Several managers are down more than 20% for the year.

Consider London-based Boyer Allan Investment Management LLP, which specializes in Asian stocks and whose flagship $1 billion Boyer Allan Pacific Fund is down 28% for the year through the end of July, after turning in a 52% gain in 2007. And at London-based RAB Capital PLC, two funds that focus on natural resources and energy -- the $1.4 billion Special Situations Fund and $751 million RAB Energy -- are down 32.5% and 27.4% through July 24.

Hedge funds as a whole are still outperforming the broader market this year, but they potentially performed worse in July. Preliminary data from Chicago-based Hedge Fund Research based on a basket of 60 hedge funds suggest that the industry could be down 2.8% for the month -- which would be the worst performance since July 2002. The Standard & Poor's 500-stock index was down 1% for July and is down 14% for the year.

"It was a comeuppance month" for hedge funds, says Jay Krieger, who runs Fundamental LP, which invests in hedge funds.

Some funds that started July ahead of peers came out of it in the red. New York-based Jana Partners LLC's flagship fund entered July up more than 4% for the year but fell 9% during the month, hurt by falling prices of energy stocks, among others. The $5 billion Jana Partners fund, Jana's biggest, is now down almost 6% for the year, after delivering an average annual return since inception in 2001 of 20%.

One fund that has seen investors rushing for the exits is the $2.3 billion Highland Crusader Fund, which had built a track record investing in troubled or restructured companies. Investors in the fund, which is down about 15% this year, had put in redemption requests for more than 20% of their money as of the end of June. [This past] Friday, the fund's manager, Dallas-based Highland Capital Management, said it would pay investors in installments over a period of as many as nine months.

Nicholas Allan, co-founder of Boyer Allan, said a big problem for his fund was a June jump in oil prices that hit Indian stocks. "We had not anticipated how strong commodity pricing would be in an economic environment we felt was so weak," he said.

RAB said its funds' holdings, which consist largely of smaller energy and natural-resources companies, have been hit as investors flee to the relative safety of larger companies. Still, RAB said, "The outlook for many of the underlying investments in our natural-resources strategies continued to develop favorably."

August 5, 2008

Mutual funds that place bets against the market have been doing better than their long-only rivals. And the trend should continue, so long as the bear keeps its grip on stocks. Certain high-flying natural-resource companies are among the names that experts love to hate.

Short selling is a tough way to make a living. It attracts the ornery and/or skeptical types who like betting against the "lemmings" crowd. But betting and winning are quite different matters. We frequently feature articles from ThePrudentBear.com (e.g., two this week from Doug Noland, here and here), which is affiliated with the Prudent Bear funds, managers of the namesake Prudent Bear Fund (ticker: BEARX) and the Prudent Global Income Fund. A look at the former's record reveals that since inception at the very end of 1995, the fund's annual average return has been zero, while the S&P 500's has been 7.85%. So despite the smarts of the Prudent Bear funds people, which we respect greatly, an investment with them has not paid off over the long haul.

The latest 12 months has been another matter, when BEARX is up 20.6% while the S&P 500 is down 13.1%. In 2002, another major down period, BEARX was up 62.9% while the S&P was off 22.10%. Conversely, in 1998 BEARX was down 34.1% while the S&P was up 28.6%. Obviously the dominant relative longterm performance factor is that the market has been in somewhat to very strong bullish mode during a sizeable majority of the 12+ years since January 1996, while being in true bearish mode for less than 3 ... depending on how you count. As with short selling itself, in investing with a short-oriented fund timing is all-important. There is no equivalent of "buy and hold" on the short side.

A fundamental element behind the underperformance of certain bearish funds such as Prudent Bear speaks to the investing aphorism that "Wall Street's graveyards are filled with men who were right too soon." Whether the current crunch is "The Big It" that ushers in the final decline and fall of the dollar-based fiat currency system or not, many farsighted observers have been anticipating such a denouement for two or more decades. Orienting one's investment approach to benefiting from that outcome has paid off periodically when panics sweep through the financial markets, but far more often that has been a losing approach due to the ability of the string-pullers to come up with one paper-things-over fix after another -- all heavily featuring more money printing. Perhaps It is finally here, and those observers will finally get say "I told you so." But if so, don't expect them to be honored for their perspicacity.

Through the end of July of this year mutual funds in the Morningstar bear-market category are reported to be up over 9% vs. down 11.2% for the typical U.S. stocks mutual fund. Clearly the bear funds were (on average) a good place to ride out the decline of this year, and then some. Going forward? The short fund managers interviewed here, which include some of the bigger names in the short selling business, think the decline has further to run. But that is to be expected.

