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GLOBAL FINANCIAL SEIZURES CONTINUE, GOLD SOARS
The news is coming fast and furious this week, as the credit implosion picked up steam. The blog "Mish's Global Economic Trend Analysis" has become our favorite place lately to track the unraveling in real time. His analysis of the most important news items of the day strike us as right on, as they used to say in the '60s.
Take this blurb from his piece titled "No One Knows What to Do":
Thank God We Ran Out Of Time!
Reuters is reporting U.S. Sen. Dodd: no time now to set up RTC-type fund. ... Thank God time ran out. Otherwise Congress would be doing something even though "No One Knows What to Do". Besides, all Congress can do is make any problem it touches worse by trying to fix it.
The biggest problem is that Congress does not even know what the problem is. And unless you know what the problem is you sure as hell cannot fix it. Dodd thinks the problem is the "housing foreclosure crisis".
What The Problem Really Is
... It is no wonder the global markets are seizing up and gold is soaring given the above list of problems and that set of congressional leaders attempting to "fix" them.
- The Fed
- Fractional Reserve Lending
- Congressional Meddling In The Free Market
- Congressional Spending
- An Unsound Currency
- An Unsound Banking System
Sounds like the story to us too.
Gold peaked back in March and had been in virtual freefall since July. After bottoming out last week and rising only moderately the first two days this week, it suddenly jumped 10%+ on Wednesday to approximately $865, as buyers suddenly decided that gold was indeed a "safe haven." Whether this dramatic reversal, which surely brought a lot of smiles to all the gold bulls who have been scratching their collective heads for the last month, is the start of a big bull market leg a la stocks in 1982 -- coincidentally enough, gold bottomed at about 777, right where stocks did in August 1982 -- or merely a belated and rational repricing of a financial turmoil-hedge should soon be revealed.
Gold bulls have something to smile about today as it is soaring by more than $50 in the wake of renewed financial seizures. The markets have greeted the news Nationalization of AIG: Treasury to get 80% stake in return for $85 billion with a bang. Treasury Secretary Paulson has been on the phone all day assuring multiple countries Don't Worry, The Banking System Is Sound.
With that backdrop let's consider some of today's seizures starting with Russia. Bloomberg is reporting Russian Markets Halted as Emergency Funding Fails to Halt Rout.
Russian markets stopped trading for a second day after emergency funding measures by the government failed to halt the biggest stock rout since the country's debt default and currency devaluation a decade ago.
The ruble-denominated Micex Stock Exchange suspended trading indefinitely at 12:10 p.m. after its index erased a 7.6% gain and plunged as much as 10% within an hour. The benchmark fell 17% yesterday, the biggest drop since Bloomberg started tracking the gauge in May 2001. The dollar-denominated RTS halted trading after similar declines. ...
"The bond market remains effectively closed and banks are reluctant to lend to one another," said Julian Rimmer, head of sales trading at UralSib Financial Corp. in London. "The problems experienced by KIT Finance have heightened counterparty risk and reduced liquidity further."
Genius Fails Again
It is fitting that Russia is back in the news because it was the demise of Long Term Capital Management that kicked off a string of moral hazard interventions by the Fed that continues to this day. Please see Genius Fails Again for a recap of LTCM and the 1997 Russian Bond market collapse that then threatened the financial system. The derivatives mess today is thousands of times greater.
One has to wonder what today's derivatives geniuses were thinking (or rather not thinking) as they watched the collapse of Bear Stearns while munching on popcorn headed into last weekend's poker party with Merrill Lynch, J.P. Morgan Chase, Goldman Sachs, Citigroup, Bank of America, Barclays, sitting at the table with Lehman as the pot. See Fed Sponsored Poker Party Morphs Into "Old Maid".
No bets made revealing what we all knew, Lehman was worthless. That forced Lehman into bankruptcy at midnight Sunday.
Today Hedge Funds Are Frozen In Wake of Collapse of Lehman:
The collapse of Lehman Brothers Holdings Inc. is creating a quandary for hedge funds: Who to do business with in a tumultuous prime-brokerage industry.
Late last week, many hedge funds scrambled to shift that business away from Lehman and to other so-called prime brokers, which provide trading and lending services to the funds. But some were caught up in the bank's move to file for bankruptcy protection on Monday, say lawyers and other industry specialists. As a result, they have found their holdings effectively frozen, with no indication of when they might be able to access them.
Legal experts cautioned that it could be weeks or months before the mess is sorted out, leaving hedge funds unable to unwind positions at a time when many assets are falling sharply in value.
Money Markets Frozen
Reserve Primary Fund (RFIXX), the oldest US money-market fund, became the first in 14 years to break the buck after writing off $785 million of debt issued by bankrupt Lehman Brothers Holdings Inc.
Shareholders pulled more than 60 percent of the fund's $64.8 billion in assets in the two days since Lehman folded. Reserve Primary Fund reacted by placing a seven-day freeze on redemptions. Please see Money Market Fund Breaks $1, Suspends Withdrawals for more details.
Bloomberg is reporting Treasury 3-Month Bill Rates Drop to Lowest Since at Least 1954.
U.S. Treasury three-month bill rates dropped to the lowest since at least 1954 on concern that credit market losses will widen after the bankruptcy of Lehman Brothers Holdings Inc. and the federal takeover of American International Group Inc.
Investors pushed the rate as low as 0.233% as the loss of confidence in credit markets deepened. Reserve Primary Fund, the oldest U.S. money-market fund, became the first in 14 years to expose investors to losses after writing off $785 million of debt issued by Lehman. ...
The AIG rescue "smacks of sweeping the problem under the carpet rather than solving it in a structural sense," said Padhraic Garvey, head of investment-grade debt strategy at ING Bank NV in Amsterdam, in a note to clients.
Business Standard is reporting Global money market rates hit 9-year high.
The cost of borrowing in dollars for three months has jumped the most since 1999, with banks hoarding cash amid concern that more financial institutions will fail.
The London Inter-Bank Offered Rate, or Libor, rose 19 basis points to 3.06%, the British Bankers' Association (BBA) said today. The increase was the biggest since September 29, 1999. The overnight dollar rate fell 1.41 percentage points to 5.03% today. It soared 3.33 percentage points yesterday, the largest increase in its history. It was at 2.14% a week ago.
"Everybody is worrying about which bank is going to go bankrupt next," said Ronald Tharun, a money-market trader in Stuttgart at Landesbank Baden-Wuerttemberg, Germany's biggest state-owned bank. "There is almost nothing being traded in the money markets. Nobody trusts anyone else." ...
The cost of borrowing in the euro for three months rose half a basis point to 4.97% today, the European Banking Federation said. That is the highest level since December 5, 2000.
Global Systemic Distrust
"There is almost nothing being traded in the money markets. Nobody trusts anyone else."
Welcome to the wonderful world of derivatives and 30 times leverage Mr. Bernanke. Not many can claim to threaten the world's financial system. It took years of hard effort, but you, Greenspan and the Fed, in conjunction with fractional reserve lending, managed to pull it off. You and the Fed should be proud. Stand up and take a bow.
Some other worthwhile Mish blogs from this week include:
Armageddon Postponed – Fed Intervenes in Money Markets
The U.S. economy and financial system needs major long-term rest and recuperation to regain its health. The Fed has arranged for another round of amphetamines so that it can keep partying. Reak smart.
The Fed has announced new liquidity measures this morning governing non-recourse funding of asset backed commercial paper and plans to purchase short-term debt obligations issued by Fannie Mae, Freddie Mac, and the Federal Home Loan Banks.
Here is the Fed press release on liquidity measures. ...
Paul McCulley says "It is the ultimate nightmare to have a run on the money markets -- that is truly the Armageddon outcome -- and they are not going to allow that to happen."
I disagree. The ultimate nightmare is this action by the Fed, the Treasury, and the SEC. Government manipulation can never prevent financial Armageddon. In fact, government intervention and manipulation in the free markets eventually guarantees financial Armageddon.
Armageddon was not prevented, only delayed, and at taxpayer expense.
MONEY MARKET FUND BREAKS $1, SUSPENDS WITHDRAWALS
The Reserve Fund was the first money-market mutual fund. It opened for business in 1972. As reported in Reserve co-founder Henry B. R. Brown's obituary this past August, it took no small amount of time and effort to establish that the money-market fund concept would work. Brown and his partner "dreamed up the money-market account and dared to lead the great exodus out of the Scroogian thrifts," wrote Peter Lynch in One Up on Wall Street.
A month ago, the original Reserve Fund has assets of $62 billion. (Total money-market mutual fund assets were about $3.6 trillion.) Today it has about 40% of that number. And the reason is? Some fund managers who were too clever by half decided to reach for yield by including Lehman paper in the Reserve Fund's holdings. Blithely unconvinced by Lehman's plummeting stock, the managers relied on the hapless rating agencies' assessments of Lehman's creditworthiness -- the same agencies who failed to downgrade Lehman until it actually declared bankruptcy. The resulting writeoffs dropped Reserve Fund's net asset value by 3%, to 97 cents per share, thereby "breaking the buck." This is only the second time any money fund's net asset value had fallen at all. Investors not used to worrying about their principal pulled out of the fund in droves. What took 36 years to build was substantially demolished in a matter of months.
