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

W.I.L. Finance Digest for Week of October 20, 2008

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


Throw away the Blackberry and get a life, he advises.

In an “It’s over. Don’t slam the door on your way out” signoff worthy of a celebrity relationship breakup, hedge fund manager Andrew Lahde has announced his retirement by thanking all the "idiot" traders who were on the other sides of his wildly successful bets against subprime mortages. He also disses the top managements of the leading U.S. financial companies which have gone down in flames, essentially calling them idiots in chief.

On a more sober note, Lahde said he planned to repair his "stress-damaged health," and advised his fellow financial go-go types to slow down and get a life that "sucks" less.

The boss of a successful U.S. hedge fund has quit the industry with an extraordinary farewell letter dismissing his rivals as over-privileged "idiots" and thanking "stupid" traders for making him rich.

Andrew Lahde's $80 million Los Angeles-based firm Lahde Capital Management in Los Angeles made a huge return last year by betting against subprime mortgages.

Yesterday (October 17) the 37-year-old told his clients that he had hated the business and had only been in it for the money. And after declaring he would no longer manage money for other people, because he had enough of his own, Lahde said that instead he intended to repair his stress-damaged health. He made it clear he would not miss the financial world.

"The low-hanging fruit, i.e., idiots whose parents paid for prep school, Yale and then the Harvard MBA, was there for the taking," he wrote. "These people who were (often) truly not worthy of the education they received (or supposedly received) rose to the top of companies such as AIG, Bear Stearns and Lehman Brothers and all levels of our government," he said.

"All of this behavior supporting the aristocracy only ended up making it easier for me to find people stupid enough to take the other side of my trades. God bless America."

Lahde became one of the biggest names in the investment industry when one of his funds produced a return of 866% last year, largely by forecasting the U.S. home loans industry would collapse.

In his farewell letter, which concluded with an appeal for the legalization of marijuana, Lahde said he was happy with his rewards and did not envy those who had made even more money.

"I will let others try to amass nine, 10 or 11 figure net worths. Meanwhile, their lives suck," he wrote, citing a life of back-to-back business appointments relieved only by a two-week annual holiday in which financiers are still "glued to their Blackberries."

Lahde's retirement came amid an implosion among the hedge fund industry -- some 350 of the funds have liquidated this year, according to Hedge Fund Research.

His final words of advice? "Throw the Blackberry away and enjoy life."


Commodities bull Jim Rogers says that what is going on now is blanket liquidation of all assets without regard to fundamentals -- one of "eight or nine periods of forced liquidation over the past 100 to 150 years." On the other side those things with unimpaired fundamentals will do the best. Commodities demand has been cyclically dampened by the economic problems of the day, but secular supply, Rogers maintains, has been crimped as well. This means the commodities bull market will last longer and go further.

The commodity bull market will last longer as a consequence of the global financial crisis, Jim Rogers CEO of Rogers Holdings, told Commodity Online in an exclusive interview.

"We have had eight or nine periods of forced liquidation over the past 100 to 150 years wherein everything was liquidated without regard to fundamentals. This is such a period," Rogers said.

Rogers, said the commodities market is these days hit by the prospects of growth slowdown in countries like China and economic pessimism in the U.S. and Europe.

"Historically the things which have come out best on the other side are things where the fundamental have been unimpaired. Commodities are the only thing I know with unimpaired fundamentals," he said.

"The cyclical demand for commodities may slow, but the secular supply will be badly affected so the commodity bull market will last longer and go further in the end," he added.

"I have an enormous amount of cash and I have been using it to buy more Japanese Yen, more Swiss Francs, more agricultural products. ... There is a liquidation phase going on, where everything is being liquidated. They are selling everything in sight," Rogers said last week speaking on CNBC.

"In a period like this the way you make money coming out of it is to own the things were the fundamentals have not been impaired."


Did Chairman Bernanke learn the correct lesson from the Great Depression? (No.)

Only the government, some wag observed, can take a perfectly good commodity like paper and turn it into something worthless. In slightly disguised form, that is what the Fed and its cohorts are doing when they try to forcefeed the system "credit" generated out of thin air.

Mises Institute adjuct and writer Frank Shostak explains why the current machinations of the world's central banks will not work and are actually counterproductive in this great background piece. As Mike "Mish" Shedlock puts it in his "Keynesian Claptrap From PIMCO" blog entry: "It is a sad state of affairs that Bernanke who fashions himself an 'expert' on the Great Depression knows less about the cause and cure of it than anyone who reads and understands the [Shostak] article."

Sad, and not without consequences for the rest of us.

On Wednesday October 8 the Federal Reserve, European Central Bank, and four other central banks lowered interest rates in an emergency coordinated bid to ease the economic effects of the financial crisis. The Fed, ECB, Bank of England, Bank of Canada, and Sweden's Riksbank each cut their benchmark rates by half a percentage point. Furthermore, China's central bank lowered its key one-year lending rate by 0.27 percentage points. According to a joint statement by the central banks:
The recent intensification of the financial crisis has augmented the downside risks to growth and thus has diminished further the upside risks to price stability. Some easing of global monetary conditions is therefore warranted.
The Fed's decision brought its benchmark rate to 1.5%. The ECB's main rate is now 3.75%; Canada's fell to 2.5%; the U.K.'s rate dropped to 4.5%; and Sweden's rate declined to 4.25%. China cut interest rates for the second time in three weeks, reducing the main rate to 6.93%. One day earlier the Reserve Bank of Australia had lowered its policy rate -- the cash rate -- by 1% to 6%.

Only a day earlier Federal Reserve Chairman Bernanke announced that the U.S. central bank is ready to intervene in the commercial paper market. The Fed will now buy commercial paper issued by corporations -- meaning the U.S. central bank will make direct loans to corporations.

It seems that Bernanke is ready to push trillions of dollars to keep the monetary system alive.

Bernanke is of the view that a major reason for the Great Depression of 1930s was the failure of the U.S. central bank to act swiftly to revive the paralyzed credit market. By "swift action," Bernanke means massive monetary pumping.

The Fed chairman continuously reminds us that at least he has learned the lesson of the Great Depression and will make sure that the error that the Fed made then will not be repeated again. At the conference to honor Milton Friedman's 90th birthday, Bernanke apologized to Friedman on behalf of the Fed for not pumping enough money to prevent the Great Depression:
Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again.
(Milton Friedman and Anna Schwartz wrote that the key factor behind the Great Depression was the failure by the Fed to pump large doses of money.)

Central-bank policy makers have said that the key for economic growth is a smooth flow of credit. For them (in particular, for Bernanke) it is credit that provides the foundation for economic growth and raises individuals' living standards. From this perspective, it makes a lot of sense for the central bank to make sure that credit flows again.

Following the teachings of Friedman and Keynes, it is an almost-unanimous view among experts that if lenders are unwilling to lend, then it is the duty of the government and the central bank to keep the flow of lending going.

For instance, if in the commercial-paper market lenders are not there, then the Fed should step in and replace these lenders. The important thing, it is held, is that various businesses that rely on the commercial-paper market to keep their daily operations going should be able to secure the necessary funding.

Will the increase in money pumping by central banks unfreeze credit markets? Experts believe that this will do the trick. If the current dosage of pumping will not work, then the central bank must continue to push more money until credit markets start moving again, so it is believed.

It is true that credit is the key for economic growth. However, one must make a distinction between good credit and bad credit. It is good credit that makes real economic growth possible and thus improves people's lives and well-being. False credit, however, is an agent of economic destruction and leads to economic impoverishment.

Good Credit versus Bad Credit

There are two kinds of credit: that which would be offered in a market economy with sound money and banking (good credit), and that which is made possible only through a system of central banking, artificially low interest rates, and fractional reserves (bad credit).

Banks cannot expand good credit as such. All that they can do in reality is to facilitate the transfer of a given pool of savings from savers (lenders) to borrowers. To understand why, we must first understand how good credit comes to be and the function it serves.

Consider the case of a baker who bakes 10 loaves of bread. Out of his stock of real wealth (10 loaves of bread), the baker consumes 2 loaves and saves 8. He lends his 8 remaining loaves to the shoemaker in return for a pair of shoes in one week's time. Note that credit here is the transfer of "real stuff," i.e., 8 saved loaves of bread from the baker to the shoemaker in exchange for a future pair of shoes.

Also, observe that the amount of real savings determines the amount of available credit. If the baker had saved only 4 loaves of bread, the amount of credit would have only been 4 loaves instead of 8.

Note that the saved loaves of bread provide support to the shoemaker, i.e., they sustain him while he is busy making shoes. This means that credit, by sustaining the shoemaker, gives rise to the production of shoes and therefore to the formation of more real wealth. This is a path to real economic growth.

Money and Credit

The introduction of money does not alter the essence of what credit is. Instead of lending his 8 loaves of bread to the shoemaker, the baker can now exchange his saved eight loaves of bread for 8 dollars and then lend those dollars to the shoemaker. With 8 dollars, the shoemaker can secure either 8 loaves of bread (or other goods) to support him while he is engaged in the making of shoes. The baker is supplying the shoemaker with the facility to access the pool of real savings, which among other things includes 8 loaves of bread that the baker has produced. Note that without real savings, the lending of money is an exercise in futility.

