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THE DAMAGE TO DATE
For those who want to know just how far markets have fallen this year, Rob Nolan provides a summary, evidently written just before Friday's move up.
Relative strength is found in biotechs, transports consumer stocks (includes staples), and utilities, which are all down 31-32% for the year so far. These compare well with the standard yardstick, the S&P 500, which is down 45%. Financial stocks, in the form of banks and broker/dealers, have done the worst -- not surprising given they spearheaded the credit excesses on the way up. But surprisingly gold stocks, the putative anti-financials, have provided no hedge at all, falling 48% year-to-date even after the recent rally.
One- and three-month Treasury bills yield essentially zero. Further showcasing the stress in the credit system, investment grade bond spreads stand at a record 270 basis points over Treasuries. It has been a year to remember ... and there is still a month and change to go.
For the week, the S&P 500 dropped 8.3% (down 45.5% year-to-date), and the Dow fell 5.3% (down 39.3%). The Morgan Stanley Cyclical index was pounded for 11.9% (down 59.8%) and the Transports for 10.6% (down 31.7%). The Morgan Stanley Consumer index dropped 4.6% (down 31%), while the Utilities added 0.4% (down 31.3%).
The broader market was weak. The small cap Russell 2000 sank 10.9% (down 46.9%), and the S&P 400 Mid-caps dropped 11.3% (down 48.6%). The NASDAQ100 fell 8.0% (down 47.9%), the Morgan Stanley High Tech index 7.1% (down 51.4%), and the Semiconductors 10.5% (down 55.8%). The Street.com Internet Index fell 5.2% (down 43.5%), and the NASDAQ Telecommunications index dropped 6.9% (down 48.9%). The Biotechs sank 11.5%, increasing 2008 losses to 30.8%. Financial stocks were hammered. The Broker/Dealers sank 21.8% (down 72.9%), and the Banks dropped 23.7% (down 58.3%). With Bullion rallying $58, the HUI Gold index rose 14.2% (down 48%).
One-month Treasury bill rates ended the week at an amazing 0.03% and three-month yields at a stunning 0.01%. Two-year government yields declined 12 bps to 1.09%. Five-year T-note yields dropped 31 bps this week to 2.01%. Ten-year yields sank 54 bps to 3.20%, and long-bond yields dropped 56 bps to 3.67%. The implied yield on 3-month December 2009 Eurodollars fell 22.5 basis points to 2.145%. Benchmark Fannie MBS yields declined 24 bps to 5.30%. The spread between benchmark MBS and 10-year T-notes widened 29 to 210 bps. Agency 10-year debt spreads widened 11 to a record 161 bps (intra-week high of 191). The 2-year dollar swap spread declined 7.5 to 107 bps, the 10-year dollar swap spread declined 12.5 to to 21.5 bps, and the 30-year swap spread declined 21.5 to an astounding negative 21.5 bps. Corporate bond spreads took a turn for the worst. An index of investment grade bond spreads surged an incredible 70 to a record 270 bps, and an index of junk bond spreads widened 17 further to 997 bps.
AFTERSHOCKS FROM THE OCTOBER MELTDOWN
Last time we carried a piece by Gary “SirChartsAlot” Dorsch he was providing commentary on the inflationary fires spreading throughout the world thanks to U.S. monetary policy. Times change.
Dorsch excels are comprehensively documenting worldwide financial and economic goings-on at a given time. This makes for long but useful articles. In 2007 he did a great job of showing how the money and credit expansion was a joint effort by all the world's central banks, notwithstanding the finger-pointing at the U.S. Fed. This article combs through the wreckage of the October crash aftermath, focusing on the U.S. along with UK, China, and Japan. Needless to say it is a grim picture.
October is famous for stock markets crashes -- the Crash of 1929, "Black Monday" 1987, the Asian Contagion crash in October 1997, and the sub-prime crash of October 2008. U.S. Treasury chief Henry Paulson's ill-fated decision on September 14th, to pull the plug on the 158-year old brokerage firm of Lehman Brothers, set in motion a horrific chain of events that unleashed a torrent of panic selling on commodity and global stock markets, froze the European and U.S. banking systems, and changed the direction American politics for years to come.
At its lowest point in October 2008, the meltdown in equities around the world erased $12 trillion of market value for the month and $31 trillion from a year earlier. Lehman's bankruptcy left sellers of credit default swaps with liabilities of $270 billion, and hedge-funds scrambled to raise cash by selling anything they could get their hands on, including commodities and stocks. The Reuters/Jefferies Commodity Index plunged 23% in October, its steepest monthly decline since 1956. Investment grade corporate bonds lost 7.4% in October, their worst month since 1976. (The 1976 episode was due to accelerating inflation rather than default fears.)
At the same time, U.S.-home prices continued their unrelenting slide for a 20th straight month, to stand 22% below their peak in July 2006. Falling U.S.-home prices have reduced homeowner wealth by about $3 trillion, and stock market losses add up to an additional $8 trillion. This reduced household wealth could force U.S. households to cut aggregate spending by $300 billion a year or more.
Historically, September is the cruelest month for the U.S. stock market, but residual selling often spills over into October. The Dow's loss of 18% in October 2008 was the biggest since the crash of October 1987. Paper losses totaled $2.5 trillion. But for Republican nominee John "Maverick" McCain, a late October to November 4th rally, boosting the market by 15%, was too-little, too-late. The tide of opinion among the investor class whose 401k's and IRA's had plummeted, tilted against the Republicans, and was made worse by the unrelenting slide in home prices. (See charts.)
In mid-September, Republican nominee John "Maverick" McCain understood the fatal impact of a stock market meltdown on his presidential bid. He frantically suspended his campaign in order to persuade rebellious House Republicans to quickly agree to a $700 billion rescue plan for U.S. banks, and prevent a meltdown in the market. But House Republicans decried it as a "bailout" and helped to kill its first version, sending the Dow into a tailspin of 777 points. But Obama stayed quiet and above the fray.
The Treasury's bail-out -- purchasing toxic mortgage-backed securities from banks was badly flawed and utterly rejected by the marketplace. Even after the House finally passed the bill on October 3rd, the Dow Jones Industrials plunged another 3,000 points and free-fell to a 5-year low. It was not until the British and Euro-zone governments moved aggressively to inject capital directly into their banks, and the U.S. Treasury followed suit, did some measure of calm and stability return to the global stock markets. But for "Maverick" McCain, the collateral damage from the October market meltdown torpedoed his long-shot bid for the presidency.
The Dow Jones Industrials rallied 15% in the week prior to November 4th election results, a move that has surprised many traders. Barack Obama's higher tax policies combined with far-left Democratic control of Congress defied the conventional wisdom that markets like lower taxes and at least some gridlock on Capitol Hill. However, soon after Obama's victory speech in Chicago, the stock market rally fizzled out, and the Dow began melting down -- 800 points over the next 36 hours of trading.
McCain had a steep uphill climb, tied to an expensive war in Iraq, linked to a deeply unpopular Republican president, 760,000 jobs lost this year before the stock market crash began in mid-September, roughly 90% of Americans saying the economy is on the wrong track, and his selection of Sarah Palin as his running mate, turned off 60% of independent voters. The Arizona senator was also handicapped by his confessions that economics was not his strongest suit, which showed during the debates, while the Mainstream Media elite gave its blessings to Barack Obama.
Americans are naturally eager for fresh start, a "New Deal," as is typical during periods of economic hardship. And a majority of voters turned to Obama in a giant leap-of-faith -- a man who many Americans know little about, and with no executive experience, less than four years out of the Illinois Senate. McCain tried to paint Obama as a tax-raising Socialist, who will "spread the wealth around," a fear that resonates with the biggest and most powerful traders in the financial markets.
Uncertainty over how Obama and the far-left Social Democrats in Congress would alter tax policies for U.S.-multinationals listed on the NYSE, and capital gains taxes on wealthy investors, intensified the stock market's meltdown in October. On corporate taxes, Obama proposes to tax world-wide income earned by American multi-nationals at the 35% U.S.-corporate rate, the world's second highest. Obama is also promising a windfall profits tax on oil companies, and in his stump speeches, talked about lifting the capital gains tax on wealthy investors to 20% next year.
The volatility on Wall Street was unprecedented in October, with gut-wrenching swings of 500-points or more per day. The CBoE's Volatility Index (VIX), which measures how much traders are willing to pay for stock options, typically at-the-money S&P 500 index put options, soared to a high of 89.5 on October 24th. Even in the biggest panics this decade, the VIX did not move above 48. The VIX tends to go up during sharp market declines, and falls during sideways or rising markets.