Bloomberg is reporting Reserve Money Fund Falls Below $1 a Share, Delays Withdrawals.
Reserve Primary Fund, the oldest U.S. money-market fund, became the first in 14 years to expose investors to losses after writing off $785 million of debt issued by bankrupt Lehman Brothers Holdings Inc.
Shareholders pulled more than 60% of the fund's $64.8 billion in assets in the two days since Lehman folded. Losses on the securities firm's debt forced the fund to break the buck, meaning its net asset value fell below the $1 a share price paid by investors, New York-based Reserve Management Corp., its closely held owner, said yesterday in a statement. Redemptions were suspended for as long as seven days.
Assets in money-market funds, considered the safest investments after cash and bank deposits, rose to a record $3.59 trillion this month as stock and commodity markets fell. ...
The $260 million Colorado Diversified Trust has also fallen below $1 a share because of losses on New York-based Lehman's debt, according to the S&P statement. The fund pools investments for state and local governments and schools, according to its Web site.
Reserve Primary held $785 million in Lehman commercial paper and medium-term notes. The fund's board decided yesterday that the debt was worthless. That pushed the fund's net asset value to 97 cents a share, the company said in the statement. Investors who requested redemptions by 3 p.m. New York time yesterday will get all their money back.
Money-market funds, which are regulated in the U.S. by the Securities and Exchange Commission, strive to preserve the $1 a share net asset value, meaning that investors can always get back their principal, as well as interest earned by the fund on its investments. They are required to hold debt that matures in 13 months or less, with a weighted average maturity of 90 days or less. The securities must have top short-term corporate debt ratings.
"We'd all forgotten that any investment comes with risk and we're learning it the hard way now," said Kiyoshi Ishigane, a Tokyo-based senior strategist at Mitsubishi UFJ Asset Management Co., which oversees about $61 billion. "Even the safest investments, like the money-market funds, are starting to pose risks and that shouldn't be a surprise given the crisis in the financial industry."
MarketWatch is reporting Money market giant freezes redemptions. ...
What happened is a couple of fund managers who arguably should have known better, relied on continually hopeless ratings by Moody's, Fitch, and the S&P. It took the big three an actual bankruptcy to downgrade Lehman as noted in Moody's, Fitch, S&P, SEC are Useless. The rating agencies only downgraded AIG one notch, and are pathetically behind on rating mortgage backed securities.
Expect to see more blowups likes these, especially with any money market fund making a claim of "high yield". The only way to achieve high yield is to take risks. A 3% loss does not sound steep except there are not supposed to be (and there should not be) any losses at all.
The only truly safe place at the moment is in U.S. treasuries held to duration, CDs held to duration, checking accounts, and savings accounts. The CDs, checking accounts, and savings accounts have an additional stipulation that they must be under the FDIC limit.
THE GREATER DEPRESSION AND WHAT YOU SHOULD DO ABOUT IT
Doug Casey has been forecasting the coming of a "Greater Depression" for a good long time now. Of course the events of the last year are consistent with both that event and that event occurring within a visible time horizon rather than the indefinite future. What should you do about it? Hunker down now, before it is forced upon you, is the gist of the advice.
I believe in the existence of the business cycle. That is partly because almost everything in life is cyclical, which has been recognized at least since the tale about Joseph and the 7 fat years and 7 lean years. The Austrian school of economic thinking explains why the business cycle keeps coming around and does so without relying on a soothsayer to interpret your dreams. I urge you to read the appropriate chapters in either Crisis Investing for the Rest of the 90’s or Strategic Investing (both by Casey) for a full explanation. But, in a nutshell, government intervention in the economy -- through taxes, regulation and, most importantly, currency inflation -- causes distortions and misallocations of capital that must eventually be unwound. The distortions degrade the general standard of living, and the economy goes into a recession (call that an incomplete cleansing). Or it goes into a depression -- wherein the entire sickly structure comes unglued.
The last real depression took place in the 1930s. The economy very nearly went over the edge again in the early '70s and again in the early '80s. Both times massive re-inflation of the currency papered the problems over (but at a cost). Meanwhile, most importantly, continuing technological innovation and increased savings (motivated by the fear of bad times) led to recovery. Since then we have had 25 years of what Herman Kahn predicted would be "The Long Boom."
Unfortunately, much, much more severe taxes, regulations, and inflation have caused much, much more severe distortions in the economy -- especially over the last 15 years. And the boom was financed largely by debt, which made everybody feel and act much wealthier than they really were. It is as though you borrowed a million dollars and spent it all on wine, song and high living. For a while, you would have a high standard of living and perhaps have a lot of fun. But eventually, when you either paid the money back with interest or were forced into bankruptcy, your standard of living would take a painful drop. The U.S., in particular, has been living far above its means, burning up its own capital and trillions more borrowed from abroad.
This is not news to readers of International Speculator or even the intelligent layman who follows the news. Oddly enough, there is one glaringly obvious thing that is not in the news today at all. That is the fact that interest rates -- nominal rates too, but especially "real," after-inflation rates -- are close to their lowest levels in history. And in today's extraordinarily risky environment, they are artificially low. This, and the reasons for it, should be headlines.
All over the world, but especially in the U.S., currencies are being inflated radically; M3 is rising at about 18% per year. Without exception, interest rates eventually reflect inflation. Therefore interest rates are going to rise radically. Governments are currently suppressing rates by lending money cheaply and promiscuously, to keep both borrowers and commercial lenders from going under. But rates are soon going to explode -- especially long-term rates. My guess is that we will see at least the levels of the early '80s, which would mean 15%+ for long-term Treasury bonds. And I will say that is coming within a couple or three years at the outside.
The government wants low rates, obviously, because low rates make it a lot easier for homeowners to pay their mortgages, among other things. But they forget that low rates also discourage saving -- which is the one thing that can actually bring down real rates. Officialdom is between a rock and a hard place, and they are choosing to inflate the currency, hoping to stave off an epidemic of bankruptcy among consumers who borrowed and among the financial institutions that did the lending. The effort will fail and both groups will go bankrupt, simply because the whole society has been living above its means. That will result in large-scale commercial bankruptcies and unemployment.
Higher interest rates will absolutely hammer the economy.
It seems to me a near certainty that we are about to enter something I have long called "The Greater Depression." I suspect it will be inflationary (in the direction of what Germany underwent in the early 1920s, or Zimbabwe today), rather than what the U.S. had in the 1930s. I should somehow trademark the term "Greater Depression," except that I am sure Boobus americanus would then blame me for it.
Here I would like to pinpoint my prime candidate for the Decline and Fall of the Roman Empire, since it almost seems America has been reading pages from their playbook since day one. Many reasons have been evoked for the fall: moral turpitude, immigration, barbarian invasion, Christianity, lead pipes, etc., etc. My candidate is economic stagnation brought on by taxes, regulation and inflation. I would love to discuss that assertion in detail, but that is not what this article is about.
What should you do?
Reduce your standard of living now (while the situation is still under control), greatly increase your savings (in gold, which is real money) and rig for greatly changed patterns of production, consumption, employment and business for a considerable time. The hurricane that is just starting to hit the economy will both trigger and worsen problems in other areas. Starting with politics, because nearly everyone today believes the ridiculous notion that the government should guide the economy.
COMRADE BERNANKE DOES IT AGAIN
The largest lurch toward socialism that the U.S. has ever seen.
Peter Schiff looks beyond the surface facts of the AIG bailout -- its size and the debate over whether its collapse would have engendered the horrific consequences feared -- to the deeper implications. The bottom line is the Fed printed money and bought control of AIG. In the future why stop with incipient bankrupt companies? Why not buy sick ones that might go downhill in the future? (This would be a logical extension of the Mommy State philosophy as well.) Or why not just buy perfectly healthy companies, because the Fed can?
This may seem farfetched, but the pattern is consistent that where powers are granted to -- or seized by -- the government, they eventually get used. When most just saw another bailout, Schiff sees a historical lurch towards socialism.
By nationalizing nearly 80% of AIG for $85 billion, the Fed is doing a lot more than simply flushing taxpayer money down the toilet. The greater wrong is allowing the agency that has the power to print money to take control of a private enterprise, especially without the approval of the company's shareholders. The move represents the largest lurch toward socialism that this country has ever seen, and signals the end of the vibrancy of America's once vaunted free market economy. Since there is no limit to the amount of money the Fed can create, there is no limit to the number of assets they can acquire.
The "line in the sand" that the Government seemed to draw by refusing to bail out Lehman Brothers was erased in just two days by the very next wave of financial panic.
While Fannie and Freddie were arguably quasi-government agencies that deserved special protection, no such status exists with AIG. Where does the Fed get the authority to use the money it prints to take over private companies? Congress never gave such authority and, even if it had, it would be unconstitutional, as Congress itself has no such authority to delegate. What about the shareholders? Why did they not get to vote on this acquisition? Whatever happened to private property rights?