Observe that money fulfills the role of a medium of exchange. Hence, when the baker exchanges his 8 loaves for 8 dollars, he retains his real savings by means of the 8 dollars. The money in his possession will enable him, when he deems it necessary, to reclaim his 8 loaves of bread or to secure any other goods and services. There is one provision here: that the flow of production of goods continues. Without the existence of goods, the money in the baker's possession will be useless.

The existence of banks does not alter the essence of credit. Instead of the baker lending his money directly to the shoemaker, the baker lends his money to the bank, which in turn lends it to the shoemaker.

In the process, the baker earns interest for his loan while the bank earns a commission for facilitating the transfer of money between the baker and the shoemaker. The benefit that the shoemaker receives is that he can now secure real resources in order to be able to engage in his making of shoes.

Despite the apparent complexity that the banking system introduces, the act of credit remains the transfer of saved real stuff from lender to borrower. Without the increase in the pool of real savings, banks cannot create more credit. At the heart of the expansion of good credit by the banking system is an expansion of real savings.

Now, when the baker lends his 8 dollars, we must remember that he has exchanged for these dollars 8 saved loaves of bread. In other words, he has exchanged something for 8 dollars. So when a bank lends those 8 dollars to the shoemaker, the bank lends fully "backed-up" dollars so to speak.

False Credit Is an Agent of Economic Destruction

Trouble emerges however if, instead of lending fully backed-up money, a bank engages in fractional-reserve banking, the issuing of empty money, backed up by nothing.

When unbacked money is created, it masquerades as genuine money that is supposedly supported by real stuff. In reality, however, nothing has been saved. So when such money is issued, it cannot help the shoemaker, since the pieces of empty paper cannot support him in producing shoes -- what he needs instead is bread. But, since the printed money masquerades as proper money, it can be used to "steal" bread from some other activities and thereby weaken those activities.

This is what the diversion of real wealth by means of money "out of thin air" is all about. If the extra 8 loaves of bread are not produced and saved, it is not possible to have more shoes without hurting some other activities -- activities that are much higher on the priority lists of consumers as far as life and well-being are concerned. This in turn also means that unbacked credit cannot be an agent of economic growth.

Rather than facilitating the transfer of savings across the economy to wealth-generating activities, when banks issue unbacked credit they are in fact setting in motion a weakening of the process of wealth formation. It has to be realized that banks cannot relentlessly pursue unbacked lending without the existence of the central bank, which, by means of monetary pumping, makes sure that the expansion of unbacked credit does not cause banks to bankrupt each other.

We can thus conclude that, as long as the increase in lending is fully backed up by real savings, it must be regarded as good news, since it promotes the formation of real wealth. False credit, which is generated "out of thin air," is bad news. Credit which is unbacked by real savings is an agent of economic destruction.

Fed and Treasury Actions Only Make Things Worse

Neither the Fed nor the Treasury is a wealth generator. They cannot generate real savings. This in turn means that all the pumping that the Fed has been doing recently cannot increase lending unless the pool of real savings is expanding. On the contrary, the more money the Fed and other central banks are pushing, the more they are diluting the pool of real savings.

Yet most commentators are of the view that, given the present fragile state of the financial system, the central bank and the government must intervene to prevent the collapse. But how can the government and the central bank help in this regard? How can the central bank or the government generate more real savings?

The only thing that the government and the central bank can do is to redistribute the real savings from other people and give it to banks. Now, if the pool of real savings is still expanding this can "work" -- and lending might flow again -- but the overall pool of real savings will weaken as a result of the transfer of real savings from the nonbanking sector to the banking sector. If, however, the pool of real savings is falling, then it will not be possible to increase the flow of lending.

Why Doing Nothing Is the Best Policy to Revive the Economy

Given the growing likelihood that the pool of real savings is in serious trouble, does this mean that the flow of credit will remain frozen? What can be done to unfreeze the flow is to allow the interest rate to find its own level.

With a weakening real economy, lenders will be willing to lend only at the interest rate that allows for higher risk and for the fact that less real savings is available, all other things being equal. At a much higher interest rate, the so-called financial crisis and the shortage of credit will vanish.

The problem then is not with the credit market as such but with the fact that the central banks are pushing massive amounts of money and trying to force interest rates artificially lower. This of course makes it even less attractive for lenders to enter the credit market. Hence the shortage (i.e., the credit crunch) is the result of the central bank not allowing interest rates to reflect the levels that are in line with the facts of reality.

Why then are authorities resisting market forces and allowing the crunch to persist?

Because if interest rates were allowed to be higher, many bubble activities would become unprofitable, and would cease.

Most of those in a position to influence policy are of the view that this would lead to a serious economic slump and therefore should not be allowed. Supporting bubble activities with easy money further impoverishes wealth generators and delays the prospects of a meaningful economic recovery. The pumping by the Fed will distort the interest-rate structure further and worsen the credit crunch. The best policy is for the Fed to do nothing as soon as possible. By doing nothing, the Fed will enable wealth generators to accumulate real savings. The policy of doing nothing will force various activities that add too little or nothing to the pool of real savings to disappear. This will make make the generation of wealth much more rewarding.

As time goes by, the expanding pool of real savings will work towards the lowering of interest rates. This in turn will provide a base for the further expansion of various wealth-generating activities. Therefore, the sooner the Fed stops tampering, the sooner an economic recovery will emerge.

The Lesson They Refuse to Learn

If the pool of real savings is still growing, then doing nothing (and allowing the interest rate to reflect reality) will allow the recession to be short lived and economic recovery to emerge as fast as possible. (At a higher interest rate, various bubble activities will go belly up. As a result, more real savings will become available to wealth generators. This in turn will work towards the lowering of interest rates.)

We suggest that decades of reckless monetary policies by the Fed have severely depleted the pool of real savings. More of these same loose policies cannot make the current situation better. On the contrary, such policies only further delay the economic recovery.

By impoverishing wealth generators, the current policies of the government and the Fed run the risk of converting a short recession into a prolonged and severe slump.


The recession, the credit crunch, the housing collapse and the bear market have not run their course. It is the second mouse that gets the cheese.

Alan Abelson keeps warning everyone not to be too anxious to jump into the market, and so far he has been right. The old cliché/metaphor is that it is dangerous to try and catch a falling; it is safer to left it lodge in the ground and vibrate for a while first. Or, as we heard it alternately and entertainingly expressed: "The trouble with catching falling safes is that it is hard on the arms."

There are, it has long been an article of faith, no atheists in foxholes. And now, thanks to the remarkable events of the past few weeks, one might confidently attest, there are not any capitalists in them, either.

For when the going gets tough, the tough in commerce, industry and particularly finance get going -- fast as their corporate jets will carry them to Washington, begging to be rescued.

Rescued from what? you might well ask. Why from their own folly, of course. Those stalwart stewards of the private sector have undergone a most extraordinary conversion, from the unshakable conviction that government is the problem to the wondrous epiphany that government is the solution.

Now, we do not want to get too picayune or prim. The guys and gals who run our great corporations have never been shy about hitting up the public purse for a little something, whether in the form of tax breaks or contracts or even subsidies. But this time is different (to use a phrase certain to evoke guffaws, but, just this once, happens to be true) in both scale and circumstances.

On the first score, in responding to pleas, particularly from banks and their kin, Uncle Sam is pulling out as many stops as he can. It is hard to get a decent handle on what this enormous effort adds up to since it seems to grow daily by leaps and bounds and because it has assumed so many different guises, from purchasing or guaranteeing billions worth of wasting assets to massive loans and outright investment. (Which makes you wonder whether the powers-that-be keep discovering new problems or they have only the foggiest notion of what they are doing.)

But the sum is incontestably staggering, likely approaching a couple of trillion dollars and counting. And if you toss in the capital transfusions that the French, Germans, Brits et al. are also pumping into the wobbly global financial system, the already burgeoning total swells to numbers not dreamed of in your worst nightmares, something like $3 trillion.

The hope obviously is that in the fullness of time (a nice precise span that ranges anywhere from a year to an eternity) when this still-gathering storm blows itself out, the bulk of that monetary lifeline will wind up back in the public coffers. Miracles do happen.

If you are one of those trusting souls who think the taxpayers will come through unscathed and with something to show for having put their money at risk besides grudging gratitude, we have got a piece of property with killer views and no neighbors that you can have for a song. Did we neglect to mention it is in lovely, downtown Chernobyl?

What makes the circumstances the improvident lenders have gotten themselves into so special is the virtual shutdown of credit, which, for better or worse and right now for worse, is the lifeblood of our economy. It undeniably cried out for quick and dirty remedial action before the economy followed the stock market into the abyss.

But for some strange reason we do not find it entirely reassuring that the very same people charged with foreseeing and forestalling the credit disaster and who so miserably failed to do so -- Paulson and Bernanke somehow leap to mind -- are entrusted with the formidable task of repairing the damage. Mark it down to our being an incurable malcontent.

The damage is huge and mounting. Merrill Lynch's David Rosenberg estimates our credit losses so far weigh in at $600 billion and he reckons that before the crisis breathes its last, that formidable figure will balloon by between $1 trillion and $1.5 trillion.