Most importantly, the VIX is regarded as a contrarian indicator. Historically super-high VIX readings signal extreme fear and panic, and have coincided with significant bottoms in the stock market. On October 25th, contrarians lifted the Dow nearly 900 points higher, betting the 4th worst bear-market in history had run its course. The 2000-2002 bear market fell 49% before finding a bottom and the 1973-1974 bear market lost 48%. After the 2007-2008 bear-market tumbled 46% from the October 2007 high, contrarians figured that the trading patterns of the past would once again, serve as a reliable guide for the future.
We assume the all-time worst bear market he fails to identify is the over 90% decline of 1929-1932.
The "Group of Seven" cartel of central bankers and the Bank of Japan played a key role in engineering the late October stock market surge, by capping the rise of the Japanese yen against other major foreign currencies. On October 26th, the G-7 central bankers issued a veiled threat to intervene in the marketplace if necessary, to block the yen's advance, "We are concerned about the recent excessive volatility in the exchange rate of the yen and its possible adverse implications for economic and financial stability," the G-7 finance officials said.
The next day, Japanese Finance chief Shoichi Nakagawa warned that Tokyo financial warlords were "watching the foreign exchange market with great interest," secret code words for intervention to weaken the yen. Within 48 hours, the Euro had surged 10 yen to 125 yen, and the U.S. dollar rebounded from a 13-year low of 91 yen to as high as 99.70 yen. The unwinding of "yen carry" trades, that has been terrorizing the global stock markets since the Lehman bankruptcy, was successfully brought under control by the G-7 central bankers.
Dorsch's article last month, "Weapons of Financial Mass Destruction," explains just how huge the yen carry trade is.
However, threats of intervention cannot suppress the yen forever, in a market where roughly $550-billion changes hands each day. Tokyo backed-up its verbal intervention threat by pressuring the Bank of Japan to cut its overnight loan rate to 0.30-percent. Currency traders hadn't been expecting a BoJ rate-cut and quickly scrambled to cover short dollar positions towards 100-yen.
The Brazilian real also rebounded against the yen, a key catalyst that ignited a +30% rebound in the Sao Paulo's Bovespa Index. Emerging stock markets in Asia and Latin America soared after the Federal Reserve swapped $30 billion with Brazil, Mexico, South Korea and Singapore to bolster their foreign currency reserves. Brazil's government is struggling to prop up its currency, which has already lost a third of its value against the Japanese yen.
Brazil said it would put a quarter of its $210 billion of foreign exchange reserves on the line to defend the real. Brazil's central bank has spent $40 billion in foreign exchange interventions so far, Brazil's central banker President Henrique Meirelles said on November 6th, adding that the worst of the crisis has already passed.
Preventing unwinding of "yen carry" trades was only one juggling-act performed by the U.S. Treasury's "Plunge Protection Team" in late-October. There was also the job of snuffing out the surge in US$ Libor interest rates, to which $360 billion of adjustable rate home loans, ARM's, and many business loans are pegged. After adopting the more sensible European approach, the U.S. Treasury began injecting $250 billion directly into U.S. banks, and over the next 20 days, the 3-month U.S. dollar Libor rate quickly fell by 242 basis points to 2.40% today.
The flood of U.S. dollar liquidity pumped into the global banking system by the Fed, together with aggressive interest rate cuts around the world, have calmed the panic and eased the worst of the credit crisis. Libor rates in England and the Euro-zone have declined by 70 basis points respectively, signaling that the $3.2 trillion of emergency funds approved by governments may be thawing out credit markets.
Still, until U.S. home prices stop falling, the S&P 500 Index is skating on very thin ice. The average U.S. home price might fall another 10% in the year ahead to get back to pre-bubble levels. Worse yet, home price declines can overshoot on the downside, which would increase the number of sub-prime homeowners with negative equity, and create a strong incentive to default on their mortgages. And in a vicious cycle, more foreclosures put more homes on the market, driving prices even lower, increasing bank losses. That is why powerful stock market rallies, engineered by bargain hunters and central bankers, have typically ended up as bull-traps.
The stunning collapse the U.S. industrial sector in the past two months was a bombshell that shook the ground beneath the Republican Party. The ISM's factory activity index plunged 20% over the past two months alone, to a reading of 38.9 in October, its lowest since September 1982. The purchasing managers' gauge of new factory orders plunged to 32.2, the lowest since 1980, from 38.8 the prior month, and exports, the one bright spot for the U.S. economy this year, also collapsed, with the ISM's export gauge dropping to 41, the lowest reading since 1988.
U.S. auto sales plummeted 32% in October to the lowest since January 1991, led by General Motors's 45% slide, as reduced access to car loans and a weaker economy kept consumers off dealer lots. With credit drying up and new-vehicle sales slumping, 700 car dealerships will close this year, and taking with them an estimated 37,100 jobs. That is a heavy blow to the U.S. economy. The country's 20,700 dealerships accounted for $693 billion in sales last year, or 18% of all retail sales. Dealership wages and salaries make up 13% of the nation's retail payroll.
However, bargain hunters in badly battered blue-chip stocks, are betting the ISM Factory Index has hit rock-bottom, will recover in the months ahead, perhaps with a V-shaped pattern. The risk for bottom pickers however, is the possibility that the chart pattern for the ISM factory indexes, will evolve into an L-shape pattern, or a prolonged period of stagnation at deeply depressed levels in the months ahead. Worse yet, the ultimate bottom might be located at lower levels.
Synchronized slide in global economies and markets.
Despite all the adverse problems in the housing and banking sectors that froze credit markets, toppled banks and brokers and wreaked havoc with stock markets, the Republican ticket was still within the margin of error in mid-September. However, during the presidential debates, McCain failed to point out that foreign stock markets in Asia, Europe, and Latin America were also melting down by 50% or more, and factory indexes overseas had fallen off a cliff to multi-year lows. Highlighting the synchronization of global economies and markets, might have helped McCain deflect some of the blame for the economic downturn.
In Japan, the Nikkei 225 index plunged to its lowest in 26 years in late-October, shedding 60% from a year earlier, and handing investors' $2.5 trillion of losses. Japan's factory activity index plunged to the 42.2 level in October, far below the 50.0 mark dividing growth from contraction, for the 8th straight month, suggesting the worsening global slowdown has pushed Japan deeper into recession.
New export orders, a key engine of growth for Japan, fell to 37.5 from 45.4 in September, the lowest on record, after contracting for the 9th straight month. Japanese exporters are also getting battered by the stronger yen, which reduces the value of overseas profits earned in Euros or U.S. dollars when repatriated back into local currency. To make matters worse, Toyota, the largest Asian automaker, reported U.S. auto sales plunged 23% in October from a year earlier. Honda, Japan's 2nd-largest automaker, said car and light truck sales fell 26% from a year ago.
If traders are looking for China to miraculously to save the world economy, the latest signs of an economic slowdown in the Asian juggernaut are not promising. The CLSA China Manufacturers Index (PMI) showed that factory activity contracted sharply in October, falling to 45.2, its lowest level since the surveys began in June 2004. Manufacturing is a key engine of growth for China's juggernaut economy, and accounts for about 42% of China's GDP.
Companies from Hong Kong, Taiwan, America and Europe flooded into the Guangdong province to set up low-cost factories that made everything from sneakers to laptops and iPods. China's vast manufacturing hub along the Pearl River Delta, has long been regarded as the world's factory floor. However, Chinese manufacturers are now seeing their order books cut, both at home and abroad, as the world economy falls deeper into recession. For the first time in three years, the growth rate for Chinese exports in the third quarter of 2008 declined.
Government statistics show that 67,000 Chinese factories have been shut down in the first half of this year, and another 33,000 plants will closed by year's end. Factory owners in China were straining under soaring labor and raw-materials costs, and an appreciating Chinese currency. When the credit crunch took hold, Western importers slashed orders for Chinese goods and bankers curtailed loans to factories, so many operations were pushed over the edge.
China has been the biggest driver of global demand for commodities this decade, including agriculture, base metals, and energy. For instance, from 2000 through 2007, China's energy demand grew by 65%, and accounted for 1/3 of the total increase in oil consumption around the world. One big question is what will happen to Chinese oil demand if the global economy goes into a tailspin? Given that there are 2.2 billion people in China and India, there should be plenty of demand for commodities, even if their economies slow to an average growth rate of around 7% in real dollar terms. Yet signs of "demand destruction" from China's factories in recent months have sliced the Reuter's Commodity Index in half.
Bank of England pushes the panic button.