Where does this stop? What other troubled companies will the Fed nationalize, and how much will it cost? Why stop at troubled companies? If the Fed can buy into a sick company, why not a healthy one? Now that we have allowed the Fed to take over any asset it wants, private property rights are meaningless. When oil prices get really high, why bother with a windfall profits tax when the Fed can simply nationalize Exxon-Mobil with a few cranks on its printing press. Who needs Bolsheviks when you have the Fed?
AIG is not a bank; it is not even an investment bank. The "lender of last resort" power was supposed to apply only to banks, to prevent runs. It was not meant to apply to any company that had been declared "too big to fail."
I suppose the Fed is trying to get around some of the more obvious illegalities by having the new AIG shares issued on behalf of the Treasury. What happened to the concept of an independent Fed? Here you have the Fed seizing a private company and ceding control to the U.S. Treasury. Rather then acting independently, the Fed and the Government are merely partners in crime.
On the economic side, the Fed expects us to believe this is a smart investment. Does anyone really think that officials at the Fed and Treasury are suddenly private equity experts? These are the guys who missed both the tech and housing bubbles, and who assured us that subprime problems were contained. I would not trust them to run a lemonade stand, let alone one of the largest insurance companies in the world.
The idea that this bailout was necessary given that the alternative would be worse should by now be fully discredited. All of today's financial problems are the direct consequence of Fed policy that was designed to weaken the recession that followed the bursting of the tech bubble and the shock of September 11th. Of course, the tech bubble itself resulted from the Fed's actions to sooth the pain following the collapse of LTCM, the Russian debt default, the Asian crisis, and Y2K.
I suppose the precedent for all of these actions was established back in 1979 when the government guaranteed Chrysler's debt. It sure would have been a lot better and a whole lot cheaper if we had simply let Chrysler fail. The road to financial hell, or in this case socialism, is certainly paved with "good" intentions. Today's historic surge in the price of gold shows that at least a few investors are refusing to march in the parade.
For a more in depth analysis of our financial problems and the inherent dangers they pose for the U.S. economy and U.S. dollar denominated investments, read my new book Crash Proof: How to Profit from the Coming Economic Collapse.
CRISIS EXPOSES FLAWS IN U.S. ECONOMY, TARNISHES IMAGE
Apparently the U.S. still had a "free-market reputation" to defend going into the crisis that intensified this week. How do we know? Because Bloomberg tells us the government's "rescues" may end up tarnishing said reputation. This is a little like saying the last two years have tarnished housings' reputation for never going down in price. Or that George Bush has tarnished America's image as a constitutional republic. The alert and thoughtful need not apply.
To be sure, there are some valid points made by Bloomberg. A major one is that outsiders are properly observing that who gets rescued has a major political component to it. This will leave vitality-draining zombies walking around on life support down the line, and represents a diminition in the voluntary exchange sector of the economy in favor of the centrally managed sector. In other words: creeping socialism/fascism.
Another point is the simple one that as the U.S. overtly assumes more and more liabilities which had previously only been contingent, the quality of its debt goes down. In what may be the first instance of more of what is to come, the cost to hedge against losses on U.S. government debt rose to a record after the rescue of American International Group. Benchmark 10-year credit-default swaps on Treasuries rose to 30 basis points, more than double those on government debt sold by, e.g., Germany, Austria and Sweden. Even decrepit socialist France's debt is only at 20 bp. The assessment of the market is apparently that the unthinkable is now thinkable.
We think the crisis is merely revealing for all to see just what a hollow shell the U.S. economy is. In Warren Buffett's colorful metaphor, when the tide goes out you see who has been swimming naked. The credit crisis is the tide going out, and we see the U.S. economy has been swimming naked. And the site is not one for sore eyes.
The rapid-fire rescues of financial firms may end up tarnishing America's free-market reputation as the moves expose defects in the U.S. economy, undermining its standing with foreign buyers of the dollar and U.S. Treasury securities.
The government's actions might add hundreds of billions to a budget deficit already expected to hit a record next year. The salvage operations, which include Tuesday's takeover of American International Group Inc., also raise questions about the U.S. commitment to a free-market economy that, until recently, was the envy of the world.
America's credit "profile is now weaker because contingent risks have become actual risks to the U.S. government," said John Chambers, managing director of sovereign ratings at Standard & Poor's in New York.
The result: Foreign investors may demand higher compensation for providing the money the U.S. government and economy depend on. That, in turn, could translate into lower living standards for Americans as borrowing costs are pushed higher and the dollar is pulled lower.
There is not much evidence that any of this is happening yet. The yield on the 10-year Treasury note fell to 3.4% yesterday from 3.9% two months earlier as investors sought refuge from the recent turmoil in financial markets. The U.S. currency, meanwhile, has strengthened to $1.43 per euro from $1.59 on July 17.
Yet in what may be a sign that the complacency will not last, the cost to hedge against losses on U.S. government debt rose to a record yesterday (Wednesday) after the Federal Reserve's rescue of insurance giant AIG. Benchmark 10-year credit-default swaps on Treasuries increased 4 basis points to 30, more than double those on government debt sold by Austria, Finland or Sweden, according to BNP Paribas SA.
Is the market saying there are some circumstances where the U.S. would default outright rather than de facto default by hyperinflating the dollar debts away?
Until now, the U.S. has enjoyed a special status among investors, thanks to the size of its economy, the power of its military and the depth of its financial markets. The dollar supplanted the British pound as the world's reserve currency after World War II, enabling America to borrow freely from abroad and run up big trade deficits. All this fed the country's sense that the U.S. was exceptional, destined to be the global political and economic leader.
America can no longer take its privileged position for granted. It has already lost some of its diplomatic luster because of President George W. Bush's go-it-alone foreign policy and the invasion of Iraq.
The successful introduction of the euro a decade ago has created a rival for the dollar as the world's main currency for trade and investment. The rapid growth of emerging markets, particularly China, has also undercut America's attractiveness to the world's financiers.
That is why the ongoing financial turmoil is so dangerous. The meltdown has created "a crisis of confidence in the U.S. government," said Jim Leach, a former Republican U.S. congressman from Iowa who is now a professor at Princeton University in New Jersey. "The twin pinions of American strength -- our politics and our finance -- are under the gun today.
Estimates of the eventual price the U.S. government will have to pay to end the credit crisis vary widely, ranging as high as $2 trillion. Many are lower than that, at roughly a half-trillion dollars -- equal to about 4% of GDP. Kenneth Rogoff, an economics professor at Harvard, wrote in the Financial Times today that the U.S. may have to spend between $1 trillion and $2 trillion.
While such a bill would be more than twice what the U.S. paid in today's dollars to resolve the savings-and-loan crisis in the early 1990s, budget experts said it would be manageable to finance on its own. The trouble is, the federal government already faces liabilities in the tens of trillions of dollars as baby boomers retire and begin collecting Social Security and medical benefits.
Joshua Rosner, an analyst with research firm Graham Fisher & Co. in New York, said the costs are unclear partly because the Treasury is effectively keeping some of them off the government's balance sheet by parking them at the Fed. That is the same sort of practice that got Citigroup Inc. and other banks in trouble during the now year-old credit crisis.
Fed Chairman Ben S. Bernanke and his colleagues committed $29 billion to back the takeover of Bear Stearns Group by JPMorgan Chase & Co. in March. Treasury Secretary Henry Paulson followed with a pledge this month of as much as $100 billion each for Fannie Mae and Freddie Mac to ensure that the two mortgage companies continue supporting the battered housing market. The Fed then kicked in an additional $85 billion this week for AIG.
Harvey Pitt, chief executive officer of Kalorama Partners in Washington and former chairman of the Securities & Exchange Commission, argued the rescues would help reassure foreign investors that the U.S. is not prepared to accept a free-fall in financial markets. The bailouts, unfortunately, also do something else: They highlight the fragility of the U.S. financial system.
"The foreigners are torn right now," said Mohammed El- Erian, co-chief executive officer of Pacific Investment Management Co. in Newport Beach, California (PIMCO). "On the one hand, they are stunned by what is happening to the U.S. financial system. On the other, they are impressed that we are getting a policy response that is relatively fast."
Sovereign-wealth funds invested just $900 million in new capital in U.S. and European financial institutions so far this quarter. That is down from $6.43 billion in the second quarter, $19.7 billion in the first and $28.5 billion in the final quarter of last year, according to data compiled by Bloomberg News.
Nobel Prize-winning economist Joseph Stiglitz said that the haphazard nature of the bailouts may discourage investors from putting money in the U.S. because it increases uncertainty about who will survive and who will fail.
"We used to believe that America was a country or a government that was based on the rule of law," the Columbia University professor said in a September 16 interview on Bloomberg Radio. "Today, we appear to be a law of discretion. Who gets bailed out seems to be totally up to the discretion of Paulson, of Bernanke."
Sometimes Stiglitz gets to go to the head of the class. Other times he seems clueless. The above is an example of the former.
