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THE BIGGEST MONEY GRAB IN HISTORY
John Gilluly, writing in Seeking Alpha, summarizes the post-bailout deal scenario. The big fish who survived got bigger, with cleaned up balance sheets thanks to the taxpayers. They will borrow from the Fed for chickenfeed and loan it out to everyone else at rates reflected a "credit crunch." Nice deal for the big fish.
Jaws must be rolling over in his watery grave. Congress is about to work out a "deal" with the Great Whites of Wall Street's Sea of Dreams -- and hand our toothy marauders their biggest "rags to riches" gift ever. Just a week ago they were on the ropes, choking on bad mortgage debt, wrapped tight with de-leveraging and sinking share prices. Today: bonanza is on the way.
Here is how the deal is shaping up. On Thursday morning some recalcitrant Republican congressmen balked at Treasury Secretary Paulson's plan and embarrassed the president in the process. So that night the Feds put a gun to their head. They seized the largest savings and loan in the U.S. and handed its $220 billion in deposits to JP Morgan Chase for a penny on the dollar. The congressmen then decided to reconsider. Who's next?
So now the bailout is going "forward" and as it does, it only gets better for the biggest of the big banks. JP Morgan will off load WaMu's gargantuan mortgage portfolio to the Treasury for a song ("value to maturity"). Ditto with Bank of America and their billions ($) in toxic MBS portfolios from Merrill and Countrywide; and Citibank, Barclays, and Wells-Fargo will do the same. All of a sudden the worst balance sheets in the world will look like they left Mr. Clean's Laundromat.
Clearly, these are not your everyday sharks. Great Whites think alike and because of their size, they all think BIG. The Feds know this and are going to loan them (indefinitely) any amount of money they want -- whenever they want it -- at 2% or less so they can turn around and loan this money to you and I and every business in America at newly restrictive but higher "credit rates". How did the Feds solve the world's biggest credit crunch? They gave its perpetrators an offer they couldn't refuse. And this is euphemistically called re-liquefying.
Now, the crew who is angry about all this can ask themselves the alternative. What else could have been done? Wall Street could have sold the American financial industry to the Arabs for $1 trillion, a fee about equal to ARAMCO's 1H 2008 oil profits. Or they could have sold it to Singapore, or China, or some of the fat cats in India or Japan. Instead, the U.S. Treasury bought it, rotten fish heads and all.
And here is where the taxpayer has one glimmer of hope. Who is gonna run this bailout fund? Is there a patriot out there willing to put these sharks on a diet and make them pay up for the rescue they are getting, and make the deal just that, a deal for the American people? I have heard that Bill Gross of PIMCO has stepped forward and offered his services to administer this -- I hope the Feds take him up on it. Buffett's name has been mentioned too. Exceptional times sometimes call forth exceptional men to deal with them. Let us hope this is one of them.
What will all this mean for the markets? I think immediately there will be a sense of calm, and an eerie change in the earnings outlooks for the SPX 500. Ex-financials, or rather, ex-this horrible MBS situation, the rest of the market has been growing profits handily year over year. Even AIG's insurance divisions have been doing fine. When the gaping holes caused by the financials are "taken off the books" the direction should be up.
Where will this leave us going forward? Wall Street usually mirrors Main Street about 6 months in advance. 2009 could be a difficult year. As I mentioned in a previous article, we are entering a time of systematic deleveraging across our society. Contraction is the essence of deleveraging -- contraction in asset values, in P/Es, in leveraging at the margins, in how finance is approached. There is still too much stock available, too much real estate for sale, and not enough willing (or able) buyers. The price is going to have to come down to attract them. Our domestic investment banking industry was wiped out in September 2008, and gone with it the high leverage they once employed. The decade ahead will be completely different from the one behind us. Expansion drives drives everything in a bull market: P/Es, leverage, risk-taking, asset values. Those times are GONE.
Several years ago I marveled at Richard Russell's comment (Dow Theory Letter) that we were in a secular bear market that would last for more than a decade. Now I get it. The bull market rally of 2003-05 was really an OPM (other people's money) rally, leveraging up on borrowed money and pretending it was cash at hand.
WHO IS BEING BAILED OUT? AND WHY?
Wall Street is not being bailed out by taxpayers. Wall Street’s creditors are being bailed out by bond buyers.
This editorial from Barron's includes a small dose of cant -- bonds eventually get paid off by taxpayers, right? -- but a fair dose of applied common sense. In any case, properly guilty parties are fingered. Oddly, it is difficult to tell whether the writer favored a bailout or letting nature take its course.
Unjustified assumptions were floating around the airwaves and newspapers last week like flotsam in a flood. One of the worst was the idea that the pending business of the nation is a taxpayers' bailout of Wall Street. That is wrong. What the Treasury secretary, the Federal Reserve chairman and the Congress are working on is a Treasury bondholders' bailout of lenders to Wall Street.
The taxpayers have no immediate skin in this game, except as citizen-onlookers in a highly indebted country. The deficit in the 2009 fiscal year is officially projected to exceed $400 billion. Rolling in the cost of war and natural disaster, it is realistically projected to exceed $600 billion. The actual deficit will depend on how fast the government can shovel bailout money out the door, but a trillion-dollar deficit is very possible.
Borrowing, not taxes, will fund this mess. Nor will taxpayers be paying the interest on this nightmare. The Treasury will borrow that also for as long as it can. The whole scheme depends on the world's capitalists lending the U.S. Treasury all it needs.
With T-bills yielding 2% per annum, and bonds also posting low yields, the markets today affirm the government's faith in its own emissions. But faith is fickle. Rather than borrowing short, the Treasury should create some really long bonds. A 50-year bond would be advisable and a consol -- the perpetual bond that never pays principal -- would be best of all.
Investors, however, should insist on Treasury Inflation-Protected Securities (TIPS), if they can get them and if they trust the government not to keep creating new definitions of inflation that cheat TIPS holders.
Follow the Money
Wall Street firms are not being bailed out. They will receive money with which to pay their obligations. Their creditors and clients -- the hedge funds, pension funds, endowment funds, sovereign-wealth funds, money-market funds, municipal funds and college-saving funds -- will receive the federal cash. Theirs is the bailout. Wall Street's nearly insolvent firms may survive, but not with reputations and character intact.
Another weird idea that found currency last week was that deregulation caused the mortgage mess. Congressmen, columnists and crank economists have rounded up their usual suspects, including former Sen. Phil Gramm, the Competitive Enterprise Institute, the Heritage Foundation, the Cato Institute and the American Enterprise Institute, among other Washington adherents of free markets. They stand accused of tormenting the bureaucracy and its rule of law, creating the conditions for Wall Street firms to take risks in the market that no sane regulator would permit.
In fact, a big piece of the problem is that regulators were not sane. Regulation and regulated institutions encouraged the risk-taking, helped to finance it and continue to excuse it. Barry L. Ritholz provides some details in the Other Voices column this week.
Unsound regulation still has its adherents. We have heard that the mark-to-market rule and the up-tick rule and short-selling generally are big parts of the problem, pushing price below value. Allegedly, this can be solved with different rules. Not so. The problem is that real estate, mortgages, highly leveraged assets and the highly leveraged institutions that hold them are not worth as much as investors thought. Restoring investor confidence with regulation is better called a con game.
Aiming at the Right Target
Who bought or guaranteed bogus mortgages under political pressure and political management? Fannie Mae and Freddie Mac, with sotto voce federal backing. Who did the pressuring? A string of presidents and their appointees at the Department of Housing and Urban Development and a legion of congressmen inspired by housing activists dreaming of home-ownership for all.
Without guarantees and outright purchases by Fannie and Freddie, most toxic mortgages would have been unsellable, as would the perfumed packages of putrescence called mortgage-backed securities. Congress wrote laws like the Community Reinvestment Act to spread the wealth of banks and told constituents that they could own homes without saving a down payment.
Another and perhaps the least-mentioned political cause of the housing bubble was enacted by Republican tax-cutters in the Congress of 1997 and signed into law by President Clinton. They eliminated tax on the first $500,000 of capital gains on married couples' owner-occupied homes. Previous tax law gave tax-free status only to gains rolled over into new owner-occupied housing whose price was at least as high as the old one's. By making it possible to get tax-free gains in cash, the change went a long way to ignite speculation. Using low down-payment loans, speculators found leverage of 49 to 1 and tax-free profits were as irresistible as 10 to 1 leverage in the stock market of 1929.
The Last Refuge
At times like these, partisan politics is of little interest. Herbert Hoover and a Democratic Congress were not entirely responsible for turning a market crash and a run-of-the-mill recession into a great depression that lasted a decade and brought on world war. Nonpartisan institutions, such as the Fed and the markets, were also important.
Today, however, it is very difficult to understand the Federal Reserve's policies. It is not so much a central bank as a central repository for the nation's waste paper. Bob Eisenbeis of Cumberland Securities put it this way: "Bringing real estate and possibly other highly suspect assets onto the government's books with only vague ideas as to how the assets will be priced, managed or liquidated holds the potential to create the biggest toxic Superfund yet."
Bernanke's spurious distinction between market prices and "hold-to-maturity prices" is making the Fed's situation worse. Even the Fed does not intend to hold to maturity. It is just another speculator. The actual real-estate problem is that nobody dares hold mortgages to maturity for fear of being on the wrong end of a default.