Like a house beginning to sag dangerously after the underpinnings begin to give way, the economy is cracking across a wide front as the collapse of credit takes its inexorable toll. The great consumer spending binge, which for decades has been a mighty economic spur, is over. Consumer confidence plunged to 57.5 this month from 70.3 in September, the biggest drop and the lowest level since the University of Michigan launched its sentiment index back in 1978.

More tangible evidence that Jane and John Q. are really feeling the pain and hunkering down in earnest, was the sharp decline in September retail sales to a 3-year low. Nothing short of horrendous is the latest bulletins on housing. Starts of single-family homes in September plummeted 12% to still another 26-year nadir. And building permits, a precursor for homebuilding, skidded 8.3% to the lowest level since November 1981. And factory chimneys across a broad swath of industries have started to emit dust instead of smoke.

Those chronic optimists, who have become a bit more shy about trilling their joyous notes in recent months, shrug off the downpour of dismal data as "old news." Old, shmold, it hurts just the same, and -- you can bank on it -- there is plenty more where that came from.

Investors, perverse lot that they often are, decided last week the time was ripe to emerge from their funk. In doing so, they thumbed their noses at the rush of negative dispatches from the economic front as well as other normally discouraging items. Such as:

Powerful fresh evidence of the slumping economy exclusively reported by Bloomberg that Louanna, a Las Vegas stripper who in good months took in as much as $30,000, made a mere $6,000 in September. Talk about bare markets!

Or the depressing disclosure that Joe the Plumber, who enjoyed his 15 minutes of Waholic fame after being prominently featured in last week's presidential debate was really Sam the Plumber, was not legally a plumber, had a tax lien on his house, likely would have had trouble coughing up the dough for the plumbing company he claimed he wanted to buy, and, in any case, need not have lost any sleep worrying about earning enough to warrant a bigger bite under Obama's soak-the-rich proposal.

Offsetting such ordinarily insuperable deterrents to bullish impulses were, first and foremost, perhaps, the market was due -- make that overdue -- for a decent bounce after the terrible pummeling of recent months that dropped the leading indexes to roughly (and very roughly) 40% of their peaks a year ago. Bear markets, as you must be tired of hearing, are invariably interrupted by powerful rallies, rallies that last for more than a wink and can retrace as much as half the ground lost.

The second big spur was the precipitous break in the price of oil, a heck of a lot worse than we ever imagined it would be. The spectacular swoon was part and parcel of the great retreat in commodities generally, triggered by unmistakable signs that the festering woes of the economy and the pinched condition of the consumer were leaving their mark on demand. The panic to dump petro futures was aggravated by the credit crunch and, more specifically, necessitous selling by hedge funds and other heavily-margined investors.

And last but not least what helped fire up investor optimism (briefly, anyway) was an op-ed piece on Friday in the New York Times by Warren Buffett, in which he announced he has been busily buying stocks and the good old American kind, to boot, plans to keep doing so long as the price stays right and exhorted investors to follow his lead.

As always, Buffett was folksy in his explanation of what prompts his bullishness. (“Be fearful when others are greedy and be greedy when others are fearful.”) He sprinkled his advice with some obvious caveats and cautioned that he hasn't any idea what the market will do in the short term -- a month or even a year from now -- but he is confident that it will turn up before sentiment or the economy does. In any case, most major companies "will be setting new profit records five, 10 and 20 years from now."

And he is quite emphatic that the investor who has been sitting with cash and calmly watching the carnage should lose no time in piling into stocks. "If you wait for the robins," he warns "spring will be over."

We need not go through the obligatory obeisance to Buffett's investment prowess and peerless common sense. We think he is great. And sure, we believe the country will survive and prosper in the future. No argument most stock prices are down sharply. But we do not agree this is the time to dive headlong into the market.

For one thing, Buffett can afford to be patient as long as he chooses. Most investors do not have that luxury. For another, the economy is in the early stage of unraveling and we do not think the market decline has discounted the havoc this unraveling may wreak by a long shot.

As to the shining prospects he summons up for the long term, they are not apt to help us all that much if tomorrow's troubles prove as harsh as we suspect they will. Then, too, as another wise man, John Maynard Keynes, famously observed, in the long run we are all dead.

Most of all, Buffett despite his long experience and savvy has not run into a crisis quite like this one because, pure and simple, it has no true precedent. That alone anyone should give anyone with fewer resources than Buffett, intellectually and otherwise, pause. Contrary to what he is saying, we cannot remember anything that deserves to be called a bull market that had to be caught early and it certainly was not true of the last two we have enjoyed.

As to his allusion to robins in the spring -- a nice play on it is the early bird that catches the worm -- as someone has noted, it is the second mouse that gets the cheese.


The unavoidable economic restructuring has now commenced.

Doug Noland has been a long-time tracker and critic of the wildly expanding role of finance in the U.S. economy, claiming that it distorted the very foundations of the system. Almost weekly he would incredulously cite statistics about how fast various facets of credit were expanding.

A particular target of Noland's was Wall Street "Ponzi Finance," wherein risky primary credits were sliced, diced, and packaged, and then pawned off as investment grade (or close) credits. In a kind of reverse fallacy of composition, what was true of the parts was assumed to not apply to the whole. As with the original Ponzi scheme, as long as new investor/suckers -- in the case of hedge funds, the suckers would be the funds' lenders -- could be convinced that the securities were good the game continued working. But once it became evident that a composite package of risky credits is indeed risky, the game started to unwind.

And now the game has utterly collapsed. Noland does not expect to see it revive any time soon. Just is it took a good 60 years for the stock market excesses of the 1920s to flicker back to life, using the portfolio insurance craze that preceded the 1987 crash as a marker, it may take a generation or two for the lessons of today to be forgotten.

I will admit to having warmed up a little to chairman Bernanke. He speaks clearly and candidly, in stark contrast to the years of Greenspan spin and deception. I certainly have sympathy for the predicament Bernanke finds himself in today, and I will give the chairman credit this week for comments suggesting that he is rethinking his flawed views with regard to Bubbles.

Yet this does not change the reality that his infamous 2002 "helicopter Ben" speeches played an integral role in fostering terminal credit and asset bubble "blow-off" excesses. I was a critic of his selection as Greenspan's successor, fearing that his appointment would bolster what had by that point evolved into runaway global credit and speculative bubbles. And while I appreciated the frankness of chairman Bernanke's comments this week, for the record I am compelled to take exception to his assertion that subsequent developments have proved the Fed adroit for commencing aggressive rate cuts a year ago last summer.

When the Fed unexpectedly reduced the discount rate on August 17, 2007, inflationary pressures were mounting and, despite subprime tumult, financial excesses were actually accelerating. Financial sector debt expanded at 16.8% rate and non-financial debt at a 9.1% rate during 2007's third quarter. Importantly, the dollar index was trading at about 81.50. Crude oil closed at $71 on August 16, 2007. The CRB index at the time was at about 300. Emerging debt and equity markets were bubbling. The bubble in the leveraged speculating community was out of control. Citigroup, Wall Street and the global banking community were struggling to dance in what had become a drunken global mergers and acquisitions blowout.

With a U.S. mortgage crisis brewing, the markets were keenly awaiting aggressive Federal Reserve largesse. They got it, and after six months of Fed rate cuts the dollar index had sunk another 15% to new bear market lows. During that period, crude oil surged almost 60% (to $110 and on its way to $145). Wheat and other commodities experienced spectacular speculative runs, provoking angst and bouts of food hoarding around the world. The CRB commodities index jumped about 40%. Emerging market bubbles went to extremes. Brazil's Bovespa equities index quickly gained about a third, while their $ bond yields dropped from an already stunning 6.5% to below 5.8%. U.S. bank credit surged at double-digit rates. GSE books of business expanded by record amounts. Money fund assets ballooned at an almost 50% rate. And funds flooded into the booming hedge fund community. A world awash in excess dollars saw generalized global monetary excess wildly inflate world markets and economies (at least partially to chase the highly profitable weak dollar trade). At home, U.S. corporate borrowings expanded at a better than 13% rate during the second half of 2007 (and 13% overall for the year).

The ECB has been widely assailed for their hesitance to lower rates, while aggressive Fed moves have been applauded. Yet I believe it is important to recognize that the Bernanke Fed only compounded earlier mistakes by signaling their intentions so imprudently to a highly speculative marketplace. There is absolutely no doubt that today's global financial crisis was made much worse because of additional late-cycle excesses -- and resulting acute monetary disorder - fostered by the Fed's accommodative stance beginning in the summer of 2007. The scope of the bubbles and today's spectacular collapses in global equities, energy, commodities, currencies, emerging debt and equity, corporate bonds, and the hedge fund community generally was exacerbated by the Fed's premature move to "mop up" after the bursting of the U.S. Bubble. Moreover, I see very little offsetting benefit to the system from lower Fed funds.

Clearly, the U.S. and global credit systems are today suffering mightily from years of reckless lending, capped off by 2007's blowoff excesses (especially corporate and M&A-related debt). Fortunately, there were indications this week that recent unprecedented global policymaker response is having some positive impact. Dollar Libor rates declined and there were other signs of an easing of conditions in the money and inter-banking lending markets. Commercial paper rates dropped to 3-week lows. At the same time, however, it is becoming increasingly clear that there has been a fundamental transformation in the pricing of long-term finance for households, corporations and municipalities.