The British pound has suddenly collapsed from a 26-year high in the summer of 2007 to a 5-year low against the dollar in October, the most brutal devaluation sterling has suffered since it was ejected from the European Exchange Rate Mechanism in 1992. Major players in London are dumping the British ounce, on expectations the Bank of England will slash its base rate to 2% next year -- which would be the lowest rate in the Bank of England's 314-year history.
Bank of England chief Mervyn King warned on October 23rd, that "the pound could face a larger and faster adjustment in the coming months as the UK economy is forced to adapt to the new post-financial crisis landscape." He warned that the UK was facing a similar economic downturn to the Asian economies in the late 1990's when foreign investors pull out their capital from their countries. "The drama of the banking crisis, which is unprecedented in the lifetime of almost all of us, will damage business and consumer confidence," he warned.
Much like the bursting of the U.S. housing bubble, British home prices are spiraling lower. Britain's biggest mortgage lender, Halifax, said UK house prices fell 2.2% in October, the 9th successive decline, and are 15.75% lower compared with a year ago, the steepest fall since records began in 1983. A report by Standard & Poor's revealed that 335,000 households in Britain now find themselves in negative equity, an increase of 250,000 in only four months. By 2010, S&P predicts that as many as 2 million UK households could be threatened with falling into negative equity.
Recognizing the extreme danger to the British economy from a double barreled slide in housing and stock markets, the Bank of England delivered a shocking 1.50% cut in interest rates on November 6th, lowering its base rate to 3%, its lowest in more than half a century. The BoE judged "the economic outlook had worsened markedly because of the global financial crisis and that drastic action was needed." However, British banks are reluctant to pass along lower mortgage rates in line with official BoE lending rates because of historically high sterling Libor rates.
British factory output also contracted for a 6th consecutive month in October as falling demand both at home and abroad tipped the sector into recession. In response, the BoE engineered the ["brutal devaluation"] to help UK exporters compete in foreign markets, and artificially inflate the income of UK multinationals earned abroad. Despite the pound's 24% devaluation however, the UK's index for new export orders fell to 43.5, its lowest since September 2001.
Commodity markets have been on their wildest roller coaster ride this year, soaring amid an inflationary boom in the first half, and then plummeting in a deflationary bust in the second half. At its peak in early July, the Dow Jones Commodity Index stood 40% higher than a year earlier, led by spectacular gains in energy, grains, and precious metals. But signs of a serious worldwide recession have meant the end of the commodities boom. Gold, tracking trends in the broad commodity indexes, has tumbled 28% since a record high of $1,030/ounce on March 17th.
Mitigating some of gold's vulnerability to sliding commodities is its traditional role as a hedge against global security risks. U.S. vice president elect Joe Biden might be right. There could be an international crisis to test the new American president in 2009. Perhaps North Korea will refuse to honor its disarmament promises, and fire up its plutonium reprocessing plant. Perhaps Iran's Revolutionary Guard units located in Lebanon, the Gaza Strip, southern Iraq, and its "special groups" in the Persian Gulf, will become more active, once the U.S. military withdraws from Iraq.
Tension in Russian-American relations has been driven to a post-Cold War high by Moscow's invasion of South Ossetia. Russian President Dmitry Medvedev wasted no time on November 5th, and in his first state of the nation speech, said Moscow will deploy Iskander missiles near Poland, and equipment to electronically hamper the operation of U.S. missile defense facilities in Poland and the Czech Republic. "From what we have seen, the creation of a missile defense system, the encirclement of Russia with military bases, the relentless expansion of NATO, we have gotten the clear impression that NATO is testing our strength," Medvedev warned.
On the financial crisis, Medvedev said overconfidence in American dominance after the collapse of the Soviet Union "led the U.S. authorities to major mistakes in the economic sphere. The American administration ignored warnings and harmed itself and others by blowing up a money bubble to stimulate its own growth," he said. Of course, the Kremlin has also been guilty of inflating the the Russian stock market bubble, by expanding its M2 money supply an average 50% per year.
Soaring oil prices also fueled a boom in Russian stocks over the past few years, and bloated Russia's foreign exchange reserves to a peak of $597 billion, the 3rd-largest in the world, from just $10 billion in 1998. Four years of high oil prices have left the country with no foreign debt. But since July, sliding oil prices, concerns about the Russian banking sector, and a mass exodus of foreign investors from Russia's stock market, has wiped out 3/4 of the Russian Trading System Index's value, led by Gazprom and Rosneft, the country's biggest energy companies.
Moscow has been forced to draw-down $113 billion from its reserves to $484 billion, in order to support state-run banks with subordinated loans, to buy equities on the stock exchange, and to defend the Russian ruble in the foreign exchange market. Russian kingpin Vladimir Putin argues there is no alternative to his prescription of greater state control over the economy and stock markets, and that the turmoil in Western capitalist economies only proves it.
Putin's prescription is no different than that proposed by the governments of all the Western "capitalist" economies. He could have demonstrated some farsighted and enlightened leadership by not following their example. We guess not.
Since August, the Bush-Paulson team has seized America's largest insurance company, AIG, nationalized mortgage giants Fannie and Freddie, pumped $250 billion into U.S. banks, paid the $29 billion dowry for Bear Stearns to enter its shotgun marriage with JP Morgan Chase, and will soon bail out GM, Ford and Chrysler. Is America sliding on the slippery slope towards Europe's "Enlightened Socialism?"
GOLD, FAITH AND CREDIT
Richard Daughty, aka "The Mogambo Guru," is -- what? -- the Andy Kaufman of the investment world. His self-styled on-page persona is that of an id-driven man who cannot keep up even the pretense of civility when confronted with the crimes and idiocy of policy makers like the "demonic, loathsome Alan Greenspan." The bottom line advice is always buy more gold and silver, and sometimes guns, ammo, and canned goods. We do not know how good his actual investing record is, but he sure is funny.
The nominal issue at hand in this piece from The Mogambo is the gap between the price of gold in the physical market and the futures market. Last week we covered Al Martin explaining this away as the "unwashed" public, who are seldom right about these things, getting taken advantage of. Martin thinks gold is in a bear market, and the price will go down while the physical gold premium disappears. Double-whammy for the unwashed. Daughty does not think the same way, to put it mildly.
Whoever is right about gold, the natural question is why not buy gold on the futures market and then take delivery? Totally riskless arbitrage opportunities may not be available but if you want to own a lot of bullion then buying it via the futures market certainly looks like the cheaper way to go. Ah, but Comex is not entirely trustworthy on this matter, as the Hunt brothers can testify. The exchange can decide to declare force majeure and, e.g., impose an arbitrary cash settlement price if there are major delivery issues. And if the the exchange insiders have major short exposures and are the ones most in danger of being squeezed? Well pardon us if we entertain a few uncharitably suspicious thoughts about how that might resolve. And of course a raving paranoid (to go along with the -- we think -- gag) like The Mogambo ... don't even ask.
Like many people, I have been looking at the price disparity between the market prices of gold and silver bullion (averaging about $1,000 an ounce for gold and $16.50 an ounce for silver) versus the prices of gold and silver futures (about $730 and $8.90 respectively), and I am thinking to myself that I would love to get a piece of that luscious arbitrage action where I buy the gold and/or silver futures at a low price while simultaneously selling the same gold and/or silver bullion at a higher price, telling the buyers that they must pay in advance and then wait up to a few months for me to deliver their gold and silver, pocketing a hell of a lot of money on the buy-sell spread and the interest the money earns until the futures contract matures so that I can take delivery and settle up, and then spend the rest of my life on a wild, hedonistic spree of spending, spending, spending!
Then, sadly, I remember that such a plan requires money, and I do not have any money because I have already spent all my money thanks to inflation in prices killing me, thanks to the damned Federal Reserve and the demonic, loathsome Alan Greenspan who was its chairman from 1987 to 2006, and who is directly responsible for all our economic problems. And every time I think about it, I get more angry, and I want to scream, scream, scream in my Anguish And Outrage (AAO)!
I see that I have gotten off-track, and I apologize for starting off with an idea of how to make a lot of money by playing the huge, gaping, unbelievable arbitrage opportunity between gold and gold futures, but then let it degenerate into a personal attack on Alan Greenspan, ex-chairman of the Federal Reserve, whom I despise for what he has done to us, and who deserves some cruel punishment for it.
Yet, I am the one at the police station being held for "creating a disturbance" just because I helpfully informed a group of Girl Scouts at the supermarket to, as security video reveals, "Hang it up, you stupid kids, as your entire future has been destroyed first by the Federal Reserve under Alan Greenspan creating too much money and credit for almost two decades, and now Ben Bernanke at the Fed and Henry Paulson at the Treasury have grossly exceeded even those insane monetary excesses by huge, huge multiples of that!