The right cure is the courage of capitalists. If the market's prices really are wrong, one man's losses will turn into another man's profit; capital will be redeployed to more productive uses than big houses in barren suburbs; the nation will recover easily.
RON PAUL: THE AUSTRIAN SCHOOL AND THE MELTDOWN
From the one national-level politician who predicted what is now happening ...
The financial meltdown the economists of the Austrian School predicted has arrived.
We are in this crisis because of an excess of artificially created credit at the hands of the Federal Reserve System. The solution being proposed? More artificial credit by the Federal Reserve. No liquidation of bad debt and malinvestment is to be allowed. By doing more of the same, we will only continue and intensify the distortions in our economy -- all the capital misallocation, all the malinvestment -- and prevent the market's attempt to re-establish rational pricing of houses and other assets.
Last night (article was written last Friday) the president addressed the nation about the financial crisis. There is no point in going through his remarks line by line, since I would only be repeating what I have been saying over and over -- not just for the past several days, but for years and even decades.
Still, at least a few observations are necessary.
The president assures us that his administration "is working with Congress to address the root cause behind much of the instability in our markets." Care to take a guess at whether the Federal Reserve and its money creation spree were even mentioned?
We are told that "low interest rates" led to excessive borrowing, but we are not told how these low interest rates came about. They were a deliberate policy of the Federal Reserve. As always, artificially low interest rates distort the market. Entrepreneurs engage in malinvestments -- investments that do not make sense in light of current resource availability, that occur in more temporally remote stages of the capital structure than the pattern of consumer demand can support, and that would not have been made at all if the interest rate had been permitted to tell the truth instead of being toyed with by the Fed.
Not a word about any of that, of course, because Americans might then discover how the great wise men in Washington caused this great debacle. Better to keep scapegoating the mortgage industry or "wildcat capitalism" (as if we actually have a pure free market!).
Speaking about Fannie Mae and Freddie Mac, the president said: "Because these companies were chartered by Congress, many believed they were guaranteed by the federal government. This allowed them to borrow enormous sums of money, fuel the market for questionable investments, and put our financial system at risk."
Doesn't that prove the foolishness of chartering Fannie and Freddie in the first place? Does that not suggest that maybe, just maybe, government may have contributed to this mess? And of course, by bailing out Fannie and Freddie, has the federal government not shown that the "many" who "believed they were guaranteed by the federal government" were in fact correct?
Then come the scare tactics. If we do not give dictatorial powers to the Treasury Secretary "the stock market would drop even more, which would reduce the value of your retirement account. The value of your home could plummet." Left unsaid, naturally, is that with the bailout and all the money and credit that must be produced out of thin air to fund it, the value of your retirement account will drop anyway, because the value of the dollar will suffer a precipitous decline. As for home prices, they are obviously much too high, and supply and demand cannot equilibrate if government insists on propping them up.
It is the same destructive strategy that government tried during the Great Depression: prop up prices all costs. The Depression went on for over a decade. On the other hand, when liquidation was allowed to occur in the equally devastating downturn of 1921, the economy recovered within less than a year.
The president also tells us that Senators McCain and Obama will join him at the White House today in order to figure out how to get the bipartisan bailout passed. The two senators would do their country much more good if they stayed on the campaign trail debating which one is the bigger celebrity, or whatever it is that occupies their attention these days.
F.A. Hayek won the Nobel Prize for showing how central banks' manipulation of interest rates creates the boom-bust cycle with which we are sadly familiar. In 1932, in the depths of the Great Depression, he described the foolish policies being pursued in his day -- and which are being proposed, just as destructively, in our own:
Instead of furthering the inevitable liquidation of the maladjustments brought about by the boom during the last three years, all conceivable means have been used to prevent that readjustment from taking place; and one of these means, which has been repeatedly tried though without success, from the earliest to the most recent stages of depression, has been this deliberate policy of credit expansion ...
To combat the depression by a forced credit expansion is to attempt to cure the evil by the very means which brought it about; because we are suffering from a misdirection of production, we want to create further misdirection -- a procedure that can only lead to a much more severe crisis as soon as the credit expansion comes to an end. ... It is probably to this experiment, together with the attempts to prevent liquidation once the crisis had come, that we owe the exceptional severity and duration of the depression.
The only thing we learn from history, I am afraid, is that we do not learn from history.
The very people who have spent the past several years assuring us that the economy is fundamentally sound, and who themselves foolishly cheered the extension of all these novel kinds of mortgages, are the ones who now claim to be the experts who will restore prosperity! Just how spectacularly wrong, how utterly without a clue, does someone have to be before his expert status is called into question?
Oh, and did you notice that the bailout is now being called a "rescue plan"? I guess "bailout" was not sitting too well with the American people.
The very people who with somber faces tell us of their deep concern for the spread of democracy around the world are the ones most insistent on forcing a bill through Congress that the American people overwhelmingly oppose. The very fact that some of you seem to think you are supposed to have a voice in all this actually seems to annoy them.
I continue to urge you to contact your representatives and give them a piece of your mind. I myself am doing everything I can to promote the correct point of view on the crisis. Be sure also to educate yourselves on these subjects -- the Campaign for Liberty blog is an excellent place to start. Read the posts, ask questions in the comment section, and learn.
H.G. Wells once said that civilization was in a race between education and catastrophe. Let us learn the truth and spread it as far and wide as our circumstances allow. For the truth is the greatest weapon we have.
You might expect that the solons who utterly failed to foresee today's events might consult the one man who did in coming up with a "rescue plan." You would be wrong.
A detailed Austrian critque about why central bank interventions that attempt to prop up a credit pyramid are unwise and doomed can be found here.
Disaster Is About to Strike
Peter Schiff posted this letter from Ron Paul to his supporters on his own site.
Whenever a Great Bipartisan Consensus is announced, and a compliant media assures everyone that the wondrous actions of our wise leaders are being taken for our own good, you can know with absolute certainty that disaster is about to strike.
The events of the past week are no exception.
The bailout package that is about to be rammed down Congress's throat is not just economically foolish. It is downright sinister. It makes a mockery of our Constitution, which our leaders should never again bother pretending is still in effect. It promises the American people a never-ending nightmare of ever-greater debt liabilities they will have to shoulder. Two weeks ago, financial analyst Jim Rogers said the bailout of Fannie Mae and Freddie Mac made America more communist than China! "This is welfare for the rich," he said. "This is socialism for the rich. It's bailing out the financiers, the banks, the Wall Streeters.
That describes the current bailout package to a T. And we are being told it is unavoidable.
The claim that the market caused all this is so staggeringly foolish that only politicians and the media could pretend to believe it. But that has become the conventional wisdom, with the desired result that those responsible for the credit bubble and its predictable consequences -- predictable, that is, to those who understand sound, Austrian economics -- are being let off the hook. The Federal Reserve System is actually positioning itself as the savior, rather than the culprit, in this mess!
There goes your country.
- The Treasury Secretary is authorized to purchase up to $700 billion in mortgage-related assets at any one time. That means $700 billion is only the very beginning of what will hit us.
- Financial institutions are "designated as financial agents of the Government." This is the New Deal to end all New Deals.
- Then there is this: "Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency." Translation: the Secretary can buy up whatever junk debt he wants to, burden the American people with it, and be subject to no one in the process.
Even some so-called free-market economists are calling all this "sadly necessary." Sad, yes. Necessary? Don't make me laugh.
Our one-party system is complicit in yet another crime against the American people. The two major party candidates for president themselves initially indicated their strong support for bailouts of this kind -- another example of the big choice we are supposedly presented with this November: yes or yes. Now, with a backlash brewing, they are not quite sure what their views are. A sad display, really.
Although the present bailout package is almost certainly not the end of the political atrocities we will witness in connection with the crisis, time is short. Congress may vote as soon as tomorrow. With a Rasmussen poll finding support for the bailout at an anemic 7%, some members of Congress are afraid to vote for it. Call them! Let them hear from you! Tell them you will never vote for anyone who supports this atrocity.
The issue boils down to this: do we care about freedom? Do we care about responsibility and accountability? Do we care that our government and media have been bought and paid for? Do we care that average Americans are about to be looted in order to subsidize the fattest of cats on Wall Street and in government? Do we care?
When the chips are down, will we stand up and fight, even if it means standing up against every stripe of fashionable opinion in politics and the media?
Times like these have a way of telling us what kind of a people we are, and what kind of country we shall be.
CHANGED FINANCIAL LANDSCAPE
Doug Noland has been predicting a systemic crisis on the order of what we are now seeing for years, but it sounds as if its ferocity has taken even him by surprise. Written prior to the passage of the bailout package, he was sufficiently unnerved by what had transpired that he expressed the hope that a "mindful" (?) deal would be worked out quickly.
Structurally, what Noland has been labeling "Wall Street finance," where Wall Street had insinuated itself into the credit creation process traditionally reserved for banks, is busted and disgraced. This, he believes, will prove to be a momentous financial and economic development. Wall Steet finance and the whole U.S. bubble economy went together like hand and glove, and thus the later is headed for the dustbin of history too. He mournfully speculates that the financial structure that emerges from the ashes will finance fewer productive endeavors yet will prove fully capable of fueling stubborn consumer price inflation.