Over the past year, Fed funds were reduced 375 basis points to 1.50%. At the same time, 30-year jumbo mortgage borrowing rates are up 88 bps to 7.62%. And despite "nationalization," benchmark Fannie Mae MBS yields are still 33 bps higher than they were a year ago. Spreads on benchmark credit card and auto loan asset-backed securities (ABS) were said to have widened between 100 and 125 bps this week to record levels. Junk bond premiums (S&P) have surged from 380 to 830 bps. During the past 12 months, investment grade spreads have almost quadrupled to 200 bps. And while there was minimal investment grade issuance this week, it is worth noting that those deals that did make it to the market were sold (mostly utilities) at spreads above 400 bps. Meanwhile, an index of municipal bond yields has risen from 4.15% to 6.01%.

There is now recognition that "de-leveraging" is behind the jump in private-sector borrowing costs. And yes, the system has suffered through bouts of forced liquidations before (1994, 1998, and 2002 come to mind), although nothing in the past is relevant to the massive overhang of credit instruments now weighing on the marketplace. There remains, however, hope that some degree of normalcy will return to the fixed income marketplace when policy measures have had time to take effect and liquidations have inevitably run their course. I will throw out a thesis that there will be no return to what we grew to accept as normal. Despite policymakers' best intentions (and resulting ballooning deficits and Fed credit), market yields appear poised to surprise on the upside.

Wall Street finance is an unmitigated bust. Wall Street Alchemy -- transforming endless risky loans into perceived "money-like" debt instruments -- is a spent force. The greatest credit and speculative bubble in history is collapsing. Trust in innovative private-sector credit instruments has been broken. Confidence in contemporary private-sector "money" has been severely shaken. Not in our lifetimes do I expect to again see booming securitization and derivatives markets. The days of unfettered leveraged speculation are over. And, importantly, the amount of Wall Street risk intermediation -- through sophisticated securities, complex derivative structures, various types of credit insurance, financial guarantees and liquidity arrangements, and unlimited speculator leveraging -- will be significantly reduced for years and decades to come.

And it is my view that the demise of Wall Street risk intermediation means higher yields for household, corporate and municipal long-term borrowings. For years, there was virtually insatiable demand from Wall Street for high-yielding risky credits -- loans that could be transformed/intermediated into perceived safe and liquid debt instruments. Almost any risk could be sliced and diced, structured, and transferred to the "marketplace," with enticing securitizations emerging from the financial alchemy. In many cases, these securities were then accumulated by the leveraged speculating community, in the process creating additional financial sector leveraging and the perception of endless system liquidity. It seemingly did not matter at all that we spent instead of saved.

Along the way, there were times when this bubble found itself under some degree of stress. But with lower financing costs from the Federal Reserve and moves by speculators to arbitrage widening spreads, this financing mechanism would quickly right itself. Indeed, soon the credit bubble would more than regain any lost momentum. Importantly, the expanding scope of the speculator community and the endless amount of cheap credit from the Wall Street firms (along with the global mega-"banks") nurtured the perception that this historic episode of Ponzi Finance could last forever.

Today, Wall Street risk intermediation is a bloody wreck, the securities and derivatives markets are in complete disarray, the deeply impaired Wall Street firms have no choice but to rein in lending for securities speculation, and the hedge fund industry is in the midst of a massive de-leveraging and industry collapse. The market for creating, pricing and distributing finance is in complete upheaval.

Not only is the capacity gone for Wall Street to transform risky long-term loans into palatable debt securities. Market dynamics have profoundly altered the appeal of speculative risk arbitrage. For one, there is now a multi-trillion dollar inventory of risky debt securities overhanging the market (from speculator de-leveraging). Second, the capacity for speculators to procure cheap financing for securities leveraging has been greatly diminished. Third, since there will be scant Wall Street demand for new risky credits (previously transformed into easily marketable securities), ongoing financing requirements for the real economy will burden an already stressed marketplace with an unrelenting supply of risky credits. And, fourth, risky credits are especially unappealing as the economy sinks into a deep downturn.

In summary, The "Arb" Game is Over. Both supply and demand dynamics have been radically altered, while the cost and availability of new borrowings is now so uncertain. And, truth be told, speculative risk arbitrage had evolved into a primary monetary policy stimulus mechanism under the Greenspan Fed. In the event of any kind of systemic shock -- or at any point market liquidity began to wane -- a Greenspan signal of lower financing costs was all that was required to incite risk-taking and leveraging. Today, in contrast, with Wall Street finance in crisis no amount of rate cutting or other policymaking can resuscitate leveraged speculation. Going forward, the price of long-term private-sector borrowings will be determined by unadulterated supply and demand dynamics.

For years, the Wall Street bubble distorted the price of finance. In particular, high-yielding risky loans -- the favored domain of Wall Street "alchemy" -- were dramatically mispriced. This under-pricing of risk led to a massive (and self-reinforcing) over-extension of risky loans -- for real estate, for speculating in securities markets, for funding enterprising businesses and municipalities, and for consuming. Over the long life of the credit bubble, this historic expansion of risky credits altered the very fabric of our economic structure. In particular, Wall Street finance fostered asset inflation, over-consumption, and a finance-driven "services" bubble economy. The consequences were momentous, and the unavoidable economic restructuring has now commenced.


The best business book ever offers nostalgia – and cautionary tales.

It was 20 years ago that Barbarians at the Gate: The Fall of RJR Nabisco, chronicling the battle to take over the tobacco/packaged food giant, came out. RJR C.E.O. Ross Johnson planned to take the company private himself, and enlisted the aid of the then kings of the LBO hill Kohlberg Kravis Roberts. Johnson subsequently tried to pull the deal off with Shearson Lehman Hutton instead, but once Henry Kravis learned of Johnson's plans a frenzied bidding war ensued. Ultimately Johnson lost and KKR "won," at the cost of saddling RJR with huge amounts of debt which burdened its operations for years.

Being much earlier in the bull market and before the credit mania reached full flower, the 1980s register as relatively innocent times in comparison to today. The system was stressed by the Crash of 1987. Some timely liquidity injections by Greenspan and probably some pioneering stock market manipulation by the "Plunge Protection Team" were required to stabilize things. But compared to the meltdown of 2008 that was small stuff.

To be sure, incipient signs of the excesses to come were in evidence, of which the wanton incurring of debt in the RJR takeover battle was perhaps the most glaring. It is just that at the time no one had any idea how high the house of cards would yet be built before finally blowing over. The subsequent history of the development of the Wall Street finance machine is what makes the book relevant, and not just nostalgic. On the later point, as this review points out, the "barbarians" of 20 years ago at least had the virtue of possessing outsized, entertaining personalities. The disgraced financial kings of the more recent past just robbed everyone efficiently and remorselessly, and then tried to blow town before they were caught.

Barbarians at the Gate, which chronicles the wild and crazy 1988 takeover battle for RJR Nabisco, is the best business book ever published -- and especially relevant today.

Barbarians chronicled the frenetic Wall Street fight for the tobacco and food giant -- at the time the biggest takeover in Wall Street history. The major players were the ambitious Peter Cohen, who headed the Shearson Lehman Hutton unit of American Express, the ferociously independent Teddy Forstmann of Forstmann Little, and Henry Kravis, the ultra-competitive leader of Kohlberg Kravis Roberts.

Perhaps the book's greatest contribution to the beleaguered Wall Streeters today is much needed relief, in the form of nostalgia. The RJR deal was rich in melodrama and the kinds of outsized personalities who are largely absent from the Street today. (Perhaps they have migrated to the Internet!)

I covered Wall Street in the late 1980s for Investor’s Daily (now known as Investor’s Business Daily). It was relatively easy to gain access to a chief executive, and even the guys who sported bright red suspenders did not take themselves so seriously.

Like the leaders in the Internet world before the bubble burst, Wall Street titans, back then, were fun to cover. Everyone, it seemed, craved publicity, was rich beyond his or her wildest dreams and acted a little nuts.

The riveting fly-on-the-wall narrative in Barbarians (Collins Business), by co-authors Bryan Burrough and John Helyar, also presents a lesson or two as finance professionals ponder the disintegration of their investment banking industry.

The ultimate lesson is that greed is not good, whether it applies to the go-go 1980s or the sub-prime wave of the 21st century. The Gordon Gekko character notoriously said "greed is good" and "greed works" in Wall Street. Oliver Stone's movie came out late in 1987, on the heels of a stock market crash and a sweeping insider-trading scandal, and neatly served as a precursor for the madness of the RJR Nabisco saga the following year.

The book is rich in appreciation for what in retrospect, seems like a simpler time. How simple? Time published an explosive cover story entitled "Greed on Wall Street," which was so powerful that it actually influenced the outcome of the deal as it detailed the lavishness of life on the Street.

We recall an analyst/commentator we did business with at the time awarding Time a "Keen Grasp of the Obvious Award" for that headline, saying greed on Wall Street was about as surprising as sand in the Sahara or salt water in the Pacific.

(Can you imagine today Time or Newsweek, whose impact has been diluted in the generation of digital media and 24-hour cable news channels, possessing the power to make waves with one of its covers?)