"And in a matter of weeks, too ... all of which guarantees roaring inflation and all its miseries and horrible, screaming pain and suffering for everyone, so that now you, and your parents, and your brothers, and sisters, and aunts and uncles and cousins and all the ponies and everyone you love will all die horrible, lingering, painful deaths of starvation and disease, crying out in ceaseless agony! Ya ever sing any songs about THAT around the campfires, you little doomed morons?"
I was quite proud of myself that I had "gotten through" to them, as they all ran off, screaming in terror, just like I do when I hear about this stuff! "Congratulations, Mogambo!", I thought to myself!
However, this is not about what you can and cannot say to children, as it turns out, but about education. And for some reason, John Embry of Sprott Asset Management has never earned his Junior Mogambo Ranger (JMR) merit badge in "Mogambo Educational Initiatives (MEI)", and thus is also shocked and appalled at my teaching methods designed to make sure that little kids grow up having the correct information about the true nature of the Federal Reserve and the government.
Apparently leaving the education of the masses to me and not getting tied up in the clutches of a vengeful legal system, Mr. Embry is thus free to be both shocked at my behavior, and to concentrate on other things, like this glaring disparity between the futures contracts for gold and silver versus the market prices of gold and silver bullion. And he probably figures that there are lots of greedy little bastards like me out there who are looking to make a pile of money with this luscious arbitrage opportunity, which leads him to conclude that some holders of the December gold futures contracts may try to take delivery of enough contracts so that there will not be enough physical gold in the Comex warehouses to deliver! Rising demand and zero supply! Wow! What will that do to the price? Hahahaha!
This would, of course, bust the whole "paper gold" and "paper silver" scam wide open on the commodities exchange, although Mr. Embry is quick to note that this would "prompt a claim of force majeure when the exchange cannot deliver enough real metal," which is legalese for saying now that the crime has been uncovered, the commodity exchange negates the contracts, the guilty do not have to pay, nobody goes to jail or loses their jobs, and the investors get screwed out of the profits that they had coming to them.
The hapless investors thought they were going to get gold and silver at a low price, deliver it to buyers who have already paid for it, and everybody makes a fortune when the price subsequently soars, thanks to governments around the world creating so incredibly much more money and credit so that governments can spend, spend, spend.
But now these investors get (probably at best!) their money back, and probably only then after years of legal wrangling where the lawyers end up with most of the money anyway! Hahahaha! Welcome to the full faith and credit of American markets! Hahaha!
If your nerves are on edge at the way I laugh so maniacally at such calamity, take comfort that gold will (theoretically, at least) soar when physical demand finally swamps physical supply, especially if the Europeans and Asians are serious about replacing the dollar as the world's reserve currency with something else, as there is nothing else that will work.
One way or the other, for the last 4,500 years, gold has always preserved buying power, at least, while nothing else has, and sometimes gold was actually an investment opportunity because it was so under-priced. Like now! Whee! This investing stuff is easy!
SIFTING CAUTIOUSLY THROUGH THE RUINS
“Everything is cheap. The question is: ‘What is the cheapest and what do you feel more comfortable with?’”
This Barron's interview with Howard Marks, chairman of Oaktree Capital Management, does not offer any easy answers about what to do next. Oaktree has about $60 billion under management but, refreshingly, Marks professes himself to be as much in the dark as the rest of us. He says: "I wrote a memo to my clients in September titled 'Nobody Knows,' and I stand by that title. If you are a smart person, that is all you can say."
With $60 billion under management you cannot just decide the bottom has arrived and jump in. Thus Oaktree's measured approach: "We have a lot of dry powder, and we are spending some of it on a steady, gradual basis. There is enough out there to buy, and we could spend it all in a couple of weeks. But we want to leg into this, and that is why we are doing it gradually."
During his 40-year career, Howard Marks has developed a reputation as a shrewd investor, most notably in distressed debt. Marks, 62, is chairman of Oaktree Capital Management, a multistrategy Los Angeles-based money manager with roughly $60 billion in assets. Besides being known for his investment acumen, Marks has developed a following for his memos to clients, in which he holds forth on topics ranging from fighting forest fires to Chuck Prince's rocky tenure at the helm of Citigroup.
In a 2005 interview with Barron's, Marks asserted that many hedge funds would suffer from mediocre returns, not high-profile blowups.
We recently caught up with him, first in early September, and again this month, to glean his observations about topics including the financial meltdown -- which he thinks has produced some investment opportunities for careful investors.
Barron’s: What is your read on the financial carnage?
Marks: We went through several years with the market swinging in one direction, and that was toward innovation, leverage and risk-taking. And those are the culprits for how we got here. The subprime crisis, Number 1, exposed the folly of those things and, Number 2, exposed and added to the swinging of the pendulum of the economy back from euphoria. What we are seeing today is a continuation of that.
What caused this mess?
Too much capital was available. Providers of capital ignored risk and competed to make loans and investments. Their competition took the form of demanding too little return, too little risk compensation and too little safety. So the stage was set for massive losses when the environment turned negative. Investor [and Barron's Roundtable member] Marc Faber -- and I paraphrase -- said there was a surplus of dollars that led to a shortage of sense. There were incredible excesses in terms of innovation and leverage, which stemmed from a lack of concern over risk and what you did not know. But cheap money made all things seem appropriate.
What are some examples?
The shortest-term money is invariably the cheapest, because of the upward slope of the yield curve. So, it is always most attractive to borrow short rather than long. In a very narrow sense, it looks seductive. Just thinking about Treasuries, you could always make money by borrowing short and buying long-term bonds, because the yield curve is upward-sloping.
But it cannot be that it always works, because there is no free-money machine. So there must be some risks in the overall proposition that are not captured merely by the yield curve. And those risks are that on a bad day, you could be asked to repay your borrowings, or you could be unable to roll over your borrowings. So to repay your borrowings, you have to sell assets. But assets could be either not sellable or only sellable at losses or prices well below what you think they are worth or what they are really worth.
You look at this and say: "OK, I can borrow money short-term at 3%, and I can buy 30-year bonds at 6%. I am going to make 3% a year forever." That will work in the long run, if you can survive to enjoy the long run. It reminds me of one of the greatest adages in this business: Never forget the six-foot-tall man who drowned crossing the stream that was five feet deep, on average. It is not sufficient to get through on average. You have to get through every day.
What went wrong with risk management?
First of all, you need a risk manager who knows the business -- not somebody who knows everything about statistics but who has never been in the job. And you had risk managers who were statisticians. They could tell you what should happen most of the time.
But what should happen most of the time is a heck of a lot different from what will happen on a bad day. So they extrapolate history, but the trouble is that history changes.
One of the great lessons is beware of platitudes, such as "There has never been a national decline in home prices." If you believe that there has never been a national decline in home prices and that there never could be, then you bid home prices up to levels that do not allow for the risk of widespread losses, because you concluded it could never happen. Then the fact that they are at those new high prices introduces, in itself, the risk of a national home-price decline.
So the actions of people relying on history change history, and that is what people lose track of.
How did you and your colleagues at Oaktree react to the conditions that led up to the credit crisis?
I wrote a memo to our clients a few years ago titled "It Is What It Is." It said the first job of a money manager is to understand the environment you are operating in and its ramifications, and to act accordingly. We do not make predictions around here, and we did not predict the things that are happening now. We said, though, that we were living in extremely bullish, euphoric and overconfident times, in which prospective returns are low and risk premiums are low, and that it was not a time to take risk.
There has been a lot written about how retail-mortgage underwriting standards deteriorated. What about standards for underwriting deals?
We were in a period in which people were not afraid of losing money; what they were afraid of was missing out on deals. So the competition to make deals got stronger and stronger, and people wanted to preserve and increase their share of the deal market.
If you are a car manufacturer and you want to sell more cars, you would try to make a better car. But if your product is money and everybody's money is the same, how do you increase your market share? You participate in an auction in which one person says, "I will take [returns of] 7%," and another person says, "I will take 6%," and another person says, "I'll take 5%." So it is a race to the bottom. And since everybody's money is the same, for the most part, the way you compete is by making your money cheaper, and this cheap money is what drove markets.
When we spoke two months ago, you said it was not the day after Christmas in terms of buying opportunities. What do you see now?
It is hard to say. If the world turns out to be reasonable, or at least within the context of what people are girding for today, then things are cheap. We know the world is going to get a lot worse over the next one, two or three years, but we do not know by how much. So, to say that things are cheap today is what I would call the perceived merits. But there are a lot of shoes yet to fall, and the merits could certainly deteriorate in the next year or so. I wrote a memo to my clients in September titled "Nobody Knows," and I stand by that title. If you are a smart person, that is all you can say.