For our country's sake, I hope our Washington politicians can work out a mindful financial sector bailout package over the weekend. Not that I am pro-bailout or for government intervention. It is just that our financial system is teetering at the precipice. Last night's federal takeover and "sale" of Washington Mutual, our nation's largest bank failure to date, was yet another major body blow. Confidence has now been shaken so brutally that our policymakers can do little to repair the damage. Yet at this point, stop-gap measures to restrain collapse seem more appealing to me than no measures at all.
The financial structure that fueled myriad credit bubbles, asset bubbles, economic bubbles and overliquefied the entire world is today no longer viable. Wall Street finance is at this point an unmitigated bust, with a few of the "holdout" sectors (i.e., the credit default market and the hedge fund community) now succumbing. The great financial alchemy of transforming endless risky loans into perceived safe and liquid "money"-like instruments has run its historic course. And with risky loans -- household, financial sector, business, municipal and speculator -- having come to play such a prominent role in the nature of spending and "output", the near elimination of risky lending will prove a momentous financial and economic development. The U.S. Bubble Economy is today in dire straits.
We have reached the point where it has become difficult to secure new borrowing unless one is of quite sound credit standing. This is the case for individuals seeking to buy automobiles and homes, to afford myriad discretionary and luxury goods and services, to finance educations, or to make the types of big ticket purchases that had been bolstering our Bubble Economy. Lenders are now moving aggressively to cut home equity and credit card lines. And, importantly, recent developments have significantly tightened credit availability for businesses of all sizes. Securitization markets have been largely shut down for awhile now. Now acute stress has incapacitated the money markets.
Unless some dramatic development reverses the current course, it will not be long before a self-reinforcing cycle of company payroll and spending cutbacks takes hold. At the same time, the municipal bond market is in disarray. The economic impact from major cutbacks in state and local government spending will be significant. Today's finance-related economic headwinds are Category-4 (and gaining) Hurricane Systemic Credit Seizure, compared to last year's Tropical Storm Subprime. Federal Reserve-dictated interest rates are extremely low -- and the Fed and global central bankers have injected unfathomable amounts of liquidity -- yet credit conditions have turned the tightest they have been in decades.
The Lehman bankruptcy marked a major inflection point in the confidence of contemporary "money." It was a decisive blow against trust in various money market instruments -- the very foundation of our monetary system. "Money" has now tightened significantly for virtually all players that had previously enjoyed cheap short-term financings. This list certainly includes the hedge fund community.
The Lehman bankruptcy also marked a major inflection point in confidence for the various "daisy chain" players involved in intermediating risky loans into contemporary "money." The market was convinced Lehman was "too big to fail." Its failure inflicted thousands of market participants with losses -- from Primary Reserve Money Fund investors caught with short-term Lehman paper to holders of Lehman's long-term bonds. Investors all over the world were impacted. The hedge fund community suffered mightily. The status of hundreds of billions of derivatives and counterparty obligations was suddenly up in the air or in the hands of the bankruptcy court. And, importantly, huge losses were suffered in the Credit Default Swap marketplace -- the marrow of one of history's most spectacular speculative manias.
Trying to add a bit of simplicity to the complexity of a credit market breakdown, I will say the Lehman collapse marked a critical inflection point in at least five major respects: First, the crisis of confidence jumped the "firebreak" from risk assets to contemporary "money," shattering trust in various facets of contemporary finance that was forged over decades. Second, it required the marketplace to reexamine exposures to various direct and indirect counterparty risks, a terminal blow for derivatives markets. Third, it pushed the CDS marketplace into full-fledged dislocation and instigated a long-overdue regulator onslaught. Fourth, it decisively burst the "leveraged speculating community"/hedge fund bubble. This has ushered in another round of problematic de-leveraging and accelerated the reversal of "Ponzi Finance" dynamics. Fifth, it instilled global fear with respect to the risks of participating in the inter-bank lending market with American institutions.
Basically, the Lehman collapse marked the end of "Wall Street" risk intermediation as a significant component of system financial intermediation. Going forward, credit growth will be chiefly generated by the banking system, supported by various forms of government backing (Fed, FDIC, Washington bailouts/recapitalizations, etc.), the government-operated GSEs, and various forms of federal government debt issuance. Importantly, this new financial structure will ensure minimal risky lending as well as significantly reduced risk-taking. And from a global perspective, I believe newfound fears of lending to the American financial sector marks the beginning of the end of our economy's capacity for trading new financial claims for imports of energy and goods.
Over time the changed financial landscape will have a profound impact on the underlying economic structure. Our economy will have no alternative than to get by on less credit, less risk intermediation, and fewer imports. In the near-term, the effects will be a rapid and pronounced slowdown of our economy's "output." And while we will only know over time, I would bet this new financial structure will allocate much less finance to entrepreneurial activities, productive endeavors and the asset markets -- while at the same time providing ample (government-directed) purchasing power to ensure stubborn consumer price inflation.
THE WAR ON TERROR MEETS THE WAR ON RISK
The fiat dollar numbers being thrown around for the bailout bills was huge. Whatever the final tally may be, it cannot be good for the dollar, versus gold and silver anyway. So buy them, already, says Byron King.
Why are precious metals moving upwards? After all, the market smashed them down all summer as the dollar strengthened. The short answer is that right now gold and silver are the only decent game in town.
Yes, there are a few other asset and income plays as well in the market. After all, there is still an economy to run out there. There are 303 million Americans, and 6.2 billion other people in this world, who want to eat every day. But much of the stock market is a crapshoot. If you love pain, then the broad stock market is the place for you. While gold and silver represent the flight to safety and quality.
The U.K. Telegraph put it nicely: "As investors scrambled to make sense of last week's events, already one conclusion was all but irrefutable -- the U.S. dollar will have to take another major fall. The dollar rally that began in July and pushed the pound's value against the greenback significantly lower has come to an abrupt end as markets face up to the fact that the currency will have to absorb the effects of a sudden shocking increase in America's budget deficit."
So we see lots of bad news for the dollar. But when you own gold, it is your asset. With a specific gravity of 19.3, gold is dense, non-reactive and otherwise immutable. Gold is nobody's liability. As one of my old professors at Harvard used to say, "That's physics."
Speaking of physics, I have looked east of the sun and west of the moon. I cannot see much good news for the U.S. dollar on any horizon. Really, what is gloomier than the news from Wall Street? The investment model of the modern era (borrow short, lend long, pay big bonuses) is dying before our eyes. "And it is about time," some might say. But it is happening on our watch. So we had better suit up in battle-rattle.
Wall Street's losses are in the range of hundreds of billions, maybe trillions. Which prompts me to inquire, where are Bonnie and Clyde when you need them? At least the Barrow couple knew who they were and what they did for a living. To their credit, on their last foray the dynamic duet had the guts to shoot it out with the cops and go out in tragic style.
But now the modern bank robbers are talking about how they should get big bonuses for all the good work they put in right until things blew up. Really, I am serious. Lehman Brothers wants to pay $2.5 billion in bonuses to 10,000 employees. That is an average of $250,000 per person. (Except I think the office runners and secretaries will get less than $250K and a select few will rake in a lot more.) What has anyone there done to deserve $250,000? Did I miss the news about somebody at Lehman discovering a cure for cancer? It is all just so ... Baby Boomer.
At the end of the day -- and the clock is ticking fast -- it is too bad that the wrong people are going to get paid. And bonuses? Oh, if only I could be a bankruptcy judge for just one hour.
The War on Risk
Do you recall the $700 billion of borrowed money that the U.S. paid over the past seven years to fight the War on Terror? Well now, with the stroke of a pen the U.S. taxpayers will pay another $700 billion (and probably more) for the "War on Risk" in the next year or so.
War on risk? It seems that way to me. Let's back up. In the past few years -- seven or so, coincidentally -- a lot of people gambled and lost. People bought houses they could not afford. Brokers arranged the loans. Bankers lent the money. Other bankers bundled-up the mortgages and sold them as "asset-backed securities." Rating agencies sprinkled their holy water on the transaction. Insurance companies insured everything against default and loss.
A lot of people were making a darn good living for a while. But it was all a farce based on cheap credit and an abiding faith in a "something-for-nothing" way of life. And it is too bad that a lot of people bought -- as the saying goes -- "as much house as they could afford." Except they could not afford it.
So now the whole mess is falling apart. And in true Baby Boomer fashion, the key perps on Wall Street want to change the rules and stick the house with the bill. That is, the White House and the House of Representatives, and your household as well.
The advertised number of $700 billion for the Wall Street bailout is just the posted price -- the "loss leader" to get the American people into the store, so to speak. But get set for a bad case of sticker shock as events unfold. A group of business reporters at Bloomberg tallied up the raw numbers and came up with their own number of $1.8 trillion.
$700 billion? $1.8 trillion? When the numbers are that big, does it even matter? It is the inflation-adjusted equivalent of fighting World War II again. Except who is the enemy?
Whatever the final tally may be, it cannot be good for the U.S. dollar. So buy gold and silver. If you cannot acquire the metal in the form of coins or bars, then buy precious metal stocks of companies with ore in the ground.