Barbarians is that rare business book that can enter the pop culture lexicon. The title of the book quickly became a catch-phrase. The book's success -- it was a Number 1 New York Times best seller for more than 40 weeks -- also made waves in publishing houses.

Its unexpected runaway success prompted envious publishing houses to scramble for finance yarns of their own (including, truth be told, 1992's creditable but highly inferior House of Cards: Inside the Troubled Empire of American Express, which John Meehan and I co-wrote).

Barbarians, originally published in 1990, virtually invented the fly-on-the-wall reporting style applied to business books. Before it came along, these tomes mainly focused on get-rich-quick schemes, gushing biographies and stock market primers.

From another perspective, the success of Barbarians also represented the best of The Wall Street Journal, the newspaper where both Burrough and Helyar starred when they worked on the book. They applied the precepts of Norman Pearlstine, then the editor of the Journal and now, after a circuitous journey, the chief content officer of Bloomberg. ...

Pearlstine stressed the idea that the best narratives contained ample contradictions and conclusions (and the Journal still does it better than any newspaper today). The formula subsequently transferred smoothly to books, as Susan "Backlash" Faludi and James B. "Den of Thieves" Stewart proved in best sellers of their own.

Michael Lewis, a renegade from Wall Street, came the closest to toppling Burrough and Helyar. Lewis wrote Liar’s Poker, a witty account of life at a Salomon Brothers trading floor in the 1980s. In its way, "Liar’s Poker revealed as much about America in that period as Barbarians did.

It is fascinating to ponder how the RJR fight would have played out had it taken place today. Back in 1988, the world moved at a more leisurely pace. There were no Internet communications to speak of. The Fox News Channel had yet to emerge, giving CNN the 24-hour news field to itself. Gossip was not necessarily king.

Newspapers were by far the dominant medium when it came to following mergers and acquisitions. Magazines struggled to compete with the dailies. Business-television stations like CNBC were not a factor and the networks seldom spent much time covering Wall Street, unless someone got arrested or the Dow Jones Industrial Average plunged.

Today, of course, newspapers are trying hard to compete against the Web. Magazines seem to be in danger of going the way of vinyl records. Many cable TV networks beat their brains out in the hope of finding out where Britney Spears had lunch.

Meanwhile, the spirit of the 1980s may not be dead altogether. Word is, Oliver Stone is trying to make a sequel to the chronicle of Gordon Gekko. Timing is everything in life, and with Wall Street collapsing, Wall Street is especially relevant.

So is the 20th anniversary edition of Barbarians at the Gate.


Looking for stable stocks far from troubled U.S. shores? Jesper Madsen’s Asian fund rides on a nice dividend cushion.

During bull markets people forget about dividends and focus on capital gains as the source of their intended returns. As the bull market gets extended they expect greater fools to create their capital gains. Then, after an prolonged bear market diminishes people's expectations, the relatively sure income from dividends suddenly looks a more attractive.

The fact is the a major part of stocks' total returns come from dividends. For instance, this piece cites a study showing that from 1802 to 2002, 64% of the returns of U.S. stocks came from the yield received at the time the stocks were purchased. Another 10% of the return comes from real dividend growth. (The remaining components of the total return were 18% from inflation and 8% from rising valuation.) Other studies show that high yield stocks on average return more for less risk. Naturally there will be cycles when the generally non-sexy high yielders underperform, but the outperformance with lower risk appears to be a persistant anomaly.

As in America so in Asia. And with less information and different accounting standards perhaps there is still more reason to emphasize dividends, unambiguous cash on the barrelhead as they are, when investing in the Far East. Jesper Madsen, manager of the Matthews Asia Pacific Equity Income Fund, claims that dividends act as a "good governance" signal in Asia as well. IPOs often pay dividends from day one, and managements are reluctant to cut them for fear of losing face and investor confidence. Using Madsen's approach for one's Asia stocks exposure strikes us as a sound approach.

American investors tend to view the Far East as a place of storybook stocks. They buy with visions of an Asian Century giving rise to lush capital gains. Rare is the investor who views Asian stocks the way he does domestic ones -- as value, growth or income plays.

Jesper Madsen thinks that is silly. "They perform the way they do in the U.S.," he says. Madsen manages the Matthews Asia Pacific Equity Income Fund in San Francisco. The $100 million fund focuses on the Far East's dividend payers.

Madsen's fund is down 16% so far this year. That puts it 14 points ahead of the dollar-denominated MSCI EAFE Index, which covers both Asian and European stocks. Since the fund's founding in October 2006, it has averaged a return of 3.3% a year, 12.3 points ahead of the index. The fund's return is net of 1.4% a year in expenses.

The more quickly an Asian stock's dividend has been growing, the better it tends to do in the future, he says, citing Citigroup research. It is no secret that dividends are one of the main reasons, contributing about 50% to total returns in the region through June. Less understood, argues Madsen, is how in Asia they act as a good governance proxy as well.

Unlike in the U.S., where initial equity offerings are dominated by cash-starved startups, new Asian listings are frequently crown-jewel privatizations that pay dividends from day one. In Hong Kong and China stocks listed since 2000 make up 60% of the market's value and already pay out 34% of its dividends, according to Worldscope and FT Interactive Data. Once dividends are in place, Asian firms are averse to cutting them.

"Management knows there are certain repercussions," as in a loss of confidence and face, Madsen says.

A fervent triathlete with a hint of a Danish accent, Madsen, 32, grew up in North Zealand, Denmark. At age 12 he hired his younger twin brothers to expand his newspaper route and at 14 started buying stocks. He sank a large piece of his holdings into an insurer that employed his father, and he lived to regret it. A scandal pushed the firm into bankruptcy and wiped out Madsen's investment, teaching him the importance of diversifying.

After school the teen worked for Lotus Development (now part of IBM) and at 19 persuaded the software developer to move him to London. Once in Britain, he attended the University of York and wrote a senior thesis on the Asian financial crisis. Madsen then moved to a remote town near Guangzhou, China to teach English and tennis. Seven months of backpacking through the Far East landed him in San Francisco in 2001 as a sales rep for Chemoil Corp. He quickly switched to Barclays as a research analyst. Madsen jumped to Matthews in 2004.

His formula for picking dividend payers is simple: sort through stocks traded on local exchanges or as American Depositary Receipts for strong balance sheets, low debt (unless it is a normal part of the business, as with regulated utilities) and strong free cash flow (after dividends and capital expenditures). Madsen is less concerned with reported earnings, which can be fudged. After stripping out what he considers necessary capital outlays, he comes up with a potential dividend pool.

Then, on quarterly tours of the region, Madsen grills company bosses -- gently in soft-spoken places in Thailand and more directly in South Korea and China. His goal is always to divine whether a firm can support its dividend. He assigns extra points to those seeking to increase payouts and whose companies have the cash flows to follow through. If unconvinced, Madsen flies off to his next destination.

"I am not an activist," he says. "I ask critical questions, and if the willingness is not there, I will sidestep."

Nearly a quarter of Matthews Asia Pacific Equity Income is invested in Japan. China, Hong Kong and Taiwan make up another 35%. Financials are the largest industry group at 21%, which helps explain recent losses. It is followed by consumer discretionary (20%) and technology (16%) stocks.

Madsen's top holding as of June was Taiwan Semiconductor Manufacturing, at 5% of assets. The New York Stock Exchange-listed foundry started paying a dividend in 2003 and is now yielding 5.2%. TSMC controls half the world market for semiconductors and spends $2.5 billion a year on research, new plants and equipment. In a capital-intensive manufacturing business, "It pays to be the market leader," Madsen says.

Like TSMC, several of the fund's other top holdings trade as ADRs. They include HSBC Holdings, the U.K.-based bank that operated for decades as the Hongkong & Shanghai Banking Corp. and has branches all over Asia. Another ADR is SK Telecom. South Korea's top phone company and owner of Cyworld, the nation's most popular social networking site, yields 5.5%.

The article concludes with a listing of major (we surmise) Matthews Asia Pacific Equity Income fund holdings. Dividend yields at October 1 prices range from 2.8% for Japanese beverage company Ito En to 13.1% for the Philippines' Globe Telecom.


Two retailing analysts interviewed.

In the U.S., consumption has reached a secular and unsustainable high as a percentage of U.S. GDP. It follows that the U.S. retailing industry as a whole will be a mature, slow-growth one. Being so huge, however, there are always those segments and operators within the industry who are rising and falling, taking or losing market share. Two retailer analysts from Credit Suisse give their perspective on the winners and losers going forward, which is pretty consistent with what we have seen from similar analysts elsewhere.

These are miserable times for many retailers. Same-store sales dropped 1.2% in September, evidence of more deterioration in a sector that has already been hurt by slumping consumer demand. How deep will the downturn be? And how long will it last? For answers, Barron's last week turned to Michael Exstein and Gary Balter, who cover retailing for Credit Suisse.

Exstein keeps tabs on Wal-Mart and other so-called softline outfits that sell merchandise such as apparel, while Balter follows companies such as Home Depot and Bed Bath & Beyond, known as hardlines, whose inventory includes items such as household goods. They see an industry that has way too much capacity and plenty of short-term pain ahead. "Consumer spending is effectively negative now for the first time since 1991," says Balter, "but 1991 had only one quarter of negative spending. This one will probably extend itself for at least three quarters." Balter and Exstein, however, do see some longer-term investment opportunities.