Mutual funds that short stocks have had a good run recently, at least compared with their long-only rivals, and, despite last week's gains, some of their managers see little hope of a sustained market revival.

Unlike hedge funds, few mutual funds do any shorting. Those that do often use differing strategies and take on different degrees of risk, so comparing them can be difficult. Funds in Morningstar's bear-market category are up more than 9% this year, versus a 12.7% decline for the S&P 500 and an 11.2% drop for the typical U.S. stock fund. (All data in this article are through last Thursday.) Funds in this category usually use various derivatives, such as futures, to hedge their bets against indexes. Most do not short individual stocks.

Some other mutual funds can both go long and short. Morningstar's long-short group is down 3.9% this year.

The Calamos Market Neutral Income Fund (ticker: CVSIX), for example, pairs a company's convertible bonds with a short position in the stock. It also uses covered calls, which provide income -- although the downside is that the stock can be called away (bought) if it rises to a specified price. "Investors tend to use this fund as a way to stay in the market and be defensive," says John Calamos Sr., the fund's founder. Calamos Market Neutral is down about 3.6% this year, but still more than nine percentage points ahead of the S&P.

Whatever the strategy, several managers say this is an excellent market in which to bet against stocks.

"The spread between the best-performing stocks and the worst-performing stocks has gotten very wide," says Harin de Silva, president of Analytic Investors in Los Angeles. "It is a great environment for short selling if you can get the stock selection right." One fund the firm advises is the Old Mutual Analytic Defensive Equity (ANDEX), which does some shorting. (The fund has just been renamed Old Mutual Analytic.) De Silva would not discuss any specific short positions. But as of June 30, the fund's short holdings included Mylan Laboratories (MYL), Leucadia National (LUK) and Louisiana-Pacific (LPX), among others, according to the fund's website.

The Aberdeen Long Short Equity Fund (MLSCX) has about 40% of its portfolio in short positions. "That is relatively high for us," says Chris Baggini, the co-portfolio manager. "We are very mindful that stocks are down a lot" but "the fundamentals are not supporting stocks, even at current levels." He cites weak profit growth as a key problem. Baggini would not discuss current shorts, but the fund's website says that, as of June 30, it was betting against Bank of America (BAC), Sprint Nextel (S), J.C. Penney (JCP), American Express (AXP) and Starbucks (SBUX), among others. The Bank of America, Penney and Sprint positions were recently closed.

Barry James, co-manager of the James Market Neutral Fund (JAMNX), which tries to keep an equal number of longs and shorts, views last week's gains as a bear-market bounce. "The outlook for the economy is especially grim," he says. "The financial institutions just do not have money to lend. That puts a stop to the merry-go-round for the consumer and for commercial enterprises."

The fund is down 2.19% this year. Its short positions include Centex (CTX), a home builder whose stock has slipped nearly 50% in 2008 on earnings woes. Another short is Las Vegas Sands (LVS), a gaming and lodging operator big in Nevada and Macau. It has fallen over 50% this year, as U.S. consumers have slowed their spending. "This is a very tough economic environment for them," says the fund's co-manager, Brian Shepardson.

A third short is Cheniere Energy (LNG), which develops liquefied natural-gas terminals and pipelines. The company has a heavy debt load and has been losing money, as relatively little LNG is being shipped to the U.S. because buyers abroad are willing to pay more.

There are not many hedge funds that are short-only. One is Seabreeze Partners Management, up 23.7% this year. Its portfolio chief, Doug Kass, now has his sights on the energy sector, which, of course, has had a huge run. His list of shorts includes Arch Coal (ACI), Peabody Energy (BTU) and Foundation Coal (FCL), all three of which have posted double-digit gains in 2008. These coal companies are vulnerable, in Kass's opinion, because they have big exposure to the weakening U.S. market and face growing competition from wind and solar power. They trade around 10 times next year's profit estimates, says Kass, "but that assumes unsustainable coal prices and profit margins.

More broadly, Kass maintains that the credit crunch is far from over, creating more shorting opportunities. "When credit becomes dear, it is a growth-limiting and P/E-lowering development," he says. "As long as this remains the case, the market holds little upside promise despite [last week's rally.]" If he is right, the short season could very well last a lot longer than the bulls believe it will.

August 7, 2008

An orderly retreat, but hardly “a bubble burst.”