HOUSE, SENATE VOTE ON BAILOUT PLAN TO “RESCUE” FINANCIAL MARKETS – CAN IT?
The Dow was down 26% from its October 2007 peak despite one bailout after another, each one weakening the federal balance sheet in ways that will undoubtedly contribute to the severity of the decline.
Seemingly lost in all the bailout debates, at in the mainstream media talkosphere, is an obvious question: Does the proposed plan have any chance of working? No way, say the people at Elliott Wave International.
Two days after the failed vote on the bailout plan sent lawmakers and government officials scrambling, the U.S. Senate will have its say on the so-called "rescue plan." The original bill was submitted jointly by the White House, the Federal Reserve and the U.S. Treasury, but has been modified after tumultuous debate in Congress. A second attempt to drum up votes is ongoing Wednesday atop Capitol Hill. [It passed through the Senate and it appeared as though it would pass through the House as this was added.]
A simple majority in the U.S. House of Representatives rejected the bailout plan on Monday, with 205 "ayes" and 228 "nays."
News reports say the Senate is preparing to vote on a revised plan Wednesday evening, but the question remains: Will this bailout plan -- or "rescue" effort, if you prefer the government's term for it -- save the financial markets?
This article offers excerpts from Bob Prechter and his colleagues, regarding bailouts in general and this bailout specifically. In his book Pioneering Studies of Socionomics, Prechter speaks poignantly in a chapter titled "When Do Bailouts Occur?" -- he identifies a distinguishable trend in bailouts as they relate to market activity.
Bailouts occur near stock market lows, when the mood is the opposite of that near peaks. As you can see in [Figure 1], Lockheed Aircraft and Penn Central Railroad applied for aid in March and May 1970, as the stock market was crashing into its biggest low in 28 years. (Aid was approved in December 1970 and August 1971.) In another bailout of Penn Central and several other northeastern railroads, Congress created Conrail in 1974, the final year of the biggest bear market since 1937-1942. (It took two separate "federal investments" of $2.1 billion in 1976 and $1.2 billion in 1980, as real stock prices continued falling, to keep Conrail on track.) The government's initial rescue of Continental Illinois bank came in May 1984, at the bottom of a fear-laden "wave two" stock market correction. (It was completed with a $4.5 billion FDIC package in late July.) Following the 1987 crash and the sluggish, mostly sideways year of 1988, Congress established the Resolution Trust Corporation on February 6, 1989 to bailout a slew of failed savings and loan institutions. Its creation marked the beginning of the biggest financial bailout in U.S. history.
Obviously, these were bailouts of major U.S. companies. The $700 billion bailout, eh'em ... rescue plan, is much larger. It involves an entire credit system, not one company. And that distinction matters.
Prechter's colleagues Steve Hochberg and Pete Kendall explain why that distinction is important, to wit: Bailouts frequently mark a price low, but not necessarily THE price low. Hochberg and Kendall have this to say in their latest issue of The Elliott Wave Financial Forecast.
The bull market is over, but the bailout craze is running at "fever pitch." In less than a month, the Federal government moved to issue a trillion dollars in U.S. Treasuries to back bailout loans; took over Fannie Mae and Freddie Mac, as well as the world's largest insurance company, American International Group (AIG); and banned short selling on financial and other stocks. As these pages discussed last month, it will not work.
Obviously, we still await the all-important "uncle point" in the government's bid to stave off decline, but as the September issue of The Elliott Wave Theorist noted, the markets "are not so dumb as to wait for it. They can already see the end of the road, and are moving ahead of it." Outside of the market, the first concrete sign of an end to the era of moral hazard is the decision to let Lehman Brothers go bankrupt. With more than $600 billion in pre-bankruptcy assets, Lehman was easily the largest Chapter 11 filing in history. WorldCom, the prior record holder, had "merely" $100 billion in assets. Lehman was also bigger and more diversified than Bear Stearns, which was deemed too big to fail just last March. Another signal of the bailout plan's eventual fate is what happened to the stock market after AIG became the property of U.S. taxpayers. In contrast to the temporary lows that coincided with Bear Stearns' shotgun marriage to JPMorgan Chase last March and the federal "protection" extended to Fannie/Freddie in mid-July, the stock market greeted AIG's surprise takeover by falling, and not to just any level. [See Figure 2] It fell below the Dow's Minor wave 1 low of 10,827.70 on July 15. It did so again early this week after the Feds hatched a plan to create a whole new government agency that will purchase distressed financial assets of up to $700 billion at a time. This action confirms that the bear market is alive and kicking. As EWFF noted here last month, "In a long-term bear market, prices keep declining beneath the bailout lows." ...
Another multifaceted indicator of the bear market's presence and extraordinary downside potential is all the different ways in which the bailouts are backfiring. The effort is not opening up the credit markets as so many had hoped, for example; it is closing them. Bank of America refused to extend any further loans to McDonald's for espresso machines, citing its financial commitment to take over Merrill Lynch. "Even well-known brands such as McDonald's face difficulties financing expansions," says Bloomberg. Then there is the "reverse auction" pricing mechanism that will use actual market prices to establish a value for distressed assets in the Treasury's $700 billion bailout plan. As EWFF has previously discussed, the complete inability to establish prices in this environment of obfuscation and manipulation is one of the keys to keeping the fantasy of solvency alive. This step toward more accurately assessing asset values is bad news for regional banks, as it will suddenly give them "a more concrete way of benchmarking just how far their own assets have declined." The takeover of Fannie and Freddie also cratered the value of their preferred stock, which accounts for 11% of the core capital of the average bank. Apparently the bailout cowboys never saw that one coming. Moreover, one of the more punitive edicts from the Securities and Exchange Commission, the ban on short selling, will not help liquidity. It will hurt it. This unintended bearish consequence was covered on page 200 in Conquer the Crash:
Sometimes authorities outlaw short selling. In doing so, they remove the one class of investors that must buy. Every short sale must be covered, i.e., the stock must be purchased to close the trade. A ban on short selling creates a market with no latent buying power at all, making it even less liquid than it was. Then it can dribble down day after day, unhindered by the buying of nervous shorts.
Once the government-sponsored short squeeze of September 19 was over, this is exactly what happened. Stocks dribbled lower through Wednesday. As of the September 18 low, the Dow was down 26% from its October 2007 peak despite one bailout after another, each one weakening the federal balance sheet in ways that will undoubtedly contribute to the severity of the decline.
Finally, there is the whole point of the government's extraordinary actions, the restoration of confidence. "The government needs to step in and inspire confidence," goes the oft-repeated refrain. Of course, the harder anyone tries to prop up confidence, the less confident people get. "The only way it will work," says columnist Jonathan Weil of Bloomberg, "is if people like you, think other people like you, think other people like you, will think it will work."
Here is how President Bush sees it: "At first, I thought we could deal with the problem one issue at a time. The house of cards was much bigger and started to stretch beyond Wall Street. When one card started to go, we worried about the whole deck going down." We did a double-take on this statement. Did the President of the United States describe the U.S. financial system as a "house of cards?" Indeed he did, and, in doing so, he took the words right out of Conquer the Crash: "Confidence is the only thing holding up this giant house of cards." The presidential avowal of a position that was once considered by some to be among the most radical statements offered in CtC goes straight to the book's main point -- at its core, it is a psychological process. The deflationary depression therein described must surely be unfolding.
INVESTING IN AGRICULTURE
Peak soil is at hand.
Top soil is on net lost each year. Loss rates range from 10 to 100 times faster than it is being replaced. The amount of farmland under cultivation worldwide has been falling since the 1980s. Only two major grain-exporting regions remain: North America, and Australasia. These basic facts, argues Chris Mayer, make farmland and related agricultural stocks a worthy long-term investment theme.
Over the summer, Iran bought a large amount -- more than one million tons -- of wheat from the U.S. That is something we have not seen in 27 summers. In Iran's case, a tough drought cut the wheat harvest by a third, forcing the country to look abroad. But still, the fact that Iran had to come to the U.S. is telling. It would be like Lee asking Grant for rations in the summer of 1863. As one analyst put it: "Do you think Iran would come to the U.S. if they had any place else they could buy it ... They are searching the world for wheat. They are buying the U.S. because it is the only thing they can buy."
Markets, like great unscripted dramas, develop their own plotlines as time rolls on. Now unfolding is a new plotline in the agriculture boom. It begins with the fact that there are fewer and fewer options these days for importers looking for large quantities of high-quality grains. But it speaks more to a deeper issue: an emerging shortage in fertile soil. Yes, we are running out of good dirt.
In fact, fertile soil -- good dirt -- may become more important to land values than oil or minerals in the ground. Some say it is already a strategic asset on par with oil. As Lennart Bage, president of a U.N. fund for agricultural development says, "Now fertile land with access to water has become a strategic asset."
Doubtful? Consider rising export restrictions around the globe, which act as a sort of fence keeping the goods within borders. India curbs exports on rice. The Ukraine halts wheat shipments altogether. The number of grain-exporting regions has dwindled, like the vanishing buffalo herds. Before World War II, only Europe imported grain. South America, as recently as the 1930s, produced twice as much grain as North America. The old Soviet Union, for all its faults, exported grain. Africa was self-sufficient. Today, only three major grain exporters remain: North America, Australia and New Zealand.