Barron’s: Retailers have been battered by the deteriorating economy. How bad have things gotten for these companies?

Balter: We have actually been waiting for this type of environment for a few years. We were in a period of excess consumer spending from effectively 2001 or 2002 into early 2007. That excess was mostly driven by mortgage-equity withdrawals and by a relatively strong employment cycle. As a result, there were secondary retailers -- I do not want to say they did not have any business in achieving the margins they did, because they obviously managed to do it -- that enjoyed the excess spending and saw margins go from 1% or 2% up to 4% or 5%. These companies effectively became the better stocks to invest in.

How about a few examples?

Balter: From about 2004 to '06, you made more money buying Office Depot (ODP) or Sears Holdings (SHLD) or Circuit City (CC) than you did buying Staples (SPLS) or Best Buy (BBY), because everybody was getting their margins pushed up, and a secondary name was better than a primary name. What happened, though, is that real-estate developers took advantage of this situation by using very cheap credit to grow at levels that they should not have grown at. That resulted in excess square footage -- and then the music stopped. Due to a combination of tightening credit and consumer spending slowing down, there was too much square footage for the demand. We are beginning to see some signals of rationalization, with secondary companies like Linens ‘n Things, which is liquidating its stores, starting to go away. It is going to be painful.

What is next for retailers?

Balter: The question is: How deep a recession do we have? Recessions are not bad for the stronger players because square footage gets cleared out, we get rid of secondary players and the ones that emerge should be stronger. We have groups of retailers -- whether it is Home Depot (HD) and Lowe's (LOW), Staples, Best Buy, Bed Bath & Beyond (BBBY) and most of the DIY [do-it-yourself] auto names that I follow, such as O'Reilly Automotive (ORLY) and AutoZone (AZO) -- that generate more cash than they know what to do with and will continue to do that. But they are going to do a lot better when there are fewer players around.

What are your thoughts, Mike?

Exstein: We have always looked at retailing as a relatively mature industry. So the capital flows that Gary talked about are very, very important in terms of what is going on. The problems in retail predate the recession and the financial problems we are seeing today. The problems in retail are problems exactly because people got very carried away as profitability exploded beginning in 2003 but really kicked up in 2005 and 2006. There were some very substantial increases in capital spending, almost double-digit increases in some of the groups in 2005 and 2006, and they imploded. What is beginning to happen now is that the retailers that most overcommitted on spending or had leveraged their balance sheets are in the most difficult competitive positions today.

Does anyone in particular come to mind?

Exstein: Clearly, a company like Bon-Ton Stores (BONT), which made a major acquisition two years ago and financed it all with debt, is now suffering with a very leveraged balance sheet. A leveraged buyout that has gone sour is Mervyn's, a department-store chain. What you are now seeing, particularly with the old-line department stores, is about survival and thinking about the balance sheet first and the P&L second.

The credit crisis has a huge impact on retailing. Who in particular is vulnerable?

Exstein: The least vulnerable company is Wal-Mart (WMT), which made a strategic decision in 2006 to pull back from capital spending. They are really getting the full impact and benefit of that this year. Conversely, a company like Target (TGT), which is a terrific company, made a decision two years to grow its receivables dramatically, and they are now getting pressure because of that.

What about Sears?

Balter: We are quite negative on their prospects, as they have underinvested in both Kmart and Sears. Their EBITDA [earnings before interest, taxes, depreciation and amortization] dropped from $3.6 billion in 2006 to $2.5 billion last year, and we project it being about $1.6 billion this year.

What kinds of retailers are best positioned to weather this storm?

Balter: The smaller the ticket, the lower the cost of the item, and the more of a necessity it is, the more likely you are going to buy it. So in my coverage area, it is [do-it-yourself auto companies] such as Advance Auto Parts (AAP), AutoZone or O'Reilly Automotive because their products are required. Right behind them is PetSmart (PETM), because you are probably going to continue to feed your pet. But in terms of selling necessities, all of those trail Wal-Mart, Family Dollar Stores (FDO) and Costco Wholesale (COST).

How will the so-called mall anchors emerge from this crisis?

Exstein: Nordstrom (JWN) emerges from this, as does Kohl's (KSS). Macy's (M) will emerge from this and, in all likelihood, so will J.C. Penney (JCP), but it is not clear in what manner the other players come out of this period.

So we can expect some consolidation?

Exstein: I'm not sure you consolidate anymore.

So what do these companies do? Go bankrupt?

Exstein: You said it, not me.

What do you expect to see, Gary, in terms of industry consolidation?

Balter: You are not going to see as many acquisitions going forward. But I will give you an example of where there should be an acquisition. Combining Office Depot and OfficeMax (OMX) makes sense, because they do not overlap that much, and you need a strong #2 versus Staples. But I do not expect to see that combination, since neither has the currency to buy the other. So we expect to see less consolidation and more closings. That is how we are going to solve some of the excess square footage.

What is the outlook for same-store sales?

Balter: Consumers right now are watching CNBC or reading Barron's, but they are not in stores. Business has stopped. Comps are going to be as low as we have seen this decade for many retailers, and they only start to improve after you get rid of excess square footage. So we are very encouraged that Linens 'n Things is liquidating its chain. That is good for Bed Bath & Beyond. But the comps vary from one area to another. Home Depot and Lowe's should be doing high single-digit negative comps. Advance Auto, Auto Zone and O'Reilly should be doing low single-digit negative comps, because there is a necessity to their products.

It sounds as if the retailers are in for an absolutely horrible holiday season.

Exstein: That is a foregone conclusion.

Do we get a recovery next year?

Exstein: It is more like in 2010. You have to see capacity come out of the system, probably in 2009. Most of the store closings announced to date will not happen until the end of this year. So they will not really begin to impact the store base until 2009, and then you are going to see another round of closings.

Balter: Even with all the efforts that the Fed is undertaking, along with the global plans, it does not solve the problem of having two million excess homes in the U.S. It does not change the fact that consumers have levered themselves for the past 25 years and they have to reverse that. So these are not overnight corrections.

On that note, let's hear a few of your investment ideas.

Balter: I will start with O'Reilly Automotive, which we rate Outperform. We like them for a number of reasons, although it is a 2009 or 2010 play. We don't really have a lot of '08 plays, given the environment. But O'Reilly just bought a company called CSK Automotive. O'Reilly's operating margins, prior to the acquisition, were in the 12% range; CSK Auto's were in the 3% range. O'Reilly's sales mix is different than Advance Auto's or AutoZone's, because they have a bigger commercial business. In contrast, CSK Auto is 82% retail and 18% commercial, and it actually does higher volumes at the retail level per store than O'Reilly does. It has a very strong market share on the West coast, as well as in Arizona, Minnesota and Chicago. As O'Reilly introduces its infrastructure and its systems to CSK and drives up its commercial business, we see significant opportunity for margin expansion next year and in 2010.

What else looks interesting?

Exstein: The only stock we began emphasizing at the beginning of the year was Wal-Mart, which we also rate Outperform. It was purely based on their decision to slow capital spending and new-store growth, which would allow them to focus on their current store base and execute better, and that is what has happened. In addition, they have been in the right place with consumables and very competitive prices. So it all came together for Wal-Mart, and we continue to like that stock.

Balter: We just upgraded Home Depot and Lowe's to Outperform, too, from Neutral. Both have seen their margins destroyed in this environment, but they are probably among the first to recover once the cycle starts to turn. These government-bailout programs for the credit markets should help stabilize the housing market. In the meantime, Home Depot and Lowe's are cash-flow machines. They both own about 85% of their stores, and they have the best interest-coverage ratios among their peers.

OK. Anything else?

Balter: Another stock we have at Outperform is Best Buy, whose shares have gone from the high 40s in February to around 25 as we speak. Current estimates for their earnings, which they won't achieve, are $3.10 a share for this year and $3.24 for next year. Let's assume that they are going to fall a little short of that, given the macro environment. The company is growing its global store footage by 8%-to-10% a year, generating roughly $1 billion of free cash flow, and it has a free-cash-flow yield of about 10%. It will likely win from consolidation as secondary players go under, possibly starting with Circuit City, but you could expand that to regional chains as well.

Best Buy has positioned itself to provide service. They have trained sales people who aren't on commission, and they have the best selection. Even as the consumer electronic cycle slows, it's still the fastest-growing segment in my coverage area. So you are either going to go to Wal-Mart because you feel you know the product or you are going to go somewhere where you need service. Best Buy has taken the approach of providing the service. But if you are just looking for price, they will have good prices as well.

One more name, please.

Balter: We also have Bed Bath & Beyond at Outperform. We have a $1.75 a share earnings estimate for this year and $1.87 for next year. It's one of the few names that we cover that has higher earnings estimates for 2009. And that is a reflection of the fact that Linens 'n Things is going to liquidate the remainder of its U.S. stores. So that could add somewhere between five and 10 points back in comps to Bed Bath & Beyond next year. More importantly, Bed Bath saw its margins drop this year because they were determined not to hand a life preserver to Linens, so they kept pressure on pricing. But that will start to reverse next year, when their No. 1 competitor is gone.