In Alan Abelson's weekly "Up and Down Wall Street" column of August 4 he concludes that the current bear market is not over: "Trust us (just this once), revulsion, not denial, will define the end of the bear market. ... even assuming this present nasty number lasts no more than a year or two longer, it is slated, we fear, to inflict a heap more damage than the considerable amount we have suffered so far. It is still caveat emptor." Abelson apparently believes that the bull market which began in 1983 -- oddly, he dates it from then, perhaps because the Dow Jones Industrials decisively pushed through the old 1973 high, rather than August of 1982 -- called it "quits" last October, when the Dow topped out at 14,198.

The second part of the column includes this interesting analyis of the oil market:

The spectacular break in oiL gave the incorrigibly optimistic seemingly solid grounds for hope. Firing up such hope were reports that demand for gasoline, not unexpectedly, was being tempered by skyrocketing prices, and, more dramatically, by the nosedive in crude from above $147 a barrel on July 11 to as low as s $122 last week.

This precipitous decline in particular triggered a raft of commentary predicting a continuation of the slide or an even more drastic skid in the months ahead. While we would just love to pay three bucks a gallon instead of four at the pump and bow to no man (or woman or child, either) in our reverence for the workings of demand and supply, most of the chirping was coming from people who would not know which end of an oil rig did the drilling.

Such prophecies, in short, struck us as strictly exercises, and often silly ones, in wish-fulfillment. A much more informed analysis (which in itself would not be hard to do) was offered by Barclays Capital Research, which consistently puts out top-notch and exhaustive reports on commodities, most emphatically including oil.

The Barclays gang observe that after what they dub as "a short-run overshooting of prices," the market has been engaged in a comparatively orderly retreat but hardly "a bubble burst." They note that not a little of the pressure on oil has sprung from concerns about softening demand. But, they comment dryly, "The demand side of the market does not seem to be quite as soft at the global level in reality as it currently is in market sentiment."

Barclays forecasts a wide range of $115-to-$140 a barrel in the current quarter, with swings fueled by political as well as economic and petroleum market data flow. The research crew looks for prices to average around $128 a barrel in the quarter.

They sum up the outlook this way: "With speculative money still moving firmly towards the short end of the market, with risk reduction still a priority for many market participants and with sentiment still relatively negative, the immediate movement of prices within the trading range is something more of a two-way street than it has been for a while. However, overall, we remain fairly positive on prices, and would see price risks as still being biased to the upside."

So don't go buying that Hummer just yet.

August 8, 2008

Billionaire George Soros operates under a theory of financial markets he calls "reflexivity." Financial markets do not just objectively discount the future, in his view. They help create it. It makes a lot of sense, and his record of taking advantage of market booms and busts is second to none.

Now Soros has come out with a new book, The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means, wherein he argues that the period from the early 1980s to 2007 was a "super bubble" fueled by constantly loosening credit standards and availability. We completely agree. (Bob Prechter and company at Elliott Wave International would also agree with this characterization -- see this posting from next week's Financial Digest.) Now Soros thinks we have entered the downside of the super bubble. We think so too, but we shall see.

Dan Amoss thinks the governments' response to the ugly side of Soros's reflexivity will seriously impair confidence in paper money. Ergo: "Look for gold, energy, and other natural resources to keep performing. Avoid financials, real estate, and consumer discretionary stocks."

Last year, I devoted several issues of my Strategic Investment service to the web of structured finance. I think it paid off. Since then, banks and brokerage stocks were punished. Energy and material stocks have soared-thanks to the Fed's inflation campaign. Fed officials have taken their ability to devalue the U.S. dollar to new heights. What collateral backs today's dollar? Mostly mortgage securities that nobody wants -- as if Treasury bond collateral were not bad enough.

Despite the latest "reports," current trends still have room to run. Just consider Fannie Mae and Freddie Mac. Those shareholders could be effectively wiped out by endless equity offerings as early as next year. The mountain of debt holders and bond insurance policyholders comes first.

Now, it is possible that the federal government could issue hundreds of billions in new Treasuries to officially guarantee Fannie's and Freddie's liabilities. If no one lines up to buy these bonds, the Fed could monetize them. Such a scenario could herald a return to double-digit long-term interest rates and a collapse in confidence in paper money -- demanding a new monetary system. We live in interesting times. Billionaire currency speculator George Soros thinks we have just entered the ugly side of a "super bubble."

I wrote about George Soros's investing framework in the August 2007 Strategic Investment. Here is the excerpt on Soros:
The growth of securitization has truly altered the global economy ...