William Poole, a senior economic adviser at Merk Investments LLC and former St. Louis Fed president, said in a Bloomberg Television interview yesterday that the market system would be hurt by increased regulation in the wake of the rescues.
"It is likely that we will see a much heavier regulatory hand that, in the end, is going to saddle lots of companies with unnecessary costs and damage our market system," said Poole, a Bloomberg News contributor.
Foreigners' appetite for investing in the U.S. may also be tempered by the impact of the crisis on the economy. Allen Sinai, chief economist at Decision Economics in New York, said the U.S. is in for an extended recession as the financial services industry -- a major source of increased productivity growth in the past -- consolidates.
Productivity growth? The U.S. financial services industry's growth has been Warren Buffett's "invisible foot" that has stifled the growth in true wealth, with help from the visible foot of government.
"The federal government assumes that it can borrow whatever it wants from foreign lenders at low interest rates for as long as it wants," said David Walker, former comptroller of the U.S. Government Accountability Office who's now head of the Peter G. Peterson Foundation in New York. "That's an imprudent assumption."
GLOBAL CREDIT SYSTEM SUFFERS CARDIAC ARREST ON U.S. CRASH
The global credit system almost grinds to a halt as yields on U.S. Treasury bills reach zero for the first time since the Great Depression.
The UK's Ambrose Evans-Pritchard's commentary on the machinations of the financial world are a cut way above the standard pap. He was noticeably ahead (so far as we noticed, anyway) of his mainstream media colleagues in sounding the alarm about the potential cataclysm which lay in store once the credit bubble started to deflate. Consistent with his pedigree and class, his recommendations tend to be on the order of what the Fed should do next to fix things, i.e., create more money and credit. Notwithstanding this systematic failure to identify root causes, his ruminations and reporting seldom fail to excite a few brain neurons.
This week Evans-Pritchard is once again blaming the Fed for not inflating enough, calling the system seizure a verdict on the failure to lower interest rates. Ignoring that, the rest of the article is more than a little interesting. The wider world is finally actively wondering or saying what the "gloom and doomers" have been expressing for, well, decades, really: The U.S. is de facto bankrupt, the U.S. dollar's role as the world reserve currency cannot last, that "The endgame will be helicopters full of cash dropped by Ben Bernanke," as the global strategist at Société Générale was quoted as saying. (The quotes sounds a little garbled, but we get the idea!)
The global credit system came close to total seizure yesterday (Wednesday). Key parts of the derivatives market shut down and a panic flight to safety depressed the yield on 3-month U.S. Treasury bills to almost zero for the first since the Great Depression in 1934.
The closely-watched TED-spread measuring stress in the interbanking lending market rocketed to 238 as the share prices of Morgan Stanley, Goldman Sachs, Citigroup, Wachovia, and Bank of America all went into a tailspin yesterday.
The collapse in investor confidence is a harsh verdict on the judgment of the U.S. Federal Reserve, which chose to ignore market pleas for a rate cut to halt what amounts to a modern-era run on the banking system. Almost none of the current Fed governors have market experience. Most are academic theorists.
The Fed had hoped that a targeted $85 billion bail-out for insurance giant AIG -- on onerous terms -- would be enough to stabilize the banks after the weekend failure of Lehman Brothers. Instead it set off a cardiac arrest at the heart of the credit system.
Bernard Connolly, global strategist at Banque AIG, said the Fed and the Treasury were doing too little, too late, to stave off disaster. Interest rates need to be cut immediately and dramatically, while Washington must prepare for a wholesale takeover of large parts of the lending system along the lines of the Scandinavian bank rescues in the early 1990s.
"Unless there is a very rapid change of mind, depression -- with all its horrors and consequences -- will be inevitable. The judgment that letting Lehman go would not create systemic risk depended, if it was ever going to be anything other than ludicrous, on very rapid action to shore up the financial system. Instead, Hank Paulson seems to be adding to the risk in the system," he said. "We fear that a virtual nationalization of the financial system will now be necessary."
America's Reserve Primary Fund suspended withdrawals after shareholders pulled out almost $40 billion in two days on news of its heavy exposure to Lehman's debt. The move came as the fallout from Lehman's collapse spread worldwide. Japan's Nikkei wire said Japanese banks would suffer almost $2 billion of losses on Lehman's bond defaults. Russia suspended trading the Moscow bourse after the Micex index crashed 24% in two days. Officials promised $44 billion to support the banking system.
As Washington bails out one financial institution after another, investors have begun to doubt the long-term credit-worthiness of the U.S. itself. The cost of insuring against default on 10-year U.S. Treasuries jumped to an all-time high of 30 basis points yesterday, as measured by the credit default swaps (CDS) on the derivatives markets. Germany is at 13, and France is 20.
"This is historically significant because we have never seen anything like it before," Daniel Pfaender, sovereign credit strategist at Dresdner Kleinwort. "What we don't know yet is whether this a liquidity issue or whether it reflects the credibility of the U.S. financial system."
Exactly: Is a solvency or a liquidity issue? People are slowly coming to suspect the former.
The Treasury's rescue of the mortgage giants Fannie Mae and Freddie Mac has added $5.3 trillion in liabilities to the U.S. government. It almost doubles the national debt (under IMF definitions), at least on paper. The Fed has now added a further $85 billion in debt for AIG. While the sums are manageable so far, what worries investors is the likely avalanche of insolvencies yet to come.
The Federal Deposit Insurance Corporation FDIC has already exhausted half its capital cleaning up after the collapse of IndyMac. It may need half a trillion dollars of fresh money to cope with the 120-odd lenders on its sick list. Professor Nouriel Roubini from New York University warns that several hundred banks will go under before this hurricane has exhausted its fury.
John Chambers, head of sovereign ratings at Standard & Poor's, said America's AAA grade is safe for now. The Fannie/Freddie bail-out is not comparable to ordinary state debt. It is backed by housing collateral, mostly based on prime mortgages.
"In the worst case scenario, the losses from Fannie and Freddie will be 2.5% of GDP. This is not to belittle the unprecedented actions of the last two weeks. For the US to lose its AAA we would have to see the sort of financial distress that occurred in the Nordic countries. It could get that bad. There is no God-given gift of a AAA rating. The U.S. has to earn it like everyone else," he said.
Charles Dumas from Lombard Street Research said America's dependency on foreign money would carry a high price. "The ultimate test will be whether this seriously jeopardizes the reserve currency role of the U.S. dollar. China finances the U.S. government. So as long as the Chinese are willing to accept an annual loss of 15% on their holdings of U.S. bonds in real yuan terms, this can go on, but the decision lies in Beijing. What is clear is that it will take the U.S. decades to pay this off," he said.
Hans Redeker, currency chief at BNP Paribas, says the U.S. debt scare is vastly overblown. America's total government debt is 48% of GDP on IMF measures, compared to 57% for Germany, 94% for Japan and 108% for Italy.
"The debt levels are nothing compared to Europe, even after Fannie and Freddie. America still has great leeway," he said. "We think the next phase of this crisis is going to be a repatriation story as American investors bring their money back from frontier markets. The U.S. broker dealers were 60 times leveraged and now they need to take assets back onto dollar balance sheets."
Albert Edwards, global strategist at Société Générale, said Washington's serial bail-outs are the inevitable result of the credit bubble of preceding years. "This was all baked in the cake long ago. What we have seen so far is just a dress rehearsal for the deep recession that is coming. America is going to be losing 500,000 jobs a month. That is when we will see interest rates go to zero. The deficit will be covered with printed money as it was in Japan. The endgame will be helicopters full of cash dropped by Ben Bernanke," he said.
IS THE U.S. GOING BROKE?
Now that the federal government has bailed out Fannie and Freddie, who is going to bail out the federal government?
Economics professor Laurence Kotlikoff has published extensively on the U.S. government's fiscal situation and machinations. He is an economic adviser to former Democratic Presidential candidate Mike Gravel, and a supporter of the "FairTax" proposal, which would replace federal income taxes with a national retail sales tax. In short he is a scholar with a conventional background worldview. Do not expect any proposals to abolish the Fed, or any pronouncements that taxation is theft.
Having said that, Kotlikoff does not deny reality: The U.S. government cannot continue running its finances as it has. He suggests that if the government would set a good role model, then the financial industry might follow suit. Failure to do so will result in an "earthquake," via "a collapse in the market for U.S. government bonds as domestic and foreign investors realize that the only way Uncle Sam can meet his future spending obligations is to print massive quantities of money."
The federal government's takeover of Fannie Mae and Freddie Mac represents a huge financial tremor. These two institutions now issue 70% of Americans' mortgages. Their failure would have triggered a complete meltdown in housing and financial markets. So now Uncle Sam is on the hook for $5 trillion, consisting of corporate debt owed by those two institutions and mortgage debt guaranteed by them.
If only the government's total debt were that low. Uncle Sam, for all his righteous indignation, is, in fact, the father of all deceptive accounting. The government has arranged its budgeting to keep the great bulk of its liabilities off the books and out of sight.