No surprise, then, to find faith in the global food supply at generational lows. So begins the scramble to secure farmland. Saudi Arabia, for example, is particularly at the mercy of the winds of global agriculture. It has little ability to produce its own food. The kingdom, reports the Financial Times, "is scouring the globe for fertile lands in a search that has taken Saudi officials to Sudan, Ukraine, Pakistan and Thailand." Saudi Arabia's quest is not one it pursues alone. There are many hunters.
The UAE has also been looking to lock down acreage in Sudan and Kazakhstan. Libya is looking to lease farms in the Ukraine. South Korea has been poking around in Mongolia. Even China is exploring investing in farmland in Southeast Asia. While China has plenty of cultivable land, it does not have a lot of water.
"This is a new trend within the global food crisis," says Joachim von Braun, the director of the International Food Policy Research Institute. "The dominant force today is security of food supplies." Food prices reflect this crimp in supply.
The mainstream press focuses on issues such as population, dietary shifts and the impact of biofuels. One thing that does not get talked about much may be the most important thing of all: A growing shortage of quality topsoil. Call it the topsoil crisis.
Quality soil is loose, clumpy, filled with air pockets and teeming with life. It is a complex microecosystem all its own. On average, the planet has little more than three feet of topsoil spread over its surface. The Seattle Post-Intelligencer calls it "the shallow skin of nutrient-rich matter that sustains most of our food."
The problem is that we are losing it faster than we can replace it. And replacing it is not easy. It grows back an inch or two over hundreds of years.
This is not lost on certain far-seeing investors. Jeremy Grantham, the curmudgeonly head of the money manager GMO, wrote about soil depletion in his last quarterly letter. "Our farmers are in the mining business! Yes, the soil is incredibly deep, but it is still finite." For every bushel of wheat produced, we lose two bushels of topsoil.
Until the final decades of the 20th century, the amount of new farm acreage added to the mix by clearing land offset the losses on a global basis. In the 1980s, the amount of land under cultivation began to fall for the first time since humble early humanity began to farm the rich land around the Tigris and Euphrates. It continues to fall today.
We lose topsoil to development, erosion and desertification. "Globally, it is clear we are eroding soils at a rate much faster than they can form," notes John Reganold, a soils scientist at Washington State University. Estimates vary. In the U.S., the National Academy of Sciences says we are losing it 10 times faster than it is being replaced. The U.N. says that on a global basis, the rate of loss is 10-100 times faster than that of replacement.
In any case, it seems safe to say that good dirt is in short supply. The obvious investment conclusion: Buy farmland. That is hard to do as an individual investor, although there are at least a few options. One is Cresud (CRESY), which owns one million acres of farmland in Argentina. Though harder to buy, Black Earth Farming (BLERF in the Pink Sheets) owns farmland in Russia -- which presents its own risks.
More investment ideas will surely surface as time goes by. The topsoil crisis has a long way to go. It is not going to resolve itself anytime soon. In the meantime, though, investors may want to rethink the phrase "cheap as dirt."
The Real Reasons Fertilizer Stocks Are in the Dirt
Agricultural commodities have endured a substantial selloff from their peak earlier this year. The Powershares DB Agriculture Fund ETF (DBA), which targets being equally weighted in corn, wheat, soybeans and sugar, is down 35% from its peak. Fertilizer producer stocks have declined along with them. Industry leader Potash Corp. of Saskatchewan (POT) is off 60% from its peak in June.
Are the fertilizer stocks worth considering now? If you believe that commodities are in a secular bull market that ultimately has a lot more room to run on the upside, a la Jim Rogers, then those stocks are a reasonable way to play that market. But, again, at what entry point? This article from a Seeking Alpha columnist provides a helpful starting point for such an inquiry.
Wednesday afternoon the sell-off in fertilizer stocks was reignited. Mosaic (MOS) released its latest earnings report and the results were good, but not good enough.
We were prepared for some rough times, but I do not think any of us thought it was going to get this bad:
For anyone looking to "buy on bad news," there is a lot more to consider. This sell-off in once-darling fertilizer stocks has happened for a lot of reasons. And those same reasons are what will limit fertilizer stocks' upside from here.
The most interesting "reasons" given for the selloff concern long-term valuations. When are these stocks cheap? The author correctly points out that these are basically mining stocks. When output prices, e.g., of potash, get high enough new mines will open up. This will limit pricing on the upside:
There is a lot of supply coming and potash prices will likely stay around $500 to $1,000 a ton over the long term. They will not be too high to attract aggressive amounts of new supply and they will not be too low so that mines are going to have to be shut down. Potash prices will probably remain in a nice range where every company makes enough money (that is even more likely since 2 cartels control more than 70% of world potash exports.)
The thesis that potash prices will stay above $500 is a good starting point. How profitable will the fertilizer companies be at $500? If the stocks sell at single-digit multiples of $500/ton profits, it starts to attract our attention.
Blame the hedge funds for pounding down the share prices or just look at it as a bubble that burst with the regular accompanying consequences, but I am now starting to turn cautiously bullish on agriculture again.
This time around it will not be a huge speculation fueled rising tide that lifts all boats. The long-term opportunity in agriculture is still there, but the biggest wins probably will not be in fertilizer stocks, they will be in other agriculture subsectors.
Fertilizer stocks are in for a long period of ups and downs. I expect them then to have a few more months of rough going with plenty of false starts too. After all, there are still a few analysts with $300 and $400 price targets on Potash Corp. that still have to turn negative before we can confirm a hard bottom.
Despite it all, anyone buying now should reasonably expect a 30% to 50% on Mosaic, Potash Corp, and Agrium despite any more ups and downs to come. Even with a lot of road blocks down the road, there is some significant value in the fertilizer producers.
None of the three stocks have any dividend yield to speak of, hence we consider them to be speculative in nature. But with the speculators in the stocks having had their heads handed to them and now exiting the sector, a contrarian investor's antennae start to vibrate. The fertilizer industry is certainly cylical and volatile, but it is not going away any time soon.
Note that a precious metals miner and a potash miner are really in the same business: dig a large hole in the ground and hope to make your money back and then some from the stuff you filter from what once filled the hole. Precious metals miners usually benefit from a gold bug premium, while in fact the fertilizer element miners make a lot more money. Something to think about ...
Finally, this article claims that at C$300/ton for nitrogen, C$400/ton for phosphate and C$500/ton for potash -- lower end prices for the major fertilizer elements -- Agrium would earn $6.75 per share and Potash $13.65, which translate to multiples of about 6 and 7. Those sound like cheap multiples of trough earnings. One might well ask how much of those earnings have to be reinvested to maintain output levels, and how closely this maintenance capital spending is to accounting depreciation.
AFTER THE BUBBLE, HOW CAPITALISM WILL SURVIVE
An interview with long-time bear Richard Bernstein: Taking cover in defensive stocks.
Richard Bernstein, Chief Investment Strategist at Merrill Lynch, went from bullish to bearish in 1998 on concerns over the then very loose monetary policy and the emerging credit bubble. "There was too much money chasing too few ideas," he puts it. That call missed the dot-com blowout leg of the bull market, but he was ultimately vindicated. Even after the vicious 2000-2002/03 bear market he stayed bearish, over similar concerns as in 1998, missing the subsequent credit-fueled move in stocks and virtually every other asset.
Suffice it to say that Bernstein is a voice worth listening to. Barron's interviewed him recently, and he has some interesting things to say about today's markets. In a nutshell: (1) Stocks are expensive. (2) Bonds are still a buy. Nobody likes them, and everyone is worried about inflation, but ... (3) We do not need to worry about inflation, as credit creation is very slow. Once a recovery starts, then we have to worry. (4) Stick to quality and think defensive, in both stocks and bonds. (5) The U.S. dollar will do well. (6) The financial industry needs to be downsized. Judge Paulson's plan by whether it facilitates this needed consolidation.
Richard Bernstein, Chief Investment Strategist at Merrill Lynch, is no stranger to the bear camp. A longtime bull in the mid-1990s, he switched his outlook in 1998 -- too early, initially, but eventually right on the mark. In the 2000s, he has remained bearish, concerned about the effects of low interest rates during much of this decade. Bernstein, 49, who has been with Merrill for nearly 20 years, admits that he missed the boat in 2003, when the Standard & Poor's 500 gained 28.6%. He remains cautious on equities, favoring bonds, especially Treasuries, and cash.
For a look at what all of the recent tumult in the financial markets means to investors, Barron's caught up with Bernstein at Merrill's New York headquarters. Merrill itself is in the middle of the action, of course, having just agreed to be acquired by Bank of America.
Barron’s: What are your thoughts on all of the recent upheaval, including the U.S. Treasury Department's attempt to buy illiquid securities from financial institutions, and its impact on the market?
Bernstein: There is an awful lot of turmoil, but it is not the end of capitalism as we know it. This is the natural downside to the credit bubble. For a long time, people would not admit there was a bubble. Then they thought the bubble was healthy.
This is the natural downfall we saw with technology stocks, and what we are seeing in financial stocks is the same thing.
You have been bearish for some time. Was that based in part on the excesses you saw in the credit markets?