In closing, what is your advice to investors looking at retailing stocks?

Balter: You want those names that you could look at in three to five years that will have the cash flow and leadership in a consolidating sector -- companies like O'Reilly, Best Buy, Bed Bath, Home Depot, Lowe's and Staples.

Exstein: Focus on the balance sheet, not the profit-and-loss statement, in the short term. The one thing that we have learned from this financial crisis it that it is not your P&L that is going to do you in; it is your balance sheet. So focus on the retailers with strong balance sheets and cash flows.

Thanks very much, gentlemen.


Insiders can sell shares for many reasons. Some sales blocks are suspiciously propitious in their timing and volume. Many if not most sales are entirely reasonable and above suspicion even if the stock is seemingly cheap. When a person's net worth and career are both highly dependent on the fortunes of one company it makes sense to reduce that risk by selling some company stock. (We recall a story where a company CEO was challenged by a shareholder about his stock sales. After hemming and hawing and muttering the standard bromides about diversifying his portfolio he finally admitted, "I wanted the cash.") With stock options being a major part of compensation these days, there is plenty of insider stock ultimately available for sale.

Insiders buy, however, for one basic reason: They think the stock is going up. This judgement is not always correct. Like the average retail or institutional investor, their egos can get engaged and they end up trying to "teach the market a lesson" and show that it is wrong ... when it is actually right.

The rules on insider trading essentially force them to buy (or sell) "too soon," well in advance of specific significant news. Insiders can also end up buying too soon on the way down when things get worse than he or she expected. But being so close to the situation, the big picture is missed. Finally, as this article posits, insiders may buy in order to artificially pump up their company's stock, knowing their moves are being tracked. (This would seem to be a strategy suitable only with thinly traded stocks during bull markets.)

So there is no surefire way to use insider transactions to enhance one's trading edge. As always, you have to do your own work. If your research indicates that a certain stock looks attractive and you discover major insider buying, it would be hard to interpret that as anything but corroborating evidence.

As this fall's market selloff has advanced, insiders as a group have stepped up to the plate. Insider transaction tracker InsiderScore says that of late the ratio of buyers to sellers was 3/1, versus approximately 1/1 as recently as September. There are lots of tools and screens one might use to sort through the market rubble at this point. Augmenting whatever else you use by following insider transactions makes sense to us.

Among the casualties of today's market rout are some prominent executives who sold shares to meet margin calls. Among the potential beneficiaries? Insiders at other companies who scooped up stock at hugely depressed valuations.

Some of the world's wealthiest men, including Mexican investor Carlos Slim Helú and Microsoft's Bill Gates, also opened their wallets, taking bigger stakes in the past month in companies they already own. So did hedge-fund manager Eddie Lampert, whose ESL Investments bought $27.6 million of AutoZone (AZO) as the stock hit a two-year low. Lampert, who controls 38% of the company, has been buying since April.

Both fresh purchases and the absolute level of insider ownership send a clear message, says one New York hedge-fund manager. "I love to know that it is people putting their own money at risk," he says. "It is a bullish sign if I am trying to build an investment case" for a stock.

Four weeks ago, the ratio of insider buyers to sellers was nearly even, according to InsiderScore. In the week ended October 14, however, buyers trumped sellers by three to one, with much of the buying concentrated in shares of smaller companies. Insider buying was strong in shares of small regional banks and energy-exploration and pipeline concerns.

Retailers also attracted insiders, notwithstanding fears that the coming holiday season may be the worst in years for the industry. In early October, in one of the market's worst weeks on record, the CEO of discount shoe seller DSW (DSW), Jay L. Schottenstein, shoveled more than $15 million into his company's stock, paying an average of less than $12 a share; the stock now trades for $11.50. Schottenstein's confidence says something, given his retail background. He is the former CEO of American Eagle Outfitters (AEO), and sits on the boards of American Eagle and Retail Ventures (RVI), parent of Filene's Basement.

Another apparent retail fan is Slim, who invested in industrial and financial businesses during Mexico's 1980s debt crisis. In early October, a Slim-controlled trust bought nearly $11 million of Saks (SKS) stock, boosting his already significant stake in the parent of tony Saks Fifth Avenue. Saks has fallen more than 70% in the past year, to around $5 a share. Slim paid about $7 a share.

Gates continued to boost his stake in Republic Services (RSG), the waste hauler. From August 5 to September 29, he invested $256.7 million in Republic, at an average price near $33. Today, the stock is around $22. Waste Management (WMI) recently dropped its bid for Republic.

When a gaggle of high-ranking officers buys, that is also noteworthy. At AAR (AIR), a Chicago-area aviation and aircraft-leasing concern, the CEO and five directors picked up more than $461,000 of stock at an average of $11.86 a share, just below today's price. Insiders at many pipeline master limited partnerships were buyers in recent days (See "How to Energize Your Portfolio," October 13).

Financials are not without fans, either. Five insiders bought shares of MetLife (MET) recently, reversing a multi-year trend of planned sales. At credit-card issuer Discover Financial Services (DFS), the CEO, CFO and chief operating officer bought shares in early October at an average of $11.55 a share; the stock now trades around $10.

Buying on insiders' heels is not a foolproof path to profits. But tracking the so-called smart money often leads to bargains.

Here is a sample listing of insider transactions of larger capitalization companies that accompanied the article.


Barron’s screen turns up 11 stocks spring-loaded for a market revival.

High quality, large capitalization stocks are the safe way to play a rebound in the market. But if your really want to go for the glory you have buy smaller, lower quality stocks. Those which survive to live another day move faster and further.

In 1939, John Templeton made his first big killing by buying $100 worth of every NYSE stock that sold for $1 or less -- 104 in all. You can bet that the list was decidedly deficient in blue chips. In fact, over 30 of them were bankrupt. Templeton quadrupled his money in four years.

If you do not broadly diversify like Templeton you have better be careful picking which laggards you choose for playing a market rebound. Refining an idea they picked up from an analyst, Barron's ran a screen looking for stocks with low price-to-book-values whose prices had performed particularly badly of late. Their quality filter consisted of eliminating financial companies, because their assets are hard to value; companies whose assets consisted of major amounts of intangibles such as goodwill; and companies whose assets were heavy with inventories, which may not realize their book value upon sale during a downturn.

Not at all surprisingly, the resulting list is not one that induces an instinct to reach for one's wallet. But neither do they induce a total gag reflex. They are real companies.

If this market has not sent you to cash, there is a good chance you have sought refuge in the "quality trade" -- filling your portfolio with brand-name businesses and rock-solid balance sheets like ExxonMobil and Microsoft. Such stocks have sunk less than the indexes. But for that very reason, they might not be the best performers when -- if? -- the market revives. If you have the courage to call this epochal bear market's bottom, you might want to know which stocks bounce quickest in an upturn.

You might consider some "cheap losers." This is Joe Mezrich's term for stocks selling at a cheap price-to-book-value ratio and a recently crushed stock price. The quantitative analyst from Nomura Securities International looked for types of stocks that did well off market bottoms after some clients said they wanted to be ready for this market's recovery. Mezrich found that a portfolio of cheap losers handily outgained the Standard & Poor's 500 from the nadir of the four bear markets since 1974. In the year following October 1990, for example, the S&P rose 28% but those stocks in the Russell 1000 that were the cheapest and had gone down the most rose 58%. Off the July 2002 bottom, the S&P rose 17% and the cheap losers rose 54%.

We are living in historic times, sad to say, and value stocks have underperformed the market by more than at any point in the past 35 years. But that may mean a bunch of cheap losers are approaching the limits of lousy performance. If the market turns, such a portfolio could act like an uncoiling spring.

Barron's replicated Mezrich's backtest on data from S&P's Compustat database, using ModelStation quant software from the S&P unit ClariFI. Going back in time to July 2002, we ranked that era's S&P 1500 stocks on price-to-book value and share-price momentum (defined as the difference between a stock's 12-month price change and its latest month's price change). Then we followed the one-year returns of the cheapest losers, reconstituting the portfolio each month. Just as Mezrich found, the strategy of picking cheap losers produced a return of about 50%.

Our backtest emboldened us to screen for today's cheap losers. The adjoining table shows some names that we plucked from the S&P 1500, with columns displaying their dirt cheap price-to-book and their terrible share performance. Many of today's cheap losers are financials, but we omitted them here for fear their book values might be suspect. We also cut those whose assets were largely intangible stuff like goodwill or whose working capital was mostly inventory they might have to sell at a discount in a recession. We made this inventory tweak by examining the "quick ratio" of current assets ex-inventory, divided by current liabilities. This eliminated retailers like Dillard's.

The resulting names are probably less familiar than the quality fare that has been popular lately. But that is the point. Wall Street has turned its back on stocks like Affymetrix (AFFX) or Cadence Design Systems (CDNS), two suppliers of essential technology tools whose end users have been belt-tightening. ... Cadence is in turmoil following Wednesday's departure of its chief executive and four lieutenants after their failed bid for rival Mentor Graphics and an unwise sales strategy for Cadence's software -- which semiconductor firms use to design new chips. Nevertheless, Cadence is an entrenched leader whose fortunes would rise after a management turnaround and a chip-industry recovery.