Are you putting new money to work?
We have a lot of dry powder, and we are spending some of it on a steady, gradual basis. There is enough out there to buy, and we could spend it all in a couple of weeks. But we want to leg into this, and that is why we are doing it gradually.
What particular areas of opportunity do you see?
Most of the opportunities are in financial institutions, some of which have been tarred with a uniform brush. In times of crisis, markets do not make fine distinctions between the good companies and the bad companies. The other area is the debt of buyouts, many of which probably were done at too high a price or with too much debt.
What is your assessment of bank loans?
Bank loans are ground zero for the imbalance of selling over buying. These loans were perceived two years ago as ultrasafe, low-yielding investments, so nobody bought them for cash. They were primarily bought on significant leverage. Now a lot of those leveraged holders have to liquidate in order to reduce leverage, and so there is a technical imbalance. Since these loans are still pretty good instruments, their yields are still the lowest among the types of securities I am talking about. But they are very attractive on a risk-return basis.
What about junk bonds?
High-yield bonds were not held on as much leverage, so they are not under the same pressure as bank loans. However, they are still under great pressure -- everything is under pressure today, and everything is cheap.
The spread for the average high-yield bond over Treasuries is around 1,400 basis points [14 percentage points]. And the spread on our portfolio over Treasuries is the highest it has ever been in 30 years. You might argue that the economic conditions are the worst they have been in 30 years, and I would not disagree. But, historically, when you bought at very high spreads, you made very good money.
It sounds like being selective in terms of which bonds you buy is paramount.
Yes, you have to be selective, and you have to diversify. Diversification is the key to high-yield bond investing, and that is why individuals generally should not do it on their own. That is true of all these areas, because one of the essential keys to prudent risk-bearing is diversification.
What about opportunities in distressed investing?
You have debt securities producing very, very high yields -- if they pay their interest and principal. They have not shown intractable fundamental problems yet, so we are buying selectively and we are diversifying. The conditions for successful distressed investing certainly would seem to be in place today. We had a few years of imprudent lending, and then we have had events transpire putting that lending to the test. And we have had a collapse of risk tolerance and very serious technical conditions. So you put that combination together, and prices can go lower and things can get worse, but this looks like a good time for distressed investing.
How do you define the various assets that cover the distressed sector?
It is bank loans and high-yield debt where there is fundamental concern about the issuer. There is not just generalized risk about the environment, but specific credit concerns about the issuer in that a lot of people believe it will not pay the loan's interest and principal.
Are there any other areas that look interesting right now?
Convertible bonds. You have a reduction of leverage in general. In this case, there is the technical factor, notably that in recent years a predominant portion of the buying of these bonds has been done by arbitrageurs, convertible arbitrageurs and hedge funds. They try to consistently create small, low-risk spreads. To turn a small, low-risk spread into a high return, they use a lot of leverage.
So Number 1, the [Securities and Exchange Commission] rules interfered with their ability to short [stocks]. Number 2, these investors had to be leveraged. Number 3, the premise of the arbitrage is that if there is a problem, the convertible bond will hold up better than the stock.
So, you go long the bond and short the stock. And the trouble is when you have these technical conditions, the relationships that should hold don't. And the bond falls more than it should, relative to the stock.
What is the upshot of all that?
Convertible-arb investors have reported terrible performance, so they are having capital withdrawn and they are deleveraging. As a result, they are forced sellers, which has made that market very cheap, as well. So everything is cheap. The question is: What is the cheapest and what do you feel more comfortable with?
You have said that the biggest threat to hedge-fund investors is disillusionment with returns -- not major blowups.
I imagine people are disillusioned, because in the past few years, they did not receive any astronomical returns. Any hedge-fund manager should produce either very high returns in the good times or great risk control in the bad times. And the greatest of the managers will produce both. Few investors got great returns in the past three or four years, when all the money was flowing into hedge funds. Now they are seeing that only the best hedge-fund managers have produced strong performance in earlier years without giving it back this year.
Will there be a winnowing?
Surely. The hedge-fund managers who were really risk-conscious and controlled the amount of money they took in will come through this period well. They probably will be offered more money, which they will probably turn down, because turning down money is a key to success.
Where does that leave the whole alternative-asset phenomenon?
There is no such thing as a free lunch. And, certainly, nothing is good because you put a label on it, be it growth stocks, or small-cap stocks, or hedge funds, or private equity. And when people start saying that something is good because of what it is called, then they are setting themselves up to lose money. Chances are they will overpay and be disappointed.
Thanks very much, Howard.
BRUSHING UP ON A COLGATE BARGAIN
Colgate-Palmolive is being punished for its hefty international exposure, even though the company still anticipates double-digit earnings growth both this year and next.
Lest anyone doubt that the defensive reputation of blue-chip consumer staples company stocks is justified, take a look at this table from Barron's. The stocks have all taken their hits, but to a far lower degree than the average stock and market indexes.
The decline in the sector, such as it is, has brought the earnings multiples of world-class companies such as Procter & Gamble and Colgate-Palmolive down to the mid-teens. Bargains? Certainly compared to recent history, although not compared to stagflationary 1970's, when such companies were burdened with rapidly inflating input costs as well as their fall from "Nifty-50/One decision stock" grace. Stealing a page from Oaktree Capital chairman Howard Marks, as expressed in his interview above, that is all any intelligent person can say: cheap versus history on average, but they could get cheaper.
This article makes a pretty decent buy case for Colgate-Palmolive. It is slightly cheaper than its fellow defensive blue chip brethren. Offsetting the economic difficulties of its overseas markets are plunging commodity input prices and market share gains.
Colgate-Palmolive may be a household name in the U.S., but the maker of Colgate toothpaste, SpeedStick deodorant and Palmolive dish soap now generates about 75% of its sales overseas, including 45% in emerging markets. Once upon a time, before stock markets and economies the world over began melting down, such international exposure was perceived as a benefit. Today, it is the source of much anxiety among investors, who fear Colgate's sales could slow in once-sizzling markets like Russia and Brazil, even as a stronger dollar takes a bite out of reported earnings.
Reflecting these concerns, Colgate's shares (CL) have fallen almost 25%, to a recent 63, from a high of 80 in mid-September. The stock traded at today's level as far back as 1999, even though earnings have more than doubled. In punishing New York-based Colgate for its reliance on foreign sales, investors are ignoring the company's defensive characteristics, not to mention its projected double-digit earnings growth, this year and next.
"People have to have toothpaste, and quality brands matter," says Lauren DeSanto, an equity analyst with Morningstar, who has a Buy rating on the shares and thinks they are worth 79. "It is a really good time to buy the stock."
Colgate's valuation would seem to buttress that assertion. By almost any metric, the stock is cheap, trading at only 17 times the past 12 months' earnings, versus a previous range of 20 to 44 times trailing results. Looking ahead, they fetch 15 times 2009 estimated earnings of $4.25 a share. That is a 19% premium to the S&P 500's multiple on expected 2009 earnings. But the premium may be justified, since the S&P's earnings could fall 20%, to $70, in 2009, while Colgate's profits are likely to be 10% above the 2008 estimate of $3.86 a share. Last year, Colgate made $3.38 a share.
The stock also looks attractive relative to that of the company's nearest competitor, Procter & Gamble (PG), which fetches 16.6 times 2009 estimated earnings. Even Clorox (CLX), which has had its own troubles in recent years, sports a higher multiple -- 15.8 times 2009 estimates.
Household-products stocks often are compared to food shares, another defensive group, and here, too, Colgate has the advantage. General Mills (GIS) sells for 16.4 times calendar 2009 earnings; Hershey (HSY) for a hefty 19.3 times, and Campbell Soup (CPB) for 16.8 times.
Colgate tried to reassure Wall Street when it reported on October 30 that third-quarter results had beaten analysts' expectations by a penny. "Given our strong momentum and excellent savings initiatives, we are comfortable with external profit expectations for the fourth quarter and full year 2008," noted CEO Ian Cook. "While our 2009 budget process is still in its initial stages, we anticipate another year of double-digit earnings-per-share growth in 2009. Our ongoing savings programs combined with the benefits of lower oil and commodity costs should fully offset the expected impact of the strengthening dollar."
Colgate executives declined to give an update.
Oral-, personal- and household-care products accounted for 87% of Colgate's worldwide sales of $13.8 billion last year, with pet foods contributing the rest. Latin America chipped in 29% of sales in the first three categories, Europe/South Pacific, 28%, and Greater Asia/Africa, 20%. The company does not break out pet-food sales geographically.