The real liability facing our government is $70 trillion. This represents the present value difference between all the government's projected future spending obligations and all its projected future tax receipts. This fiscal gap takes into account Uncle Sam's need to service official debt -- outstanding U.S. government bonds. But it also recognizes all our government's unofficial debts, including its obligation to the soon-to-be-retired baby boomers to pay their Social Security and Medicare benefits.
Given current policies, each of the 78 million boomers can expect, on average, to receive $50,000, in today's dollars, from these programs in each and every year of retirement. Multiply 78 million boomers by a $50,000 annual payment and you get close to $4 trillion per year. This helps you see why our nation's true indebtedness is so extraordinarily high.
There are other obligations, too, that are not calculated into the national debt, or even in the $70 trillion, but for which the government remains at risk. House prices have not stopped falling. They are down 20% from their peak two years ago. But they remain 70% above their value in early 2000. That was the year prices started going crazy. If the price pendulum swings back to 2000, we will see the mortgage default rate, currently at a record 9%, soar. We will also see more Americans file for personal bankruptcies and default on their credit cards. This will put many more financial institutions under water. The Federal Deposit Insurance Corp. has $45 billion on hand to cover bank failures, such as that of Indymac earlier this year, which cost the FDIC $9 billion. Large-scale bank failures could leave the FDIC short hundreds of billions of dollars. The total of insured deposits in this country is $4.5 trillion.
These are the devils we don't know. What about the one we do know -- the $70 trillion one? How do we pay for that? One option is doubling employer plus employee payroll tax rates immediately and permanently. That would take another 15% out of our pockets each payday. Not likely to happen.
Another option is to cut benefits. Medicare could be scaled back to keep its cost growth in line with the growth in the economy. Social Security is 20% underfunded, which means that its taxes have to go up or its future benefits have to come down. But neither presidential candidate is acknowledging our nation's true insolvency, let alone providing real solutions (such as raising the retirement age or indexing benefits to prices rather than wages).
The decline in the dollar and our low national saving rate reflect an old policy of the government living beyond its means. If you look at all the extra consumption, it is occurring in large part among the elderly and, in large part, in the form of health care. This is not oldster bashing. We need to care for older Americans, but we need to do so in a way that does not constitute fiscal child abuse.
There is still time, and there are ways to put our fiscal house in order. But the longer we wait, the more likely we are going to get hit by a true financial and economic earthquake.
The earthquake will come via a collapse in the market for U.S. government bonds as domestic and foreign investors realize that the only way Uncle Sam can meet his future spending obligations is to print massive quantities of money. The result will be sky-high inflation and interest rates and, most surely, a prolonged reduction in output and employment. This could happen today. It could happen tomorrow. But it will happen here just as it has happened in every other country that tried to spend far beyond its ability to pay.
Having our government acknowledge and fix its long-term fiscal crisis will provide our financial industry something it so desperately seems to need -- an honest financial role model.
WORSE IS YET TO COME
American consumers have been on a spending spree for a quarter-century, kidding themselves that paper gains on stocks and house prices are a form of saving. They never stopped as long as credit was available. Now it is gone.
Gary Shilling has been forecasting what we are now seeing for a long time now. Here he speculates on which economic sectors will be effected by the next level of consumer spending cutbacks. Areas considered recession-proof will be shown to be recession-prone. Items once viewed as necessary will be revealed to be discretionary. Check your equities exposures using that kind of thinking, he advises.
A massive U.S. consumer retrenchment is on the way, and discretionary spending is going to shrivel. I am expecting to see the biggest decline in consumer spending since the 1930s and the worst recession of the post-World War II era.
The slump in consumer outlays will be phase three of the recession already under way. Phase one, the housing collapse, commenced early last year, as the subprime slime oozed through the residential real estate market. Home prices are now 20% off their peak, but they are only halfway to their bottom, as excess inventories, the mortal enemy of strong prices, continue to do their grim work.
Wall Street's woes, phase two of the downturn, started in mid-2007 with the revelation that many financial firms were carrying far too much debt against questionable, often subprime-related assets worth a fraction of their book value. Writedowns continue, and at least one more big firm will probably follow Bear Stearns out the door [This was written before the Lehman collapse.] while Fannie Mae and Freddie Mac become wards of the state.
So far the recession has hit the financial sector hardest. Phase three will broaden it to depress GDP (which was, as the bullish Ken Fisher notes, up in the second quarter). Phase four will extend that damage as the recession goes global. That, in fact, has already begun, with economic weakness from our financial crisis spreading across Europe and Japan. Housing bubbles abroad (Spain, Ireland and the United Kingdom) are collapsing, consumers are retreating and exports to the U.S. are withering. Developing countries like China and India are dependent on exports to the U.S. and will be hard hit. American consumers have been on a spending spree for a quarter-century, kidding themselves that paper gains on stocks and house prices are a form of saving. They are way overleveraged, but they never stopped as long as credit was available. Now it is gone. The dollars they raised from home equity loans and cashout refinancings are disappearing. Their credit cards are maxed out. Many of them owe more on their cars than the cars are worth. At the same time that lenders are tightening the purse strings, consumers are facing job cuts and high food and energy costs.
Only a fifth of the $100 billion in tax rebates was spent on new purchases; the rest went to pay bills. That is over now anyway, and the full cost of consumer distress will be revealed in its wake. Anything discretionary is fair game, even for those at top income levels who are supposed to be immune to business cycles. Real estate sales in ski towns like Park City, Utah are weak. Likewise house sales in New York's Hamptons. Luxury cruise operators are discounting as if there were no tomorrow.
At the lower end, grocery store coupon-clipping is back. Consumers are trading down to Wal-Mart and Costco from department stores and choosing house brands and generics over national brands. They are tanking up with regular instead of premium. Their spending cuts are wounding apparel chains, bookstores and consumer electronics stores. Bottled water is giving way to tap. Brown-bagging your lunch costs half as much as buying it at a deli, and Ebags.com reported a 39% jump in August sales of lunch bags and coolers from a year ago.
Sit-down restaurant owners (like the Darden chain, whose restaurants include Red Lobster and Olive Garden) are suffering as people eat at home, and when they do go out, it is increasingly to low-cost fast-food places. Starbucks is closing stores. Satellite radio and TV growth is slowing. Declining business and leisure travel is softening hotel room occupancy (from 64.5% two years ago to 62.6% now). Casinos are proving recession-prone, which no one expected. People are even skipping their medical prescriptions.
Imitating their subprime counterparts who mail keys back to the bank, consumers with better credit scores will start to view their payments on home equity, auto and student loans and credit cards as commitments they can postpone or forget entirely. Losses on securitizations of those loans will add to Wall Street's woes.
When you think of consumer discretionary spending, you probably think first of expensive items like cars, appliances, air travel, cruises and vacation houses. But there is much more to it than that. I do not recommend specific stocks or exchange-traded funds in my columns, but check your portfolio against the things I have discussed. Then use your imagination and observations to add more. How about producers of motorcycles and expensive sneakers, and credit card companies?
Ken Fisher remains bullish, assessing that people are irrationally unexuberant. He has 5 large capitalization, fairly cheap stocks to buy and hold while we wait for people to regain their senses and start buying again.
What is the word for an unbubble? Maybe "cavitation" will do, if you are a hydraulic engineer. I am talking about the opposite of a speculative bubble: the absence of interest in owning stocks, a vacuum of optimism, a black hole of negativism. People are irrationally depressed, and their depression feeds more depression.
The bubble, as investing phenomenon, has been well studied ever since the 17th-century tulip bulb frenzy. Its counterpart in bear markets is not well understood. We have got an unbubble going on right now. People are dour and pessimistic. They are acting as if we were in a depression when we are not. We are not even in a recession.
In a bubble, anyone who argues pessimistically is seen as crazy. In today's reverse bubble, when you argue optimistically you are seen as the crazy one -- you "just don't get it." And because there is no word for irrational pessimism, folks are blind to it. Bubbles are hard enough to see, but reverse bubbles are completely invisible.
People see Fannie Mae's problems as huge, but in money terms the worst imaginable fix is smaller than the Anheuser-Busch takeover. When Kenneth Rogoff, a relatively little-known Harvard economist, recently pontificated that the worst was ahead, European media were transfixed. But when U.S. GDP rose in the second quarter above the quarter before, and inventories fell, both bullish facts were dismissed. Then when inventories piled up in July, it was a big, bad deal.
When the economies of emerging markets do not just grow but beat expectations, there is scarcely a mention. The fact that the earnings yield (the inverse of the price/earnings ratio) of nonfinancial firms is today higher relative to long-term interest rates than it has been in your adult lifetime is not reported either. Britain's flat second-quarter GDP was reported as a sign of recession.
Before the reverse bubble ends, buy something. Here are five stocks to own.
3M (71, MMM) is cheaper than it was five years ago. This superbly managed $25 billion (in revenues) firm grows slowly but surely, with a vast array of industrial and consumer products. Among thousands of other things, 3m makes adhesives, stethoscopes, library systems and welding helmets. At 12 times this year's earnings and 2 times revenue, and with a 2.8% dividend yield, 3M is highly likely to pay off.