It is a little bit more than that. People forget that we were raging bulls back in the 1990s, when people really were not so bullish. I can remember Alan Greenspan's "irrational exuberance" speech was in December of '96, and it really was not related to technology stocks. It was related to other stocks in the economy. But we became increasingly cautious as monetary policy got looser and looser. The idea that you could remove risk from the marketplace really made people speculate. What the credit bubble did was to expand that speculation to a broader range of asset classes. So our caution was based on the notion that there was too much money chasing too few ideas.
When you talk to clients, what are they most concerned about?
Inflation -- that is the No. 1 question, whether it is the private-client side of the business or global markets or the media. Everybody is asking about inflation. Everybody is sure that we are printing money, that the United States has quickly become an Argentina, that the dollar is going down and that inflation is going up.
And your view?
I just do not think that is the right approach. That scenario could happen. If the economy quickly turns, yes, we have a big problem on our hands. But if the economy continues to slow and credit creation continues to contract, it is going to be very hard to get sustained inflation.
I think prices are going to respond to the slower global economy. I believe the global economy will be weaker than people think. You always have to make a bet, stronger or weaker. I have been arguing that you should err on the weaker side. If that is true, then demand for commodities, demand for everything, goes down and some inflation subsides.
More than anything else, remember that inflation is a lagging indicator and credit is a leading indicator. There is not a lot of credit being issued these days.
You wrote in a recent note that the government was taking "a very Japanese approach to solving [the] credit crisis."
In Japan, they kept trying to maintain the status quo, and they kept the excess-lending capacity in the system alive. So their credit crisis dragged on for years.
The critical component to ending a credit crisis is quickly getting rid of excess capacity. In most cycles, the boom and the bust is in the industrial sector. We build too many factories. We end up with too much inventory, and then profitability comes down, and what happens? You start closing all the factories, removing excess capacity and inventory.
It is in the financial sector this time where we have tremendous excess capacity.
So, we think the financial sector is going through massive consolidation. The number of companies will shrink dramatically over the next several years. My attitude has been that the government should facilitate that process. My fear has been that what the government is trying to do is treat everything as a one-off situation and, therefore, trying to maintain the status quo for everybody else.
Treasury Secretary Paulson's proposal [to have the government buy illiquid assets from financial firms] may be the first step in terms of getting a government entity involved -- or at least admitting that there is a systemic problem. But the question still is, "Is the plan facilitating consolidation, or keeping the status quo?" That may come out in the details.
How attractive do equities look?
We have been -- and remain -- underweight in equities. Our benchmark allocation for equities is 60%, but we are at 50%. We are overweight in bonds, which has a weighting of 45%. We do not have a lot of cash, about 5%.
What would make you turn more bullish on equities?
We are looking for sentiment and valuation to improve, and we are looking for analysts' estimate revisions to actually capitulate.
So earnings estimates are not going down as much as you expected?
No, not at all. Relative to history, you would never know there was an economic slowdown going on in terms of analysts' revisions. That is largely because investors over all have not come to grips with the relationship between the credit crisis and the knock-on effects on the real economy: The next thing to look for is more defaults.
We are also watching jobless claims, which have been rising. Employment is very, very critical to the future of the economy.
Within the equity market, we are overweighting all kinds of defensive areas. Consumer staples and health care are the two dominant themes that we have right now from our sector-strategy group.
Why those sectors in particular?
One obvious reason is that they are defensive. No matter what goes on, we all still eat -- that kind of story. These sectors also have very stable cash flows and, surprisingly, when the dollar appreciates, they tend to do quite well.
Why is that?
Because when the dollar appreciates, it usually means the world is slowing. And if the world is slowing, you do not want to have economic sensitivity in your portfolio. For example, pharmaceutical companies have a lot of foreign exposure and people think of them as being very dollar sensitive. What people forget is another issue, notably economic sensitivity. And so the stocks that really underperform when you go into a global slowdown are foreign-exposed companies with economic sensitivity, like materials and energy -- not pharmaceuticals.
Could you talk a little more about stock valuations and your concerns there?
We have never had the combination of 5.5% inflation and about a 25 multiple on the S&P's trailing earnings. When we talk about a 25 multiple on the S&P, nobody can believe that it is actually the trailing earnings. And then people say, "Well, if that is true, it's only the financial stocks." Well, it is not. It is much more broad-based.
The market is just legitimately expensive, and we are so hesitant to use forward earnings, because analysts have not revised their estimates downward. So to say the market is selling at 13, 14, 15 times forward earnings is a meaningless statement.
What is ahead for the economy, and how much more pain will there be?
That is a hard question to answer, but investors who are looking for a sharp V-shaped recovery are going to be quite disappointed. I do not see that happening. That is because we are going through Phase I of this process, which is the deflation of the credit bubble. Phase II is the knock-on effects on the real economy, and we are just beginning to see that.
The S&P 500 was trading at around 1200 late last week. Where do you see it going over the next year?
Surprisingly, our models still show a return of about 6% for the S&P over the next 12 months. We have about seven different models that we use to come up with that 6%. What is very interesting is that in the last two or three months, the dispersion of forecasts for these models has gotten incredibly dramatic and has been skewed downward.
So the 6% forecast is the median, not the average, which is about minus-18. We have always used the median to try to remove some of the volatility. But we have never seen that gap before between the mean and the median.
Moving to bonds, what is your view of that asset class?
Let's start with the Treasuries, which have outperformed stocks in the last 10 years.
If these were semiconductor stocks, everybody would be piling into them. It is just amazing that we have an asset class that is outperforming and everybody still hates it. The #1 issue right now with Treasuries is probably inflation. But you need credit creation to get inflation. Printing money, which is what everybody is scared of, does not create inflation by itself, especially when the velocity of money [or the frequency it is spent] or credit creation is going down. When the global economy starts to reaccelerate, credit creation begins to pick up and, therefore, the velocity of money begins to pick up, and then central bankers are going to have their hands full. But for right now, I do not think people should worry about inflation.
So we are still very big fans of Treasuries. We are big fans of higher-quality bonds. But one of our constant themes has been that credit spreads are widening, whether it is emerging-market debt or corporates or munis. The market will continue to differentiate between really high-quality assets and lesser-quality assets.
What do you see happening to hedge funds in the wake of all this turmoil?
I expect there will be tremendous consolidation there, as well. Hedge funds are coming under tremendous pressure.
What should investors be looking at?
Instead of looking back longingly at what did work and saying it has got to come back, investors should focus on what are going to be the new growth stories.
Sectors like health care?
It is going to be very, very mundane and boring stuff compared to what we have seen in recent years. A credit bubble makes a lot of things look sexy. So we are going to go through a period of mundane investing -- staples, health care, developed markets over emerging markets, high-quality bonds instead of low-quality and emerging-market bonds. And the dollar will appreciate relative to a lot of other currencies.
HEDGING THE GLOBAL MARKET
Do invest overseas now but with an exit strategy always available and with a reserve of ready cash.
Jim Lowell, the editor of The Forbes ETF Advisor, has a couple of enterprising ideas on how to invest overseas without getting run over by the vicious bear market in non-U.S. stocks. After leaving the U.S. market in the dust the past several years, foreign stock markets have given back some of that outperformance this year. The ETF based on the broad MSCI EAFE stock index (EFA) was down about 32% through October 3 while the iShares S&P 500 ETF (IVV) was "only" off 25%. The Vanguard Emerging Markets Stock ETF (VWO) is off 40%.
The world's economies are no longer led by the U.S. as they once were, but they are still intimately and inextricably linked to it. When our American market soared in its post-2002 recession rebound, we also benefited from the robust recovery of international markets. Now, as our stocks come down to earth, we find the markets linked again. There is not quite the safe harbor you might have hoped for abroad.
For the first time since 2005 foreign equity markets are trailing rather than leading our own. The Standard & Poor's 500 was down 16% through mid-September; the MSCI EAFE Index, the best broad gauge of non-U.S. stocks, was down 29% in dollar terms. Russia, last year's hot market, is off 53% this year. Other European exchanges are giving up multiyear gains. China, the country global investors have been banking on for double-digit returns over the next 30 years, is down 56% from its peak last fall. What is a global investor to do?
Listen to sage advice. Years back I set out to live in Dublin, which at the time had a First World culture but a Third World economy. My grandmother gave me these pearls: Travel the world while you can, hold your exit visas tighter than your passport and always keep $100 in your sock. Applying that wisdom today, do invest overseas now but with an exit strategy always available and with a reserve of ready cash.
To travel today's troubled investment globe, my first pick is the no-load Fidelity Four-in-One Index Fund (FFNOX). The Four-in-One invests in a quartet of Fidelity's index funds: the Spartan 500 (55%), Spartan Extended Market (15%), Spartan International (15%) and U.S. Bond (15%). Its conservative map of the global market, its low cost (a composite annual expense ratio of 0.23%) and a decent performance (a 3% annual return since its July 1999 inception, versus 0.3% for the S&P) make it a good globe-trotting choice.