North America contributed only 18% of total sales and operating profits in the latest quarter.
In the latest reported quarter, North America contributed only 18% of total sales and the same percentage of operating profits, before corporate costs.
Latin America is of particular importance to Colgate. Sales in the region jumped 21% in the third quarter, to just over $1 billion. The company sold more products, benefited from currency exchange, and higher prices added 11%. Latin American operating profits rose 25%.
In the past month, however, emerging-market bourses accelerated their 2008 declines as foreign money fled and oil prices cratered amid declining world demand. Brazil's main stock index was down 44% this year; Russia had lost 68%, and India, 54%. Investors fear that outflows of capital from these markets will slow economic growth, hurting Colgate's sales.
Oil’s collapse from north of $145 to the $50s could add almost 45 cents to earnings per share.
Colgate contends that any slowdown would be offset by falling commodity prices. Each $2-a-barrel decline in crude oil adds about a penny a share to earnings, says Bill Schmitz, an analyst at Deutsche Bank, who has a Hold recommendation on the shares. Oil's collapse to the $50s per barrel from a peak north of $145 could add almost 45 cents to earnings, helping to offset the negative effects of a stronger dollar and slowing emerging-market sales. Colgate uses many oil-based materials in its packaging, and natural fats and oils used in its products have dropped in price, as well.
The buffer provided by lower commodity costs was evident last week when Morgan Stanley analyst William Pecoriello cut his emerging-market sales estimates for many consumer-products, beverage and food companies he covers, Colgate included. He expects the company's organic sales growth in Latin America to fall to 10% next year from a previous 14%, while sales in Europe could be flat, instead of up 2.4%, and Asia might see sales growth of 10%, not 11%. At the same time, Pecoriello lowered his view of what Colgate might spend on commodities; that should boost gross margins.
Consequently, he lowered his 2009 earnings estimate by only nine cents a share, to $4.16, and his price target by only a dollar, to 86. If gross margins do not expand, earnings could fall by 18 cents, to $4.07.
While Colgate cannot control the price of crude, it can take other steps to offset slower growth and foreign-exchange headwinds. These include expanding its market share, and adjusting the size and price of its products. The company has an 80% market share in Latin America, endowing it with monopoly-like pricing power.
Around the world, Colgate has boosted its market share by exploiting merger-related dislocations in various product categories. When Procter & Gamble purchased Gillette three years ago, P&G inherited Gillette's Oral B toothbrush division. Colgate seized on the combined company's lack of focus in the toothbrush market to double its global market share in toothbrushes to 40% in the past five years, notes Schmitz, the Deutsche Bank analyst.
A similar opportunity could arise in the mouthwash market, where Johnson & Johnson (JNJ) picked up Listerine in 2006 as part of its purchase of Pfizer's (PFE) consumer-products group. Colgate, which is seeking to grow its Colgate Plax mouthwash business internationally, potentially could seize market share from Listerine if J&J does not maintain its marketing efforts.
Colgate traces its corporate roots back to 1806, and is well-equipped to weather trouble in the U.S. or abroad. Among other advantages, its balance sheet is strong. The company has $3.5 billion of debt, $635 million of cash and $2.5 billion of shareholders' equity, its debt is rated a respectable double-A-minus by Standard & Poor's, and its financial stability allows it to pay a $1.60-a-share annual dividend, for a yield of 2.5%.
If past is prologue, Colgate's savvy management team will use the current downturn to the company's advantage, giving shareholders ample reason to flash their pearly whites.
HONDA IS GEARED UP FOR BETTER DAYS
Honda bears some scratches from the wreckage in the U.S. auto industry. But it is the best-positioned of any car maker for a recovery once the industry shifts back into gear.
The U.S. automobile makers are of little interest to anyone save vulture investors, most of whom would only be interested in odd debt issues. Their stocks are little more that speculative trading plays on bailout machinations, and who knows what else. We do not know the European auto companies well enough to say anything substantial. The two largest Japanese auto manufacturers Toyota and Honda, on the other hand, are among the world's great companies. They cannot avoid being hurt by their industry's hard times, but will surely be prime beneficiaries of a recovery ... whenever that may be. According to leading auto industry research firm J.D. Powers, a recovery is at least 18 months off.
It cannot be emphasized enough that anything is a good investment if the price is low enough, including the stocks of companies in capital intensive, mature businesses. Toyota's and Honda's stock prices are much lower than they once were. As this article points out, Honda is trading at its lowest earnings multiple in a decade. The company is run by car lovers and engineers, as Detroit was in the old days. It has been gaining market share in the U.S. and its offerings are well positioned for what the future may bring, however vigorous the overall growth rate.
Stuck in Los Angeles traffic or rolling along a Southern California freeway, the Honda [Symbol: HMC] FCX Clarity looks like any other small four-door sedan. But the Clarity -- 200 are now on the road, all leased to drivers living near Santa Monica -- is powered by a hydrogen fuel cell. It gets the equivalent of 74 miles a gallon (or, more accurately, 72 miles per kilogram of hydrogen), can travel nearly 300 miles between refuelings and sends water vapor, not pollutants, through its exhaust pipe.
The Clarity appears to be more advanced than the fuel-cell vehicles being tested by other auto makers. Still, you will not be able to buy one soon. Though Honda theoretically could start mass-producing the Clarity in three or four years, the car would not sell unless a nationwide network of hydrogen-fueling stations existed -- and that, even with government support, could take at least a decade.
But Honda is more than a technology leader, and that is why, despite the global car market's current misery, any investor with a long-term view should consider its stock whenever signs start to emerge of an upturn in the auto industry.
Amid a savage sales slump that has led the Detroit Three to plead for government aid, threatens to bankrupt General Motors and has battered most European and Asian vehicle makers, the Japanese car manufacturer is a standout. In this year's first nine months, Honda was one of just two car companies (the other being Subaru) whose U.S. sales were up. In August, its share of the U.S. market was a record 11%, making it the #4 auto maker, behind GM, Ford and Toyota, but ahead of Chrysler.
Recently, however, the downturn's severity has taken a toll on Honda. Its U.S. sales plunged 25% in October, but that still was better than the overall industry's 32% slide. Honda now expects its 2008 U.S. sales to be off 2.4%, the first yearly decline in 15 years. But the company remains confident. It will open a new plant this month in Greensburg, Indiana, that soon will be turning out 30,000 vehicles a month. And it has opted not to follow Toyota, Nissan and others in offering 0% financing.
If the global auto industry is headed into "outright collapse in 2009 ... with a recovery at least 18 months away," as the auto research firm J.D. Powers has warned, Honda will not escape hard times. But it will survive and be a winner after the downdraft ends.
"Honda is first and foremost an engineering company, with a philosophy of efficiency that is driven to get more out of less," says John Casesa, a former Wall Street auto analyst turned managing partner of New York's Casesa Strategic Advisors. "The people who run the company are the people who design, manufacture and sell the cars, people who have a passion for the business. Honda is the best-positioned of any car maker to ride out this storm, and the best-positioned for a recovery. The stock is as close to being a blue chip as exists in the auto industry today."
After changing hands at 36 last summer, Honda's Big Board-traded American depositary receipts plunged late last month to a 56-month low of 18.94 after the company reported a 41% decline in second-quarter operating income per share to 69 cents. But they quickly bounced back to their current level in the low 20s.
Predicting earnings even for the rest of this year, let alone 2009, is treacherous in this kind of environment, especially with the Japanese yen moving up lately against the dollar and the euro. Every one-yen change against the dollar boosts or lowers Honda's annual operating profit by 18 billion yen (about $180 million). However, the company recently trimmed its 2008 operating-profit expectations 13%, to ¥550 billion ($5.5 billion) and cut its net income forecast 2%, to ¥485 billion ($4.8 billion, or about $2.70 an ADR). As of September 30, Honda had about $9.25 billion in cash and equivalents and around $22.25 billion in long-term debt, and its cash flow was strong.
Honda shares carry a dividend yield of about 3% and trade at a price/earnings ratio of just under 9 based on expected 2009 earnings -- close to a 10-year low. "At this price, we have a Strong Buy on the stock," says Steve Usher, an analyst with JapanInvest. "Honda is our preferred auto stock. It is a quality stock with tremendous value and potential."
The Japanese company gets almost 30% of its operating returns from non-auto businesses, most notably motorcycles, power equipment, lawn mowers and marine engines. Motorcycles, with models ranging from heavy to light, are selling especially well in Brazil and Southeast Asia. The company also has a unit called HondaJet -- small and not profitable, but promising -- that soon will start selling light corporate aircraft.