Oil is off its peak price, so oil stocks are weak. That is a good reason to buy Total (67, TOT), the French oil company. Oil's long-term trend is still up. This vertically integrated energy firm has 16,000 gas stations selling its brand and 11 billion barrels of oil equivalent in hydrocarbon reserves all over the world. That comes to 4.6 barrels of reserves per share. The company's $160 billion market value is a dirt-cheap 6 times 2008 earnings and 0.8 times revenue. The yield is 4.4%.
Cameron International (43, CAM) will operate flat-out unless the price of oil goes through the floor, which I would bet against. If you need a big oilfield valve called a blowout preventer that can handle 10,000 pounds per square inch of pressure, you go here. As a leader in oil and gas separation equipment and other gear used in energy production, Cameron does well as long as development activities continue. Still, it sells at only 13 times 2008 earnings and twice its $5.4 billion in annual revenue. Don't fret that North America is running dry; this company operates in 100 countries.
The conglomerate Textron (41, TXT) does a bit of almost everything, from helicopters and jets (Bell and Cessna) to lawn care, golf carts, pumps, gears, fuel systems and more. Its stock is down 43% this year, back to where it was 10 years ago. When the economy bounces back, it will, too. Your risk is low, because you are paying only 9 times 2008 earnings and 0.7 times annual revenue. The stock yields 2.3%.
Latin America keeps growing, and the Chilean firm LAN Airlines (12, LFL) will grow with it. Now linking Argentina, Chile, Ecuador and Peru to the rest of the world with both passenger and freight aircraft, LAN should keep on adding gates and passengers. Think of Santiago as the Los Angeles of the future. I expect LAN to enjoy growth exceeding 15% a year, yet it sells for 12 times 2008 earnings and one times revenue, with a dividend yield of 4.8%.
GET READY FOR RISING PRICES
David Dreman, having been burned by some previous financial stock recommendations, does not have to learn the same lesson twice and is now staying away from companies that use high leverage in order to finance assets whose value is deteriorating. Instead he is recommending producers of oil, metals, and industrial commodities -- all of whose prices Dreman believes will be rising before too long.
The markets, the dollar and commodity prices have all plunged and then rebounded. Financials are still falling. Economic news both in the U.S. and abroad continues to get worse. How do you chart a course in all this? Through all the smoke, and the cacophony of distressed voices on the financial battlefield, I find several things you can sensibly do.
Before you do any of them, you need to recognize the dilemma that the Federal Reserve and the Administration find themselves in -- and are powerless to resolve. As investors are painfully aware, banks, investment banking firms and Fannie Mae and Freddie Mac (which have almost become penny stocks) are still drowning in seemingly endless pools of bad mortgages. Despite ample borrowings from an indulgent Fed, banks are far less liquid than when the crisis began. As loan defaults continue, they are going to have to write down their portfolios even more, further impairing their capital and shrinking their stock prices. They are reaching a point where they cannot raise new funds without badly diluting current shareholders. Thus the input of new funds by the Fed has not lowered rates for mortgages or raised the financial institutions' liquidity.
Consumers are trapped by stagnant wages, depleted savings and falling house prices. They are slipping behind on their mortgage and home loan payments, and their spending is being squeezed harder than in more than a generation. So the Fed and the Treasury have no choice but to keep interest rates low until the current liquidity problems are under control. Not to do so would result in a steep recession and the threat of a financial panic. Yet keeping rates down risks damage to the economy from the highest inflation since the 1978–81 period, when prices rose at an average of 11% a year. That is the Fed's dilemma.
The July Consumer Price Index was 5.6% higher than a year earlier, the Producer Price Index 9.8% higher. Import prices, thanks to a weak dollar and expensive oil, are 21.6% above a year ago, the largest one-year increase since the index began in 1982. Optimists predict that energy, raw material, commodity and import prices, the strongest forces behind rising inflation, are likely to reverse direction and drop significantly. Wishful thinking. The world is short of oil, and the appetite for it keeps growing at almost double the rate of new discoveries. There has not been a year since 1984 when new finds outstripped consumption. Even if a recession slows down oil use in the U.S. and Europe, demand will still increase in China, India and the Middle East. Rapid industrialization in those regions will continue to drive up commodity prices.
That is why I believe we will see higher inflation over the next few years. If I am right, then once financial markets stabilize and the mortgage debacle is brought under control, the Fed will have to make up for lost time by significantly hiking interest rates.
What can you do? First, if you insist on owning bonds, keep your maturities very short. It will cost you yield, but you will more than make it up when the Fed puts the brakes on and rates soar. (And if you have the stomach for risk, take a short position in 30-year Treasurys by shorting the long-bond future on the Chicago Board of Trade.) Second, do not give up on the market. Hold a well-diversified portfolio of quality stocks. They may lag inflation for a while, as they have in past spurts of rising prices, but they should catch up and significantly outperform inflation over time.
This is one of the toughest times we have been through in a generation, but it is also one that presents some very good opportunities for those who can stick it out. Those adding equities to their portfolios should start with oil producers. Many are trading at low price/earnings ratios and will present good value when business activity picks up again. Anadarko (59, APC) is an explorer and producer whose trailing multiple of 29 is the result of one-time charges; it is going for 9 times likely 2009 earnings. Chesapeake Energy (44, CHK) is a natural gas producer with a trailing multiple of 12. ConocoPhillips (78, COP) is an integrated giant. It goes for 7 times earnings and yields 2.4%.
Metals and industrial commodities have also been knocked down sharply by fears of prolonged recession. Two I like are BHP Billiton (63, BHP), which trades at 11 times trailing results and yields 3%, and Freeport-McMoran (80, FCX), with a P/E of 9 and a yield of 2%. Finally, two more good values at current prices: United Technologies (67, UTX), trading at 14 times earnings and yielding 1.9%, and Lockheed Martin (115, LMT), at 15 times earnings and yielding 1.4%.
Stock advisors aim neither for hot growth stocks nor for dirt-cheap value ones, but the sweet spot is in between.
Applied Finance supplies stock picks to about 200 institutional money managers with collective assets under management of over $300 billion. They also run a tiny $17 million mutual fund. This Forbes piece details their approach, which modifies the typical search for cheap companies earning high returns on equity/assets. Applied Finance's version of earnings is rather different from the usual accounting earnings reported by companies, adding back in certain numbers like depreciation and R&D and subtracting a charge for capital employed. In calculating a company's value they make explicit assumptions about how fast these modified returns will revert to the mean.
One must repect the effort Applied Finance has made, which looks like a heroic attempt to guage companies' true economic profits without actually going the full nine yards and making explicit projections for future cash flows. As Forbes archly observes at the article's end, if Applied Finance's young mutual fund is any indication it is a tough job.
Rafael Resendes is a prophet of financial mediocrity. He spends his days hunting not for the sexiest, fastest-growing companies but for the ones he views as cheap relative to their growth prospects. The firms he likes have both an "economic margin" -- an ability to earn more than a normal return on the capital tied up in their business -- and a reasonable price. The hot stocks he recommends selling short boast outsize profit margins or growth rates he believes will regress to the mean. He likes Johnson & Johnson. In his short-sale portfolio: Sealy Corp (ZZ).
"We'd rather bet on a firm's profits turning down than consistently beating the market," says Resendes, a University of Chicago MBA who runs an outfit called Applied Finance Group with former Chicago classmate Daniel Obrycki.
Resendes and Obrycki do not have this style to themselves. They share it with various "value" investors. Also overlapping: the growth-at-a-reasonable-price school and the "cash flow return on investment" crowd, led by Holt Value Associates, a unit of Credit Suisse. Holt likes stocks it expects to earn high cash returns on assets.
A downside of such strategies, admits Resendes, is that they miss out on a lot of home runs. Applied Finance's risk-averse strategy would, for example, have steered investors clear of Wal-Mart during most of a 20-year run ending in 2000 when the stock rose in value 20,000-fold.
Now what? After its hot-stock era Wal-Mart spent the better part of a decade skidding sideways, leaving the shares at $60. Resendes says the current price implies the company will grow at merely 5.8%, half its historical rate. He thinks it will do better than that, given the investments it has made in existing stores and the boost it will get as a stronger dollar lowers the cost of its imported wares. He considers the stock a buy.
On the flip side Resendes points to Sears Holding Co. He expects its stock to fall 20% because investors have underestimated how rapidly it is losing market share.
Resendes, a recreational poker player who hosts a Las Vegas poker tournament for his clients each year, likens stock picking to betting on the mighty New England Patriots. The team might be worth wagering on if bookies lay odds it will win by 14 points. But even the Pats are a lousy bet with a 50-point spread.
Resendes, the son of Cuban immigrants, has a finance degree and a Phi Beta Kappa key from UCal, Berkeley. Obrycki played football while earning an engineering degree from Missouri University of Science & Technology. They worked together at Holt before leaving in 1995 to, in Resendes's words, "build a better mouse trap." Applied Finance provides stock picks to about 200 institutional money managers who collectively oversee more than $300 billion. Resendes and Obrycki also run a tiny ($17 million) fund, Toreador Large Cap, that has underperformed the S&P 500 by 1.2% since its June 2006 inception.