One negative consequence is that financial markets are starting to shape the destiny of the real economy, not the other way around. Storied currency speculator George Soros was one of the first to speak publicly about the phenomenon of markets shaping economies. He calls it the theory of "reflexivity" and described it when testifying in front of Congress in 1994:

"The generally accepted theory is that financial markets tend toward equilibrium and, on the whole, discount the future correctly. I operate using a different theory, according to which financial markets cannot possibly discount the future correctly, because they do not merely discount the future; they help to shape it."
Here is reflexivity at work: As a company's stock grows more coveted by wild-eyed speculators, its cost of capital gets lower and lower as its stock skyrockets. The higher its stock price, the more capital a company can raise in a secondary stock offering by issuing a set amount of shares. So its ability to reinvest capital and grow -- its future -- is shaped by the whims of speculators.

A second consequence of the securitization revolution: The further a lender is separated from a borrower, the more potential there is for fraud on the part of the borrower and underestimation of risk on the part of the lender.

Now, before you dismiss Soros as a Big Government "world improver," keep in mind that he took the right side of every major financial crisis since World War II. The man clearly understands how markets can boom and bust, especially when greed and fear overwhelm rationality.

To see how Soros views the current crisis, I picked up his latest book, The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means. In the first half, Soros laments that reflexivity is not taken seriously in university economics departments. In the second half, he argues that the current crisis marks the end of a decades-long expansion of U.S. dollar-based credit. Soros dubs the period from the early 1980s-2007 a "super bubble." He makes a convincing case:
"Credit conditions have been relaxed to such an extent that I wonder how they could be relaxed any further. This is certainly true as far as the U.S. consumer is concerned. Credit terms for mortgages, auto loans, and credit cards have reached their maximum extension ... It may also be true for commercial credit, particularly for leveraged buyouts and commercial real estate."
Only one thing is off the mark: Soros's prescription for more government regulation. Nowhere in his book will you find an explanation of how the global paper money system practically guaranteed the formation of his "super bubble." This super bubble would not have been possible under an international gold standard. The international gold standard of the late 1800s fostered a time of incredible growth and wealth creation in a stable price environment.

It was not perfect. It had periodic depressions. But it was far better than what we are looking at: Government's inflationary policy responses to problems created by its policy of perpetual bailouts.

Do not forget that every paper currency in history eventually fell to its intrinsic value: zero. The dollar is no different, although it has taken longer than most others. For decades, foreign governments have aggressively bought dollars, propping up their value, hoping, thus, to insure long-term economic stability. Instead, this action is heavily responsible for the runaway inflation we are seeing all over the world.

Soros seems to believe that the real economy cannot grow unless credit is growing. This ignores the fact that credit growth does not create economic growth. It merely assists growth. Over the long term, the economy grows as the capacity to produce goods and services grows. No credit necessary.

But we must invest in the environment we face, not the one that we wish were in place. The government response to the ugly side of Soros's reflexivity will seriously impair confidence in paper money.

Look for gold, energy, and other natural resources to keep performing. Avoid financials, real estate, and consumer discretionary stocks.

August 9, 2008

Bear markets slide down a “Slope of Hope.”

Jim Cramer surely tempted the gods when he predicted the end of the bear market a couple of weeks ago. Cramer based his call in part using contrarian logic -- he thought there was too much pessimism in the air. But as anyone who has tried a little sentiment analysis is undoubtedly aware, there is what people say and what people do, e.g., witness investors who claim to be "bearish" while remaining fully invested. And there is pessimism and there is pessimism.

Bob Prechtor's call is that the bear has a ways to run yet. His take on sentiment is that people have not really given up on the stock market yet, which would mark a long-term bottom.

"Bye, bye, bears," said the wonderfully flamboyant Jim Cramer on his Mad Money T.V. show this week on July 30. "I'm sticking my neck out and calling the bottom," he said, mainly because he thinks that negativity in the market is striking. We applaud his willingness to take a bold stand -- particularly since we know from experience that it takes fortitude to call tops and bottoms. But we think it might be just a bit early. After all, it is not even obvious that people have given up on the stock market. In fact, his hopeful sentiment is exactly what bear markets bring out in investors -- the hope that things will turn around just after the next market dip. This is analogous to investors worrying at the beginning of a bull market, a behavior that famously has been shortened into the adage, "bull markets climb a Wall of Worry." In contrast, Bob Prechter calls the bear-market behavior "sliding down a Slope of Hope." Read more about how you can really tell what a bear market looks like in this excerpt from Prechter’s Perspective, where Bob Prechter answers questions from the media.