Honda's biggest market, North America, accounts for about 45% of its total operating profit. But expanding outside Japan and North America is an important aim for the company, especially because its operating margins elsewhere in the world are up to four percentage points better than those in North America and seven points better than those in Japan.
Ever since the company brought its first car to the U.S. 39 years ago -- the tiny two-door N600, which drew sneers and jeers from Detroit -- it has been known for fuel-efficient small cars. That is now a huge advantage.
While Honda's lineup has since grown to include the luxury Acura line, the Ridgeline pickup and the big Pilot SUV, its top sellers remain the midsize Accord and compact Civic, both of which deliver more than 30 miles per gallon on the highway. It has roughly a 65-to-35 mix of cars to light trucks, but is almost unique among large auto companies in not making a V-8 or deeply participating in the truck and SUV craze prevalent in the U.S. until two years ago.
Honda has another advantage: Not only are its U.S. plants non-unionized, but all are also among the industry's most flexible. Honda's models are designed to use common parts as much as possible and to be assembled much the same way. Its heavily robotized production lines can switch from making any one model to another in five to 10 minutes, versus days or weeks at rivals' plants. This helps produce vehicles that are uniform in quality. They are often among the top performers in the reliability ratings done by Consumer Reports and J.D. Powers. And it has allowed Honda to quickly match swings in demand, as it did this year when sky-high gas prices slashed Pilot sales and boosted those of small cars.
The company is also beginning a mini-new-product blitz. It just introduced a redesigned 2009 Fit subcompact, which has been flying off dealers' lots (but not fast enough to offset sales declines for other models). "This is the right car for the right time," says Dan Bonawitz, head of corporate planning and logistics at American Honda Motor. "It's small on the outside, big on the inside."
The Ridgeline truck and Pilot have been redesigned for 2009, and the Accord, Civic, Element and compact CR-V sport-utility vehicle will get redesigns over the next two years. Also updated will be the Odyssey minivan -- the first Honda that will offer the company's new V-6 diesel, which it claims will be so low-polluting that it can be sold in every state without the urea emission-control systems that BMW and Mercedes-Benz are putting into their newest diesels.
At the recent Paris auto show, Honda took the wraps off a hybrid-electric Insight, which has a new type of engine that will allow it to be driven on battery power alone. When it comes to market next summer, it will match the top-selling Toyota Prius in mileage and performance, while boasting a starting list price under $20,000 -- about $3,000 less than the Prius and Honda's own Civic hybrid.
Unfortunately, at the moment, all the positives are being offset to a large degree by the global economic slowdown, the continuing worries over credit availability and the possibility that the yen will keep rising against the dollar and euro.
But, eventually, the economy and financial markets will heal. And Honda, with its fuel-thrifty cars, flexible assembly plants and advanced technology, will emerge as one of the auto industry's few big winners.
The Bottom Line
Honda is trading at its lowest earnings multiple in a decade. The stock looks like a buy, but investors would be wise to wait for signs of an industry revival before scooping it up.
LOJACK: SOLID, LONG-TERM INVESTMENT
LoJack sells tracking units which helps an automobile owners or other customers locate his/her vehicle in the event of its theft. LoJack's tracking system is unique and not easily replicated. With auto sales way off, and many of LoJack's new customers signing on at the time of a car purchase, the company's sales here are hurting. However, it has a couple of revenue-growth intiatives that could partially offset that. And at around $5 a share the stock is off 80% or so from its high of a couple of years ago.
Cheap? LoJack's EPS has averaged just under $1 for the last four years, it has more cash than debt, decent revenue growth prospects, and a nontrivial "moat" surrounding its business. It sure looks cheap.
The auto industry is in a tremendous drought. For those who believe the industry will emerge from this drought sometime in the next few years, this is a great time to pick up some bargains in this industry. On Saturday, we discussed some criteria to look for when determining if a stock in this industry would make a good long-term investment. One company that appears to fit these criteria is LoJack (LOJN).
LoJack sells tracking units that help its customers locate stolen or lost mobile assets. It has integrated its systems with law enforcement agencies, has several regional networks in place (to detect stolen assets once a unit has been reported stolen), and uses its FCC licensed radio frequency and proprietary technology that can find assets that are hidden from view (unlike GPS systems), all of which make it difficult for competitors to replicate their business.
But how does it match up to the criteria we laid out for long-term investments in this area? First of all, its financing structure should allow it to last through this downturn. Its cash balance of $66 million is much higher than its total debt of $27 million. Furthermore, it has remained cash flow positive through even the last quarter (though it does show negative earnings due to a write-down of Goodwill).
Second, it is not dependent on any one car manufacturer. LoJack unit purchase decisions are made by individuals purchasing vehicles regardless of maker and by insurance companies looking to reduce losses due to theft.
Finally, could LoJack be in a secular downturn rather than just a cyclical one? This would seem unlikely. International sales were up 40% last quarter as LoJack enters new markets, which made up for the drop in domestic demand which occurred due to the slower pace of new vehicle sales. LoJack is also diversifying from its reliance on vehicles, as it recently obtained approval to use its technology for use on construction equipment (for which it has already begun to produce revenue) as well as for persons with cognitive disabilities (for which it expects to have a product out in 2009/10). It also currently has a "LoJack for Laptops" program and has also recently made its product available for motorcycles.
But is the stock cheap? LoJack's EPS has averaged just under $1 for the last four years, while its current stock price sits at just under $5. For a company with more cash than debt, good revenue growth prospects, and a few factors which make it difficult for competitors to copy, its stock price would seem to be trading at a large discount to its intrinsic value.
AMERICAN EXPRESS: NOWHERE NEAR ITS CREDIT LIMIT
AmEx has plenty of cash to weather this crisis. A misunderstood stock.
American Express is arguably -- a brave soul gives it a shot here -- one of the strongest financial services stock, with one of the best franchises. Warren Buffett is a fan of the company going way back, and may be willing to buy the whole company if things get really bad. This disaster scenario appears unlikely, with the company expected to be in the black next year despite higher losses from the credit card portfolio -- which underwent an ill-advised expansion late in the last credit cycle. The stock's low multiple of average earnings power makes it a buy, it is argued.
The credit crisis and the deepening recession have dealt a double blow to American Express [symbol: AXP], which has long been viewed as one of the globe's leading financial companies, due to its enviable card business and consistently high returns.
AmEx shares are off 61% this year to 20 -- back where they stood in 1997 -- and much of the drop has come since mid-September, when the stock traded at 40. Wall Street worries about the company's reliance on credit-markets funding, rising losses on its credit-card loan portfolio and weakening consumer spending worldwide.
These concerns are legitimate, but the market may have overreacted because AmEx should have enough liquidity even if credit-market conditions remain tough in 2009. The company is likely to be solidly profitable next year, even if losses spike on its $75 billion credit-card loan portfolio.
It helps that AmEx's biggest fan is Warren Buffett, whose Berkshire Hathaway is its largest stockholder with 151 million, or 13%, of the company's shares. The combination of AmEx's attractive franchise and Berkshire's stake suggests the company's stock may be near a bottom.
AmEx has not needed to turn to Berkshire for help because it is well capitalized compared with most major banks and brokerages, and may avail itself of various government-liquidity facilities to meet maturing debt. AmEx recently got approval to become a bank-holding company, and it is possible AmEx could merge with a bank in the next year to more quickly achieve its goal of getting a significant share of its funding from deposits.
American Express also reportedly has sought about $3.5 billion of capital under the Treasury's TARP program. That capital -- 5% preferred stock with warrants -- is more attractive to AmEx than the terms Buffett would exact.
Buffett could not be reached for comment -- and he rarely talks about potential investments -- but our sense is he would probably pump in several billion dollars in new capital if needed. Berkshire also might be willing to buy the whole company if AmEx's financial condition unexpectedly deteriorates. AmEx's market value has shrunk to $23 billion, making it easily digestible for Berkshire, even assuming Buffett pays a premium. Berkshire's market value is $155 billion. Buffett usually likes paying cash for businesses, but he might be willing to make an exception and issue Berkshire equity in the case of AmEx.
Buffett knows and loves AmEx, having first invested in the stock during the 1960s. Its appeal lies in a business model based on generating fee income from consumer and business spending on American Express cards, rather than profits from a credit-card loan portfolio. More than half of AmEx's annual revenue comes from the fee charged to merchants -- now averaging about 2.5% -- on purchases made with American Express cards. Spending on the cards worldwide should top $700 billion this year, up from $647 billion in 2007.