In the past I have recommended the iShares FTSE/Xinhua China 25 Index exchange-traded fund. It comprises the 25 largest stocks on the Hong Kong Stock Exchange, among them Industrial & Commercial Bank of China and China Mobile (CHL). It is China's equivalent of the Dow Jones industrial average, with a 50-year time warp. My exit visa is to counter the volatility of such stocks, and offset the possible effects of a global slowdown, by buying the ProShares Short MSCI Emerging Markets Fund (EUM). The ProShares aims to deliver the inverse of the performance of the MSCI Emerging Markets Index, a well-established and broadly diversified basket of stocks from 25 countries. The index is dominated by Brazil (18%), China (14%), Korea (13%), Russia (11%) and Taiwan (10.5%). That makeup tips it in favor of high energy and materials prices.
Commodities like oil and iron ore were hot when they were hot, but that cycle has turned. So, provided you already own the iShares China fund, you would be reducing your overall risk by owning the emerging market short-selling fund as well. The biggest stocks you are effectively shorting with the ProShares ETF are Gazprom and Petrobras (PBR). The fund's expense ratio is 0.95%.
What if you do not already own the iShares China? Then buy it at the same time you buy the ProShares fund. Put equal dollar amounts in these two funds.
My concern about a global slowdown also influences my final pick. The dollar, after being besieged for years by global growth and booming commodities, has never been better positioned to rebound. Since its nadir on July 15, it has appreciated 12% against the euro. I think it has further to go. European economies have continued to weaken, giving it room to grow against the euro, and any slowdown in Asia could let it pick up against the yen. Moreover, just as Asia's heated growth recently drove up oil futures prices and hurt the dollar right when the Federal Reserve was cutting interest rates, so a slackening demand for oil is now converging with the Fed's firming stance on the money supply.
So, buy the Powershares DB U.S. Dollar Index Bullish Fund (UUP), which is basically a doubled-up bet on a rising dollar. This ETF, which runs up a 0.50% expense ratio, is off 3.2% over the past year but has climbed 8.7% since the dollar's low point this summer. It would be a particularly good hedge for someone who owns an international fund (the Vanguard Total International Stock Index Fund, for example) that does not hedge its currency exposure. By owning both, you would get the benefit of rising stocks abroad without suffering losses from a rising dollar.
THE COMING BOND DEFAULT WAVE
This article, written a couple of weeks ago, might smack of closing the barn door after the horse has escaped. By now everybody expects bond default rates to go climb, and the market has priced bonds accordingly. But actually it is still early in the game, and the details of what might lie ahead are of more than a little interest. Especially for stock investors who do not pay much attention to bonds, this piece from Forbes columnist Richard Lehmann should get the neural networks vibrating.
My business has maintained a database of all corporate and municipal bond defaults since 1982. Over the years it has grown to include defaults by 4,400 issuers on $560 billion in debt. That is a record of failure that clearly should concern investors, even if defaults have been relatively few in the last several years.
One particular reason to worry right now: Corporate bond defaults come in waves, not a continuous stream. They happen when banks cut off companies' lines of credit, and that usually happens when there is a recession. That is because the economic downturn reduces the value of a company's assets and thus reduces the collateral that banks can fall back on to recover loan principal. This time we face not only recession but also a banking industry with damaged balance sheets of its own. Throw in the fact that the corporate junk bond market has grown to $1.3 trillion and you have the likelihood of defaults easily surpassing the last wave in 2001-02. In 2002, $98 billion of corporate bonds went bad, out of $757 billion outstanding.
One of the effects of such a default wave is that it makes a recession last longer, by heaping more bad news on a market whose faith in credit ratings is already impaired. That is a danger right now, as even investment-grade issuers are having to pay 8% or more for their borrowings. Such yields suggest that we may face some significant defaults even among bonds with ratings above the junk level.
What about tax-exempt bonds? You might presume that municipal bonds are not vulnerable to default, but they, too, fail in significant numbers. In fact, of the 4,400 defaults in our database, 2,900 are of municipal bonds. Their total principal amount of $44.5 billion is low compared with that of corporate defaulters, because the typical municipal issue (especially revenue bonds, which are most prone to default) is much smaller than a corporate one. Insurers, including the federal government, made good on the loss of 30% of that default volume. In those cases, muni insurance was really worth something.
The causes of municipal bond defaults are many: nursing homes that do not fill up, housing developments that were started too late, commercial projects with thin revenue streams and so-called "economic development" tax exemptions. This year we have seen an unsurprising surge in defaults connected with housing developments in Florida, California and Nevada. Jefferson County, Alabama issued $3.2 billion of water bond issues that were structured unwisely, relying on sewage-service revenues to fund them as they rolled over every month and a half. Those bonds have collapsed as interest rates soared, and they are being kept alive only by the fact that the investment bankers and underwriters who have been left holding many of them face conflict of interest charges if they try to recover all they think they are owed.
The good news about bond defaults, such as it is, is that when they do happen, all is usually not lost. Bondholders have a claim on a company's assets before stockholders, although not before banks. On average, holders of defaulting corporate bonds recover about 72 cents on the dollar. Future defaults will do worse, though, because recent changes to bankruptcy law have added to banks' advantage. Municipal bond defaults repay an average of 85 cents on the dollar for those with some sort of insurance and 70 cents for those without (the range of repayment goes all they way from zero to full face value). That sounds grim, but remember that a 30% decline in a stock's price has the same cost to the investor, and that happens even with healthy companies.
Since we are just entering the default phase of the bond market, this is no time to reach for yield. Review your holdings now, and dump all issues rated B-- and CCC. I predict that in the coming default wave as many as 50% of those issues will default. That will leave 50% that do not default, but their yields can be expected to rise as high as 20%, further depressing their prices, before the default wave begins to ebb.
You may already be looking at a loss on your below-investment-grade holdings, but much worse lies on the horizon. The same can be said about junk-bond mutual and closed-end funds. They are already weak (Bloomberg's index of high-yield mutual funds has a return of -8% this year), and they are likely to get weaker.
Forbes columnist Vahan Janjigian looks at a couple of companies that will benefit from the growth in alternative energy technologies. Unlike many of their fellow sector members, the two have earnings -- in fact their valuations are far from extreme. This is because the alternative energy angles are kickers to mature businesses. Look to buy the stocks where you are getting the later cheap and the former for nothing.
I am a terrible golfer, but I could not say no when a friend invited me recently to play at Donald Trump's magnificent Trump National Golf Club in Westchester County, N.Y. Zipping around the course in a battery-powered cart, I was able to take my mind off my game by thinking about the clean, quiet power that was transporting me. An electric car! That led to thoughts of the ongoing mania over alternative energy stocks and their wildly speculative valuations. I mean, both American Superconductor and Evergreen Solar have market capitalizations of around $830 million even though neither has yet shown a profit.
Such stocks seem to rally and retreat in perfect concert with oil prices. So why should they occupy my mind now, when oil prices have backed off from their recent high? Because alternative energy is here to stay, no matter what happens to oil in the short run and no matter who steps into the White House in January. And there might be a way to play it without buying the obvious wind and solar companies.
A lot of experts, including those at Goldman Sachs, believe the recent easing in the price of oil is temporary and it will spike again soon. That clearly would be good news for alternative energy stocks. Others, including me, perceive a bubble and expect oil to fall as low as $70 a barrel. I believe that with global economies slowing, the dollar strengthening and U.S. demand declining, even the threat of hurricanes cannot keep oil's price up. But whichever way it goes, it is not going to sink low enough to discourage politicians from enacting subsidies and mandates for oil substitutes. Both Barack Obama and John McCain believe it is in our national interest to diversify our energy supply and reduce our dependence on foreign sources. They both promise to promote alternative technologies.
Batteries are an obvious place to look for investment opportunities. What kind? Someday an exotic lithium-ion battery may sweep through Detroit, making electric cars cheap and long range. But even if there were a pure-play lithium battery company to invest in, it would probably be a bad place to put your money, with a ridiculous price/earnings ratio. Better idea: Invest in a battery company using old-fashioned technology. The company I have in mind is EnerSys (ENS). It makes lead-acid batteries not very different from the ones made a century ago.
Lead batteries will never make a dent in the electric car market because they weigh too much. But they are widely used to power industrial equipment, such as forklifts and mining equipment, and to supply standby power for things like telecommunications lines. And, important to someone with a faith in alternative energy, they are used to store energy produced by intermittent sources like the wind and the sun. For now the storage of renewable energy is only a small part of EnerSys's business, but it could be a very large part a decade from now. ... EnerSys has annual revenue of $2.2 billion and sells for 11 times trailing earnings.
If you have a 2.5-kilowatt solar collector on your roof, it will produce those 2.5 kilowatts only at noon on a sunny day. If you wanted power at night and on rainy days you would need 15 deep-cycle batteries for storage. In lead that much storage weighs 675 pounds and costs you roughly $1,000. Money in EnerSys's coffers.
Trinity Industries (TRN) is another under-the-radar alternative energy play. Trinity has been manufacturing railcars since 1977, and it has become the largest producer of them in North America. It also sells inland barges and construction materials such as concrete, gravel and asphalt. Less known is the company's already booming business in wind towers, the high pylons that support wind turbines with 126-foot blades.