As for Affymetrix, the Santa Clara, California, company is also cutting costs after announcing Tuesday that it missed September-quarter sales forecasts -- its second quarterly whiff. Shares of the genomics supplier now go for less than half of the company's $9 per share in cash, and less than twice free cash flow. Yet Affymetrix pioneered the manufacture of the "gene chips" used by medical researchers to measure activity levels of genes implicated in diseases and their treatments. Its shares now offer a cheap bet on the adoption of gene chips by doctors seeking to predict which drugs work best on a patient's cancer.

Restructuring, too, are Brooks Automation (BRKS) the semiconductor-factory supplier, and Spherion (SFN) a white-collar staffing company that is digesting several acquisitions. Briggs & Stratton (BGG), the small-engine maker, is moving manufacturing to China in an effort to widen its profit margins.

Other cheap losers are Penford (PENX), whose industrial-starch factory is coming back on line after the June floods of Cedar Rapids, Iowa, and Griffon Corp. (GFF), a supplier of garage doors, aircraft electronics and plastic film whose shares have attracted the interest of Goldman Sachs and Barron's Roundtable member Mario Gabelli.

Quant models designed to work only at certain times are admittedly tricky: if you could call the market's turn, after all, then an index-futures bet would beat any stock picks. A market bounce like last Monday's might prove a head fake. But whenever the recovery comes, stocks like these cheap, crushed survivors should have a better run than stocks that suffered less in the downturn.

Another Barron's article, the weekly "Streetwise" column, trotted out the idea of looking at stocks which had held up well all through the market selloff and then suddenly collapsed. The idea is that these are emblematic of capitulation, "sell at any price," type moves. They came up with Walt Disney (DIS) and International Speedway (ISCA).

Nice Yields, Fine Futures

The virtual opposite of the “cheap loser” stock picking approach described immediately above would be to try to pick out the crème de la crème of the blue chips. The editor of the Investment Quality Trends newsletter took a stab at just such a task, particularly focusing on dividends. The names he came up with include Philip Morris International, Johnson & Johnson, PepsiCo, Nike, Coca-Cola, Procter & Gamble, and IBM. Obviously a quality list. Our main objection is that other than perpetually cheap Philip Morris and its U.S. couterpart Altria Group, none of the list members look that cheap. That is the price you pay for quality.

Has the stock market hit bottom? In the opinion of Kelley Wright, managing editor of the Investment Quality Trends newsletter, the fact that last Monday's (October 13) stunning rally did not hold was a telltale sign that we are not quite there. However, "we are seeing true value for the first time since '74," says Wright. "While '87 was dramatic, it did not have this kind of carnage -- a necessity to clear the decks for a sustained bull move. So hold on to your hats a little longer."

Mr. Wright is distorting history here. The 1987 carnage, supposedly deficient though it may have been compared to today's, did clear the decks for a sustained bull move -- one that lasted over a decade, punctuated by only one selloff of note (in 1990). And while 1974 provided extraordinary values unseen since (including today), to say that was the last time we had "true value" is nonsense. To pick one small time interval, in the early summer of 1982 the market was littered with companies selling at single digit P/E multiples and at less than net current assets (current assets minus ALL liabilities). A good deal of the dynamism of the 1982-83 bull market liftoff came from a mass realization that stocks were truly cheap. It was like whatever the opposite of a bubble is suddenly inflating. In many ways it was the reverse of this bear market, where everyone suddenly realized that that the average stock was way overvalued.

And then what? "While it is tempting to plunge into the market with abandon," he writes in the mid-October issue of IQT, "the fact is that the global economy is in recession." Earnings will inevitably be depressed, and blue chips, while superior, are neither perfect nor impervious to lower earnings, which could affect dividend payouts. Thus, he feels it is imperative that investors be cognizant of payout ratios (the percentage of a company's profits that is paid out to shareholders in dividends), since a high payout percentage leaves little or no room for an earnings miss.

Wright says that if this bear market has provided any lesson, it is to diversify. To that end, California-based IQT regularly offers The Timely Ten, which Wright declares is not just another "best of, right now" list. Rather, "it is our reasoned expectation based on our methodology and experience for what we believe will perform best over the next five years." The accompanying table represents IQT's latest picks.

The Timely Ten are undervalued stocks that generally have an S&P dividend and earnings quality rating of A- or better (the current 10 are all A+ or A), exemplary long-term dividend growth, a P/E ratio of 15 or less, a payout ratio of 50% or less (75% for utilities), debt of 50% or less (75% for utilities) and technical characteristics on the daily and weekly charts that suggest the potential for imminent capital appreciation.

Wright certainly does not believe that all 10 will go up simultaneously or immediately. "Our four decades of research and experience, however, lead us to believe that these stocks, purchased at current undervalued levels, are well positioned for appreciation."


This article was written before gold showed its first truly significant signs of distress, by falling down towards $700 this week, before recovering somewhat after hitting the lows. Even with that selloff gold has undeniably held up better in the face of the massive worldwide asset price deflation than almost anything else. And while deflation is the dominant force currently, it is reasonable to expect that there is some possibility of major inflation, hyperinflation even, on the other side of the great de-leveraging. Thus you want to have some gold in your portfolio as insurance against that.

How to hold gold? Purchasing bullion or coins and storing it in a safe place overseas, as recommended by Marc Faber and others, is a secure but expensive option. This article covers the principal options the major available options short of that.

With financial markets around the world collapsing, about the only thing that still glitters is gold. Unlike just about every other asset, gold has risen in the past year. Though it fell markedly last week, to $785.10, it is still up 3% from a year ago. ...

Now, the market may start to shine. The yellow metal, which breached $1,000 an ounce in March during the Bear Stearns debacle, could well return to that level and head toward $2,500 as investors scramble for safety, according to many fans.

"It is premature to declare an end to the bull market in gold and the bear market in paper," John Hathaway, portfolio manager of Tocqueville Asset Management, wrote recently. "It is more likely that this massive shakeout has set the stage for a dynamic advance." Barron's Roundtable member Mark Faber puts it more succinctly: "Gold will go up because everything else is in deep s--t."

Investors can participate in the gold market in a variety of ways, such as purchasing mining stocks or mutual funds that hold them. But right now, those shares are vulnerable to heavy selling by hedge funds and others trying to raise cash. That is why many pros recommend that investors acquire the metal itself.

You can amass physical gold by purchasing coins from various governments; buying shares in the StreetTracks Gold Trust exchange-traded fund (GLD), which is backed by the metal; or buying gold on the Website Goldmoney.com. Gold purchased there is stored in insured vaults, and the holdings are audited annually. James Turk, founder of Goldmoney.com, sees gold at $1,100 or $1,200 an ounce by year-end. "... With markets melting down, uncertainty about the safety of assets and growing concern about counterparty risk, people look to assets with safe-haven status," Turk says. A longtime gold bug, Turk sees gold eventually hitting a dizzying $7,000 an ounce.

Charles Oliver, manager of the Sprott Gold and Precious Minerals Fund in Toronto, has a more restrained target of $2,000 within four years. But even that is nearly triple the current price.

When it comes to gold, such movements are not so unusual. Since Barron's penned a bullish piece on the yellow metal nearly three years ago ("Golden Opportunity?" December 26, 2005), it is up nearly 60%.

The technical signals, too, favor a rise. One key measure -- the Dow Jones Industrial Average divided by the price of an ounce of gold -- has lately been flashing bullish at about 11, down from more than 40 around the turn of the millennium. In the past two cycles, "gold did not peak, and the DJIA did not bottom, until this ratio was in the low single digits," writes John Roque, managing director and market technician for Natixis Bleichroeder.

Gold's outperformance against the blue-chip index tends to last at least 14 years. (See chart.)

Mining shares cannot be ruled out entirely. In fact, mining companies should soon benefit not only from high gold prices but declining energy tabs, which lower the companies' costs.

"Even if the price of gold fell in half, gold stocks would still be fairly valued," says Steve Lehman, senior portfolio manager of the $1.8 billion Federated Market Opportunity Fund, which counts names like Yamana (AUY), Barrick (ABX) and Newmont Mining (NEM) among its largest holdings.

Oliver, of Sprott Precious Minerals Fund, is partial to companies like Goldcorp (GG), which has some of the lowest-cost mines, and Iamgold (IAG), which, in his view, at $3.07 a share is trading at a discount to the sum of its parts. For those with a bit more of an appetite for risk, Oliver suggests Kinross (KGC), a $7 billion market-value company that he says is trading at a discount to its net asset value.

Another option: Market Vectors Gold Miners (GDX), an exchange-traded fund of gold mining and exploration companies.

As always, gold investing is not without risks. Paul van Eeden, president of Cranberry Capital, a private holding company in Toronto, maintains that gold is "already slightly overvalued." Though the Federal Reserve has flooded the economic system with dollars, which normally would stoke inflation, van Eeden believes that the central bank "has mitigated a lot of the intervention by withdrawing funds out of the market." Based on a money-supply benchmark he has devised, gold should be trading at about $750 an ounce.

Faber, too, thinks gold is "not particularly inexpensive," but because you "cannot trust the banks anymore, I am quite happy to buy gold." He recommends purchasing physical gold and storing it in a safe-deposit box in a country like his native Switzerland. Sounds like a plan.