Applied Finance screens 5,000 stocks by comparing the assets invested in a business to an income figure. The asset figure is not the obvious one. Resendes takes the reported assets and then adds back several things: accumulated depreciation (as shown on the current balance sheet), cumulative R&D outlays going back 5 to 10 years and an estimate of the degree to which inflation has increased the cost of things like factories. The result is an estimate of capital that is tied up in a company.
The income figure is tricky, too. For his measure of profit, Resendes takes earnings before interest and depreciation, but after taxes, and also adds back research and development costs. Applied Finance calls this measure "economic cash flow." Since cash flow is used to mean half a dozen other things, let us call it R&D-adjusted operating income.
Applied Finance subtracts from this a "capital charge," reflecting the return investors would expect to earn from similarly risky assets. If the result is positive, the firm is making a profit not only in a bookkeeping sense, but also an economic one. If it is negative, the firm is failing to compensate investors adequately for risk.
This is a specific twist on the general Economic Value Added (EVA) concept, which many companies use (or try to use) in allocating capital. It makes a lot of sense in theory: only invest in projects whose return exceeds their cost of capital. We wonder how often in practice realized returns meet or exceed projected returns.
Finally, Applied slaps a decay factor on each company's earnings that it calculates with variables like firm size and the magnitude of the economic margin. Small companies with fat economic margins often attract rivals and decay quickly; big ones tend to decay more slowly. The faster the expected decay, the less the company is worth. When the economic margin is negative, companies tend to revert up to the average and can be good buys.
Johnson & Johnson is an example of how the process works. After adding $32 billion in accumulated R&D expense back into J&J's balance sheet, Applied Finance calculates a capital base of $114 billion. Then it adds R&D expense, depreciation and several other smaller entries back to the $10.5 billion in 2007 net income to yield "economic cash flow" of $23 billion.
Finally, Applied Finance subtracts a "capital charge" reflecting the company's riskiness and how long the assets will generate cash (in the case of R&D, 5 to 10 years). For J&J, the charge in 2007 was $15 billion, meaning the firm earned an "economic margin" of 6.9%. That number has been declining lately, but with J&J at $72 a share, Applied Finance Group figures it is still worth 42% more, or $100 a share.
Skeptics note that among the flaws inherent in such stock picking methods are shaky accounting data and the need to guess at things like required returns on capital and decay rates.
"Anybody who says they can predict the decay rate ... I won't say they're lying, but it is impossible to do it accurately," says Aswath Damodarin, a professor at New York University's Stern School of Business and an expert on valuation techniques.
If nothing else, Dennis Capozza, a professor at the University of Michigan, found Applied Finance's stock estimates to be directionally correct. By his count, on average the gap between where stock prices began and where Applied Finance figured they should be shrank 15% to 30% a year from 1998 to 2005.
One thing Resendes says is for sure: If Barack Obama wins in November and follows through on his vow to raise the capital gains rate from 15% to 20%, it will drive up the required rate of return investors demand from stocks and drive down their prices. So there is no guarantee that the five long bets in the table below will go up. But they are supposed to beat the market over the next three to seven years, no matter who wins the election.
On the table of longs the one with the most upside is refiner Valero Energy (VLO), with a calculated upside of well over 100%. On the shorts, Applied Finance has bookstore chain Borders (GBP) potentially failing, and falling to zero.
PEP BOYS A DEEP VALUE
Auto parts retailer and service chain Pep Boys–Manny, Moe & Jack has never been a stellar performer stock- or company-wise. Its stock is selling at a lower price than it did in 1987, and its returns on capital -- the last time it earned over 10% on equity was 1997 -- and operating margins have lagged those of its publically traded peers. But at some point one is tempted to ask just how much lower a stock can go, and Pep Boys is there. The company is one of the leaders in its retail sector, has been around since 1921, has a reasonably strong balance sheet, and owns most of its locations.
Pep Boys' stock has been known to sustain huge runups when the company's margins go through an up-cycle and earnings rocket ahead. If results turn around (again), the stock could certainly make a major move. This piece claims that a part of the problem is the company's auto service business, which is a lower return business that the other auto retailers avoid. The article below makes a reasonable case that the margin of safety cushion at the current price is thick.
Pep Boys (PBY) does not stand up too well with its competitors from an earnings perspective, but maybe that is a good thing, as it creates the potential for mammoth progress to unfold. The last time the shares were at these depressed levels, they promptly rallied almost 500% to the $30 vicinity. Will history repeat itself? It often does, and this time around the company is leaner and meaner, so instead of a 5-banger, a possible 10-banger could be in the cards.
This is farfetched. But we would be happy with, oh, a triple.
The Competition: The O'Reilly Group (ORLY), Auto Zone (AZO) and Advance Auto Parts (AAP) are PBY's main rivals. They have an average PE multiple of 16, and a gross profit margin of 47.6%, which is a shocking 23 percentage points higher than PBY's gross margin of only 24.6%. Manny, Moe and Jack's SG&A cost is surprisingly superior to its competitors' at only 24.6% (quite coincidental that its SG&A costs and gross profit margin are exactly the same) of sales versus a 35% average. If PBY was just able to increase its gross profit margin 40% (1000 basis points) to 34.6%, its earnings would nearly vault to $4 a share, and with a peer multiple of 16, a possible share price of $64.
As this is posted the stock is at around 6 1/2. Without looking, we guess that PBY's superior SG&A cost margin is due to owning so many of its locations where its competition leases. PBY's lower gross margin must be due in part to the servicing business.
PBY stands out in the crowd: It is the lone auto parts retailer that owns the real estate on most of its locations. Its cash dividend yields 4.2% versus 0.60% for Advanced Auto Parts (AZO and ORLY do not pay a dividend). It is the only company that offers service to install the parts they sell. Its price to sales ratio is an astounding 0.16, compared to AZO's 1.38, ORLY's 1.49 and AAP's 0.82 calculation. The company is selling at only 68% of book value compared to AZO at 19 times, AAP at 3.9 and ORLY at 1.49 times its shareholders' equity.
Cash and Debt: PBY has increased its cash and decreased its debt through its ongoing real estate sale lease back program. It now carries $56 million in cash and $330 million in debt. Its debt load is lower than AZO's $2 billion position or AAP's $600 million of borrowings, but is higher than ORLY's long term debt of $75 million. PBY's cash position is somewhat lower than the group's average of $72 million. The company also has a $100 million stock buyback program in effect, with about $50 million remaining for future purchases.
Dead Cat bounce: I was surprised to see that the shares did not even experience a "dead cat" bounce despite dropping 35% last week. I expect that last week's disappointing 0.3% drop in U.S. Retail Sales did not help matters, but I am stunned that the shorts have not started covering to book profits or that bargain hunters have not entered the picture.
Analysts take: Goldman Sachs's Matthew Fassler trimmed his 2008 earnings estimates by $0.05 as well as his one year price target from $9 to $8; however at today's price, Fassler's opinion still translates into a substantial 33% return on investment. David Schick of Stifel Nicolaus was more upbeat, stressing, "we continue to believe that Pep Boys is pursuing the right initiatives to better position the company long term, and has added experienced senior management members in the last year. Their focus on automotive service offers their best chance for success." The analysts have overall ratcheted down their expectations, but that only makes it easier for PBY to ultimately "beat" estimates in the future.
Liquidation scenario: If PBY decided to sell off all its assets, pay off its liabilities and subsequently distribute the remaining proceeds among shareholders, the result could be pleasantly surprising. The balance sheet indicates that the company has $56 million in cash, $28 million in account receivables and $36 million in prepaid expenses. Current assets also list $560 million of merchandise inventory. If you add these items up and subtract 50% from the inventory amount (allowing for a closer resemblance to market value), their sum is $400 million. Adding an additional $1 billion for what the real estate is expected to fetch and you are left with a $1.4 billion war chest before liabilities.
The liabilities that must then be paid off are: Accounts payable of $228 million, Accrued expenses of $257 million, long term debt off $335 million and other long term liabilities of $66 million, totaling $888 million. If you take the expected proceeds of $1.4 billion and subtract anticipated payouts of $888 billion, you are left with $512 million to distribute between 52 million shares, equating to $9.84 per share, or a substantial 60% premium to the current share price. I realize that this liquidation analysis is somewhat crude and saddled with "rough estimates" but its main intention is to draw attention to the company's confounding undervaluation.
Bottom line: I thought for sure, the shares would have experienced at least a bounce last week, though I was woefully wrong. I still like the stock, but would not try and pick a bottom at this juncture, as supply still seems to be overwhelming demand. I think it is imperative to see a capitulation and a intraday trading reversal to occur before a prime buying opportunity arises. It makes more sense to wait for the shares to change course and begin an uptrend before buying more. A stop buy order placed at a trigger price of $7.11 seems the logical approach. You have to pay more, but the added cost, is well worth having the trend on your side.