Excerpted from Prechter's Perspective, 2004

Q: What are some characteristics of a major market bottom?

Bob Prechter: General despair. Investors completely give up. Sometimes you even begin to hear arguments as to why that market really has no reason to exist. For instance, in 1932, people said capitalism was dead, stocks were dead, and they would never go up again. We had that situation in gold in 1971, when the government decontrolled it. Several economists came out and said that as soon as they took off the price controls at $35 an ounce, gold would drop to $6 an ounce because it had no industrial utility.

Q: The market is an amazing beast. It even manages to do damage on the way up. Richard Russell has said that the "diabolical objective of bull markets is to advance as far as possible without any people getting in." The opposite is apparently true in bear markets.

Bob Prechter: Exactly. It is the old story. Bull markets climb a Wall of Worry. I made up a parallel maxim: bear markets slide down a Slope of Hope.

Q: In the mid-1980s, you anticipated this idea in the great bull market when it was just getting under way. You said, "Somehow the Dow has to get to 3600-plus with almost nobody aboard.

Bob Prechter: All I really meant was that for the mechanism of the market to be satisfied, there must be reasons for people to disregard really important advice at the time it is most important that they actually take it. The psychology of 1984-85 was exquisitely instructive in this regard. Advisors, newspapers and brokers hated the markets. They were amazingly bearish. So the market went up with the fewest possible people participating. In fact, they were shorting and losing money as it rose. The history of markets shows that over 90% of investors cannot make money in the market. The few successful ones you occasionally hear about usually took the approach of long-term buy-and-hold, without regard to trend, and they were lucky enough to be in a multi-year bull market.

Q: What about so-called typical investors?

Bob Prechter: So-called typical investors just do not make money for long. They get interested in the markets at the top of every bull trend, and they get scared out at bottoms. The short-term traders lose even faster. They are sending 2% or 3% of their accounts to the brokerage industry in commissions every week or so. How long can you survive that without a good rate of market success? Since people's hopes and fears are the engine of the market -- their hopes make it go up and their fears make it go down -- the result is that most people must lose money. It is their fears that make them sell near bottoms and their hopes that make them buy near tops.

Q: Let us say you could dissect the average investor's stock portfolio over the course of a full cycle. What would it reveal?

Bob Prechter: More than 75 years ago, Don Guyon, the pseudonymous author of One Way Pockets, wanted to discover why his clients always lost money in a complete bull-bear cycle. It might be argued, he reasoned, that, at worst, they should have broken even, since at the end, prices were back to where they were at the start. He found that the answer lay in the clients' temporal orientation to the market's future. At the beginning of a bull market, he found all his clients were traders. At the top, they were all "investors." This is not only precisely the opposite of the correct orientation for making money, but also entirely natural for human beings and a key reason why the market repeatedly behaves as it does.

Q: Why do you say we are experiencing a long-term top of historic proportion?

Recall that this interview was from 2004, so this was not the mother of all timing calls.

Bob Prechter: Partly the pervasive market psychology of buying and holding stocks. "Focus on the long term and hold your stocks" is what people said right after major peaks in the 1930, 1946, 1969 and 1973, too. Back, in 1974, 1978, 1979 and 1982, you almost never heard that kind of commentary. The public certainly had no truck with it. Today, it is everywhere. People are writing books about how if you just buy stocks and hold them, you will get rich. I think that is an excellent description of the past, but I do not think it is going to describe the next 10 years at all.

Q: When will we know for certain that we have seen a market top?

Bob Prechter: For certain? When it is too late to act!

Q: If you do not know until it is too late, should traders try to pick tops?

Bob Prechter: By all means, yes. Waiting for certainty means waiting long enough to miss it.

Q: At what point in the Dow would a crash scenario become a possibility?

Bob Prechter: Any time it is open.


Del Monte Produce Is Unloved, and Thus Cheap

A company in a tough business -- which fairly characterizes Fresh Del Monte Produce's business of being a vertically-integrated distributor of fresh fruits and vegetables -- with lots of hard assets looks cheap at some point, like when you can get it at book value. (Interestingly, a look at a 10-year chart of Del Monte vs. the S&P 500 reveals a comparable performance over that period, although Del Monte's price chart describes a more volatile path.) Capital-intensive companies were valued during the inflationary 1970s, but largely fell out of favor in the bull market of the lower (but understated) inflation of 1980s and forward. It might be time for connoisseurs of undervalued balance sheet assets to rear their heads again.