Trinity sold $106 million worth of wind towers in the second quarter this year, accounting for 11% of its revenue. Demand is soaring. The company has a wind tower backlog that doubled to $1.5 billion over the past year. Trinity's stock has climbed 12% since the beginning of the year (while the Standard & Poor's MidCap 400 Index has lost 13%), but it is not overvalued. It still sells for only 60% of sales and 8 times trailing earnings.
This article was written when Trinity was selling at 31. It subsequently tumbled and was selling at 21 and change on October 3 -- below book value. The company repurchased just short of 2 million shares at a price of $21.15 "in a privately negotiated transaction" on that date. The company Board of Directors had authorized a $200 million share repurchase program last December, and so far has repurchased a total of 2,719,700 shares for $61.1 million, which works out to an average price of $22.47. This means the company waited until the shares were actually cheap before pulling the trigger -- which raises management's stature in our eyes no small amount.
WHAT THE HEDGE FUNDS’ BAD SEPTEMBER COULD MEAN FOR MARKETS
Wither the hedge funds during the recent market tumult? Hedge funds were supposed to be able to help cushion bear market portfolio value hits due to their ability to "hedge" by, among other available tactics, selling stocks short -- something prohibited to work-a-day mutual funds. If their overall September performance, the worst month for hedge funds since records started being kept in 1990, is any indication then the funds were, as the old joke goes, well hedged against capital gains.
Hedge funds have been promoted to be some whole separate rarefied asset class distinct from the plebian mutual funds, notwithstanding that most hedge and mutual funds trade similar markets. Credulous investors convinced themselves to pay much higher management fees to hedge fund managers, e.g., 2% of assets under management plus 20% of realized capital gains versus a pure 1% of assets under management fee for a typical no-load stock mutual fund. Ergo Warren Buffett's characterization of hedge funds as a "compensation structure masquerading as an asset class."
With the bear market having arrived in force, we are observing the downside of what was clear all along: Using a lot of leverage looks good during a credit mania but will be deadly once the fever breaks. Many hedge funds stand revealed as one-trick bubble market ponies.
Mutual fund investors are notorious for not pulling money out of poorly performing funds, but we suspect hedge fund investors as a class will repent in the same haste they committed the original sin of investing in the first place. Redemption requests have already ballooned. Mediocre managers will lose assets, and assets in hedge funds will shrink down to a saner level. Meanwhile, as the redemption requests are serviced and convoluted positions are unwound, we expect a lot of hedge fund nominal asset values to go to "money heaven."
It appears hedge funds had a disastrous September, the worst since records have been kept (1990). Some of the names on the list are quite shocking as they are considered "the best of the best." The whole idea of a hedge fund is to offset market volatility and be able to make money in both and up and down market (or at least limit losses) -- or at least that was the old school idea of what a hedge fund offers. The new school idea is to take as much risk, lever as much as possible, and create generational wealth in a span of 2-3 years and then if the fund blows up, oh well. You start a new one in 18 months and say "well, who could expect what happened to happened -- it blew up my model."
I will say there have been some things that have worked against hedge funds of late:
I think this era is going to show a lot of institutions who threw gobs of money at hedge funds based on "models" to rethink the situation. And just from a lot of what I read on the internet, many individual investors seem to think of these hedge funds as magical entities who are above it all and can mint money like magic -- those perceptions will also be going bye-bye.
- Many long-short funds, and many quant funds, got the rug pulled out from under them with the short sale restrictions in financials, and many hedge fund strategies will not work if the rules are constantly changed -- as they have been.
- The day to day volatility as we have pointed out here is simply unfathomable -- 4% days have become the norm.
- There is no memory from one day to the next -- it is impossible to make money when no trend lasts for more than 48 hours.
- Naked shorting has finally been enforced -- this was stealing candy from a baby for many hedge funds as they could sit and effectively attack smaller companies day after day for as long as they want. The investment brokers, serving as prime brokers for the hedgies, of course were laughing it up too -- more profits for all of us! ... until the day the tables turned on them and the i-banks became the targets. Then the last two i-banks standing ran to Washington D.C. and screamed to CHANGE THE RULES since naked shorting is UNFAIR and the Frankensteins they helped create had turned on them. It is the height of hypocrisy. But without naked shorting, the "easy trade" has been taken away from some of these hedge funds. Gaming the system is not really showing any investing acumen -- it is simply skirting the rules -- I hope this becomes a permanent change and we allow smaller companies to actually enjoy an existence in the stock market.
As I have been saying, this very fat herd full of "me too" hedge funds is going to be thinned substantially in the months and year to come. Hopefully old fashioned stock picking (both long and short) makes a comeback -- you know, picking stocks with good prospects to go up, and vice versa? Instead of having 450 supercomputers from this fund battling 980 super computers from that fund? I am a traditionalist I guess.
Here is the scary stat (well, the whole story is scary)
- Maverick Capital Ltd., Greenlight Capital LLC and The Children's Investment Fund Management LLP fell more than 12% in September as stock hedge funds posted record monthly losses and braced for client defections.
- Lee Ainslie's Maverick Capital declined 19.5% and Greenlight Capital, run by David Einhorn, was down 12.8%, according to investors in the New York-based funds. Children's Investment, overseen by Chris Hohn in London, fell 15%, based on a preliminary estimate. (Maverick is very well respected and to lose 1/5th of value in 30 days is simply unfathomable; Einhorn has become a CNBC star.)
- Other managers with above-average losses for the month included Stephen Mandel, whose main Lone Cyprus fund in Greenwich, Connecticut, fell 14.7%. New York-based Third Point LLC, run by Daniel Loeb, dropped 11%.
- Stock hedge funds fell an average of 8.6% in September, the biggest one-month loss since Hedge Fund Research Inc. began collecting data in 1990. While that was better than the 12% decline by the MSCI World Index, a benchmark for global stocks, industry analysts expect investors to increase their requests to pull money from funds.
- The losses came even as many managers sought to sidestep the tumble in equity prices by holding more cash, cutting borrowing and reducing their bets on stocks expected to rise.
- Restrictions on shorting stocks in the U.S. and U.K. put in place on September 18 hamstrung funds that could no longer bet on falling prices of 15% of the companies in the Standard & Poor's 500 Index. Energy and materials shares, which many hedge funds had been expecting to rise, were some of the worst performers in the month, with the S&P 500 Materials Index down 17% and its Energy Index down 12%.
- Price swings also made trading difficult, investors said. The S&P 500 rose or fell more than 4% on six trading days in the month, compared with once in the previous eight months.
- Managers including DKR Capital Partners LP in Stamford, Connecticut, and London-based RAB Capital PLC restricted redemptions on some funds so they are not forced to sell assets at a loss to pay off investors. RAB Special Situations, down 15% in September and more than half this year, won investor approval on September 30 to delay redemptions for three years in return for a cut in fees. DKR SoundShore Oasis Fund restricted redemptions after it received requests for withdrawals totaling 27% of its net asset value. Guy Wyser-Pratte suspended withdrawals from his $500 million Wyser-Pratte Eurovalue Fund.
- The month was the worst in 19 years for a basket of 50 stocks that are widely held by hedge funds, according to Goldman Sachs's Very Important Positions index. The index fell 18.6% in September, the most since data have been tracked, and 24% year-to-date. The index is compiled of the positions that appear most frequently among top 10 holdings of hedge funds. (That is forced liquidation after forced liquidation -- and it is a spiraling effect.)
So depending on the leverage in the hedge fund system, multiple $100 Billion by (amount of leverage in those hedge funds) and that is how much selling could potentially go on in the 4th quarter to meet redemption requests. This is why I do not expect much sustained success to the upside in markets in the fourth quarter, although I would be happy to be wrong.
- Funds of hedge funds probably put in more than $100 billion in year-end redemption notices by this week's September 30 redemption deadline, according to London-based advisory firm Clontarf Capital.
Hopefully by December 31 a lot of smaller to medium funds have closed up shop, exited positions, and we can carry some semblance of normalcy beginning January 1. But I would love to be a fly on the wall at some of these offices as the "brightest and best" explain to their investors how a "hedge(d)" fund could perform quite so poorly.
IT IS “ABSOLUTE NIRVANA” FOR VALUE INVESTORS
Value investing newsletter publisher/fund manager/conference founder Whitney Tilson is finding lots of reasons to chear the selloff in stocks. Value investors appreciate a sale on the NYSE as much as a storewide sale at Target, so this is to be expected.
When the Value Investing Congress convenes next week in New York City, some of the world's top value investors will share their ideas for the best stocks to own -- and short.
Henry and I got a sneak preview this morning with the conference's co-founder, Whitney Tilson, managing partner of T2 Partners and Tilson Mutual Funds.
"In a cash-constrained world of chaos and panic, we are finding tremendous bargains," says Tilson, who co-edits Value Inevstor Insight, a newsletter focused on value investing.
Berkshire Hathaway (BRKA) is the "best way to play the credit crunch," says Tilson, whose fund owns Warren Buffett's holding company. Other long positions include beaten-down retailers like Target (TGT) and Barnes & Noble (BKS), which Tilson says have the balance sheets to survive the downturn -- and buy back stock along the way.
To hedge against those positions, Tilson has been betting against financials and short companies exposed to the consumer with high P/E ratios, including Apple (AAPL) and Research In Motion (RIMM), as discussed in the accompanying video.
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