DO FOREIGN CURRENCY ETF’S HAVE A PLACE IN YOUR PORTFOLIO?
Foreign currency trading has traditionally been limited to those with large amounts of capital to trade, or those willing to use major leverage in order to trade the minimum sized forex contracts. No longer. Exchange traded funds (ETFs) have invaded this domain, and one can participate in small-sized forex trades without using leverage. This useful article serves as a good introduction to the arena.
After looking like it was on a fast track to zero the first half of this year, the U.S. dollar rebounded dramatically over the last few months. The PowerShares U.S. Dollar Index Bullish Fund ETF (symbol UUP) rose from under 22 at its July low to almost 26 earlier this month -- a 17%+ trough to peak rise, which roughly mirrors the the euro's decline from $1.60 to under $1.40 over the same period. This is obviously not as exciting as if you had traded using 10-1 leverage with a forex broker, but if you got the intermediate trend right and sat still you made a nice return while sleeping at night.
Now it looks like the USD's bull move may be at the very least taking a breather. The mind can come up with all kinds of "reasons" why it should be weaker -- especially this week -- but markets do what they do because they do it over shorter time frames. What Benjamin Graham said of the stock market can be said of financial markets in general: In the short run they are voting machines; in the long run they are scales.
Our point is that there are now no contraints on your capacity to trade on the basis of your foreign currency convictions. The price of entry is low if you use a no-frills online broker, and the risk is easy to manage. For those who want to be heavy in cash right now, the question is cash in which currency? Almost any solution will have a corresponding ETF that can be used to implement it.
Whether you know it or not, you are probably investing in foreign currencies now. If you own an ETF or mutual fund in any international equity or fixed income product, you are taking a currency risk. It is not an indirect risk; it is as direct as it gets. Foreign holdings are priced in their native currencies, and every price movement is captured in the dollar denominated net asset value [NAV].
Even if you sell your foreign assets and invest only in American firms, you do not escape exposure. On average, large American firms do about 30% of their business in the international sphere. Their profits are immediately affected by movements in the currency markets. You cannot escape currency risks, but you can be aware of them, and you can do something to accommodate them.
The first line of defense against unhealthy currency risks is to make sure your portfolio is fully diversified in its international holdings. This spreads your currency exposure as widely as possible. Just as in stocks and bonds, where diversity is of utmost importance, the same applies to currencies and all other asset classes you own.
For many investors, just making sure your international holdings are well diversified is probably enough to reduce the currency risks to an acceptable level. But, you may want to add additional currencies to your portfolio, because there are substantial benefits derived from doing so. The most widely acknowledged benefit is the low correlation that currencies have with virtually all other classes. This feature of currenices is unique in its level of non-correlation. Other asset classes claim to be of low correlation (real estate, bonds, emerging markets for example), but when the correlations are quantified, currencies stand far above all others.
Just ask yourself, since early November of 2007 when equity markets began their slide, wouldn't it have been great to have assets in your portfolio that actually increased in value over the period? Would that help you keep on course for achieving your financial goals? It is easy to talk "buy and hold," but it is not so easy to actually stick to your guns when your investments drop by 20% or 30% in a steep market slide. This kind of market sends investors panicking to the sell window just when they should be standing fast.
Currency investing may provide just the cushion you need during rough periods, helping you to stay the course. And staying in the game is what it is all about; you cannot win if you do not play. If you panic and sell during the lowest periods, then you will be buying back at higher prices later -- buying high and selling low. Not what the doctor ordered.
If you decide to take a second step and buy currencies directly, you will discover some of the other properties of Forex (Foreign Exchange Currency) trading: first, currencies may actually make money for you by appreciating in price, and secondly, you will earn interest on your foreign currency holdings.
In Forex trading, a strategy that seeks to buy currencies that are expected to rise in price is called a "value strategy," and it is no different than your expectations that some equities are undervalued. If your analysis tells you that the Chinese Yuan, for example, is undervalued, then buy the Yuan. It is available in an ETF (CYB) (from WisdomTree) or in an ETN (CNY) (from Van Eck/Morgan Stanley). If you are right, you will profit from the Yuan's rise. If not, you will at least experience the second benefit from owning a foreign currency -- you will earn interest on your investment. This comes about because the banks that hold the currency you bought use your investment deposit to purchase commercial and government-issued short-term interest bearing investments.
So, while you are technically holding currency, you are actually holding short-term debt obligations denominated in the currency you bought. When the debt instrument matures, the interest owed is paid and passed on to you. With the Yuan and most other emerging market currencies, where it is often difficult to find local short-term deposit possibilities, the fund managers use futures contracts that accomplish roughly the same thing -- you profit from receiving the differential between the spot price and the forward contract price. Either way, you earn something on your holdings.
This feature of earning interest on the currency you own is a significant strategy for making money on foreign exchange investments. It is called the "carry trade," and is responsible for trillions of dollars of currency trading. But, it is also possible you may incur a loss if the price of your currency falls during the time you were earning interest. This possibility makes holding foreign currencies different from holding U.S. dollars in a money market account. Money market funds are managed to keep a constant value -- not difficult since there is no chance of the dollar falling in dollar value.
But when your money crosses an international border, the currency risk raises its head. This is a good reason not to engage in the carry trade -- you might lose. Although currencies usually have lower volatility than equities, there are still risks. You must be comfortable that you want to take the risks and that you can afford the potential losses that may result from currency investing.
Once you have decided to allocate an appropriate amount to currencies in your portfolio, then the fun begins. Now you can choose among all the currencies available for trading, and the list is getting longer every month. This is a good thing, in my view, for not too long ago, if you wanted to hold Forex, you had to open a special trading account with one of the online trading brokers. It is a fast-moving, wild and wooly environment, highly leveraged, where fortunes are made and lost on an hourly basis. This is not suitable for most investors, especially those who have lives outside the Forex arena.
Fortunately, a new kind of ETF and ETN has been recently introduced that allows an average individual investor to buy a fairly good range of currencies. There are currently about 12 pairs available, and additional pairs can be bought if you select one of the bundled exchange-traded products. Speaking of pairs, do not be put-off by this terminology. In fact, one cannot speak of the dollar rising or falling without referencing another currency. The dollar cannot rise or fall in relation to itself; it can only change with respect to some other currency. Neither can any other currency. So, when you buy Mexican Pesos in the U.S., you are borrowing dollars from yourself and investing them in Pesos. You own a currency pair: U.S. Dollar/Mexican Peso. If you were in London and bought Pesos, your pair would be the Pound Sterling/Mexican Peso.
I am going to post these lists in two groups: individual currency ETFs or ETNs, and bundled currencies of both formats.
Individual Currency Products:
Bundled Currencies Products:
- Rydex Shares ETFs: Currencies: Australian Dollar (FXA), British Pound (FXB), Canadian Dollar (FXC), Euro (FXE), Japanese Yen (FXY), Mexican Peso (FXM), Swedish Krona (FXS) and Swiss Franc (FXF)
- WisdomTree ETFs: Currencies: Euro (EU), Japanese Yen (JYF), Brazilian Real (BZF), Indian Rupee (ICN), New Zealand Dollar (BNZ), and South African Rand (SZR)
- Barclays iPath ETNs: Currencies: Euro (EROS), British Pound (GBB), Japanese Yen (JYN)
- Elements ETNs: Currencies: Australian Dollar (ADE), British Pound (EBG), Canadian Dollar (CUD), Euro (ERE), Swiss Franc (SZE)
- Van Eck/Morgan Stanley ETNs: Currencies: Chinese Renminbi-Yuan (CNY), Indian Rupee (INR)
In lieu of recommendations, let me leave you with disclosure on my current holdings: BZF, FXM, JEM and UUP. If you will read through the currency posts I have made over the last year at Seeking Alpha, you will get a good idea of why I have chosen these products. But, I do not recommend others necessarily follow suit. My rationale is: the first two are individual carry trade holdings that pay high interest rates. The second two are bundles to give my portfolio more diversity and earn some interest; JEM holds 15 emerging markets currencies and pays a good dividend. UUP holds the G10 currencies doubled up with leverage for the bullish dollar -- strictly a value play.
- PowerShares ETFs: Bundles: Group of 10 Carry Trade (DBV), U.S. Dollar UP (UUP), and U.S. Dollar Bearish (UDN)
- Barclays ETNs: Barclays iPath Optimized Currency Carry (ICI), Barclays GEMS Index (JEM), Barclays Asian and Gulf Currency Revaluation Note (PGD).
I also keep tight limits on currencies as a percentage of my total portfolio. This year I have gradually allowed my allocation to be just under 15%. This is toward the high end of most recommendations. But this is a new area of investing, indeed, as all alternative asset classes are, and there is no consensus in the financial advisor community about it. Some do not recommend any, some recommend more. Use your best judgment to keep the risks balanced and within your comfort zone.
You should support any decision you make with the full knowledge of the risks involved and a thorough investigation on your own about each possible investment. There are good reasons to own foreign currencies. There are also good reasons not to own them. Good luck!
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