For a picture of love turned rapidly to hate, punch up a one-year chart of Fresh Del Monte Produce (FDP) -- from 22 in late July 2007 to 40 this April and back to 22 today. Momentum types enamored of the trendy "agflation" theme rode the grower and distributor of fresh fruit until the cocktail-party chatter veered elsewhere. An announced acquisition and profit-margin concerns also took a toll.

Yet with most of the company's shares having changed hands in three months on the way down, it is back to being a boring, cheap stock of a decent, $1.4 billion-market-value company navigating an admittedly tough business. It trades near book value, and book value here is a pretty hard number -- ships, farmland carried at cost, etc.

Management has managed to earn industry-best returns on equity over time, and even following an earnings shortfall last week, the stock trades below 10 times projected earnings and far below where similar companies have been acquired in the past. Plenty, at least, to like, if not love.

After a Franchisor Files for Bankruptcy

The restaurant business is a tough one, but that does not keep people and corporations from trying to make a go of it -- perhaps because restaurants are such a part of everyone's everyday experience. With consumer discretionary spending currently contracting following a recent restaurant opening boom we are, yet again, in a cycle stage where there are too many seats for the number of people looking to sit down. Stores will be closing.

Media billionaire John Kluge recently pulled the plug on his holding company which owned the Bennigan's and the Steak and Ale Chain concepts. All holding company-owned stores were shut down immediately, but what about the fanchisees? Interesting question ...

What happens to franchisees when a franchisor goes bankrupt? Bennigan's owners are about to find out. The pub-themed casual dining chain filed a Chapter 7 bankruptcy on July 29, meaning it chose to cease operations and liquidate its assets rather than attempt to reorganize under Chapter 11. Bennigan's closed all company-owned locations and announced plans to sell off the assets. The remaining 138 franchisees are still operating, but they face a tough road ahead. ...

The collapse of S&A Restaurant Corp., which owned Bennigan's and the Steak and Ale Chain, took franchisees by surprise. S&A is part of Metromedia, a large, privately held conglomerate run by billionaire chairman John Kluge that has had interests in media, energy, and other sectors. [Larry Briski, president of the Bennigan's Franchise Operators Assn. and owner of four Bennigan's in the Chicago area] says there was no indication the restaurant chain was on the brink of bankruptcy in a meeting with company officials last month.

The franchisees' supply chain is intact, and Briski expects vendors to honor their contracts. Sales at his restaurants have not been affected by the bankruptcy. "We are moving forward. We are excited about the brand," he says.

But the outlook for Bennigan's franchisees and others in the casual dining space does not look good, analysts say. High food, gas, and labor costs are squeezing the restaurants' margins while leaving consumers with less disposable income to eat out. The predicament follows several years of aggressive expansion by casual dining chains, many of them franchises.

Tempting Small-Caps Unearthed by a Top Japanese Fund

Japanese fund manager Tadahiro Fujimura Fujimura says "Japan's recovery will be faster than the U.S.'s or Europe's, because its firms are less leveraged." We are partial to that way of thinking. He also thinks the Japanese small-cap market is definitely poised to rebound. For those interested in the Japanese stock market, Fujimura's fund looks like an interesting way to obtain exposure.

"You have to dig for a long time before you are lucky enough to find something other than fool's gold. There are always gems to be found, but it is never easy."

Fund manager Tadahiro Fujimura knows what he is talking about -- it has not been easy in Japan's markets for nearly 20 years. The 44-year old is the head of investment and research at Tokyo's Sparx Asset Management and also oversees its new Sparx Japan Smaller Companies Fund (ticker: SPJSX). ...

For much of his career, Fujimura has had to maneuver in Japan's slow-motion stock market fall, which has taken Tokyo's Nikkei 225 from a high of 38,916 in December 1989 to a close last Thursday at 13,376, a decline of more than 65%.

In addition to being voracious readers, Fujimura and his team of two analysts and two portfolio managers, who focus on both small- and mid-cap stocks, are relentless travelers, visiting 1,600 companies each year trying to find the gems. Sparx, through strong performance, new money flows and acquisitions, is one of Tokyo's few money-management success stories over the last decade, growing roughly 6-fold to about $12 billion in assets.

In all, Sparx now has 68 funds and employs a total of 20 analysts and seven portfolio managers. The firm's founder, Shu Abe, is one of the country's most respected value investors and an aggressive activist in pushing for shareholder rights. ...