Looking out a year, the stock could hit 30 if the company navigates the credit crisis and looks on track to earn in 2010 anything close to its target of a 30%-plus return on equity. That would imply profits of over $3 a share. It has earned a 27% return on equity so far this year.
Next year's profits are apt to fall, along with those of most big financial companies. The Wall Street consensus for 2009 of $2.50 a share seems high. We are assuming $2 a share, down from an estimated $2.59 a share this year.
Even under the gloomy scenario of Barclays Capital analyst Bruce Harting, AmEx will remain in the black next year. He cut his 2009 estimate last week to $1.60 from $2.25 a share. Harting assumes that charge-offs on AmEx's domestic card-loan portfolio average 9.2% in 2009, up from 5.9% in the third quarter and 3% a year ago. He also assumes domestic spending on American Express cards falls 5% in 2009, compared with a 7% increase in the first three quarters of 2008.
AmEx CEO Ken Chenault is considered among the best financial-services executives, but he erred in rapidly expanding the U.S. credit-card portfolio in recent years to $64 billion from $38 billion in 2004. AmEx's credit-card loan losses are rising. The loss rate on AmEx's charge-card portfolio remains low at just 0.33%.
"This company can weather a huge hurricane and come out fine," says Vitaliy Katsenelson, head of research at Investment Management Associates in Denver. "American Express is one the simplest financial companies to analyze. It is much more transparent than Citigroup or JPMorgan or Goldman Sachs."
He argues that the government safety net removes a key risk with AmEx: funding. AmEx has relied on commercial paper and on securitization of credit-card loans, two markets that are difficult now to access. AmEx says it is comfortable about its ability to refinance some $24 billion in debt maturing in the next year.
The company's ratio of tangible common equity to what it calls "managed" assets of $156 billion -- which include credit-card loans financed with debt and securitizations -- is 6%, versus 4% for Goldman Sachs.
It is understandable that investors shun AmEx because of the company's exposure to the credit markets and the consumer. While next year is likely to be difficult, the company should come through in good shape. And if things get really tough, Chenault probably can pick up the phone and find a willing listener in Omaha.
GOOGLE KEEPS THRIVING DESPITE TOUGH ENVIRONMENT
Google is not our style stock. A stock price low enough to constitute buying with a margin of safety looks highly unlikely, so we do not track it closely. The one thing we can say is that the stock is cheaper at under $300 than it was at $700. It is also an inherently interesting business. If you use the Web it is impossible to avoid Google an opposed, e.g., to distant numbers 2 and 3 Web companies, Yahoo! and Microsoft (as a Web presence, not a software purveyor), whom we rarely encounter.
This analyst argues Google is cheap at $275. The stock's price-to-sales and cashflow ratios are both well below the bottom of the range it has exhibited during its short, raging bull market, trading history. We will wait. Others may be intrigued.
A study of online advertising was recently released by the Interactive Advertising Bureau and PricewaterhouseCoopers. What it revealed is that internet advertising is growing despite the economic downturn. Total online advertising revenue for the third quarter neared $5.9 billion. That is an 11% improvement from last year's third quarter and a slight 2% gain from the previous quarter. The study also concluded that year-to-date web advertising has brought in $17.3 billion, which is an improvement from $15.2 billion through three quarters in 2007. This study should not be considered the final authority on interactive advertising, but it does demonstrate an apparent resilience in the face of economic hardship.
The study is welcome news to Google (GOOG) which has seen its stock fall by 60% so far this year. Apart from the generally negative momentum of the stock market, Google's stock has suffered from the expectation that its search-engine-based advertising would suffer as companies strip their marketing budgets. Advertising has been curtailed significantly as many retailers are struggling and the automakers are just trying to stay in business. However, the brunt of the pull-back has been felt in more traditional media like television and print. Growth in what is termed interactive advertising has not suffered nearly as badly. One potential reason is that interactive advertising results are more easily quantifiable because mouse clicks are tracked. By tracking where eyeballs are looking, advertisers can know what is working and what is not, which is of course very valuable.
When it comes to bringing traffic to your interactive ad, there is no better company to work with than Google. Internet searching continues to grow, as we mentioned in our October 1st piece ("Just Google It"). A Pew internet usage study found that now 1/2 of all internet users surveyed use a search engine at least once a day. Only 1/3 did in 2002. What has happened in the meantime? Oh that is right, Google happened. Of course, I am only kidding, but Google's dominance in search traffic is astounding. Month after month Google generates around 70% of web queries. Google has hit the "sweet spot" of having incredible proprietary search technology, a single and clean layout, and loads of open source programs and widgets for an ever growing internet audience. The company is suffocating its weaker search competition such as Yahoo! (YHOO) and Microsoft (MSFT). These factors all enable Google to attract internet users from beginner to expert to its site as well as offshoots. However, as its stock price swoons, Google has begun to monetize its formerly ad-free Google Finance site.
Our readers will remember that we believed that GOOG was Undervalued at around $400 and now that the price is down more than 30% to $275, we have GOOG rated Greatly Undervalued. The markets are fearful but by our indications Google is doing the right things as both revenues and earnings continue to grow. Sales growth for 2008 is estimated to be 36% and earnings for the year are expected to be up 25%. That assumes that 4th quarter results are in line, and they probably will not stray too much from these estimates.
Google has been strengthening its fundamentals but its stock continues to slide, so by any historical valuation method, Google is very cheap. Price-to-sales has historically ranged between 7.2x and 14.3x, but the current price-to-sales is a meager 4.7x. Similarly, the historically normal price-to-cash flow range is 24.2x to 49.0x, but the current price-to-sales is just 15.1x. For Google to return to just the low end of these fundamental valuation ranges, we would expect to see the price in the upper $400s. Some would say that we are overly optimistic, but Google has continued to thrive during a tough environment and we expect them to remain the top search engine and internet advertising business into the foreseeable future. Consider the words of Piper Jaffray's esteemed technology analyst Gene Munster as he endorses Google (he has a buy rating and a $600 price target on GOOG):
Google continues to be far and away the best company in the Internet space and operates in an advertising vertical (direct response) that historically fares well in an economic downturn. We believe this combination makes Google the top Internet stock to own in the current economic tumult.
The “Don’t Be Evil” Principle Permits Profits
Thomas W. Hazlet, professor of law and economics at George Mason University, explains a good part of Google's phenomenal success. Its principals learned from their early mistakes of distrusting the free market, and tapped into its power instead. Credit them with being quick studies.
Just how successful has Google been? One revealing measure: Google's market value is approximately equal to 90% of the combined market value of Disney, News Corp., Time Warner and Viacom -- once thought to be a permanent U.S. media oligopoly. The fearsome four allegedly controlled content to protect their sponsors, and there was nothing anyone could do about it.
Google's natural search results are unsullied by capitalist running dog payoffs, whereas the paid search results are rank ordered from the highest bidder on down. Web surfers get to decide which set is more useful to them. The media advertising business not been the same since.
It is amazing what turns up when you Google almost anything -- especially Google: The Internet application has become a corporation to be reckoned with.
Founders Larry Page and Sergey Brin changed Web search by ranking pages according to their popularity, not just their textual relevance, and superior search was only a start. Scaling the technique to serve an enormous global audience would consume vast resources. Cataloging an ever-expanding Web would require massive personal-computer farms fed by transcontinental fiber. How would they pay for it -- and maintain the reputation of their search results?
Brin and Page rejected standard banner ads. As they said in an academic paper in 1998: "Advertising-funded search engines will be inherently biased towards the advertisers and away from the needs of the consumers. Since it is very difficult even for experts to evaluate search engines, search-engine bias is particularly insidious."
Tossing their prized search engine into the clutches of a sneaky, revenue-extracting enterprise was the last thing the young visionaries had in mind. That would be evil. They sought an innovative model guided by a conviction that the solution would not be found in the for-profit sector: "The issue of advertising causes enough mixed incentives that it is crucial to have a competitive search engine that is transparent and in the academic realm," they wrote.
Their prediction was nearly $100 billion off, even by the standard of recently depressed Google share prices. That is a stunning margin of error, whether in Silicon Valley or on Wall Street. These wunderkinder had relied on popularity -- a market by any other name -- for their breakthrough search engine. But they rejected the market when they were first looking for money.
Brin and Page learned. Their estates now rank 13th and 14th on the Forbes 400, at about $16 billion each.
They discovered that Google's clean page layout provided a clean frame for mercantile ethics. Google would display "organic" search results on the left, with paid ads neatly above and stacked to the right. It assured users: Here are Google's picks along with some commercials; let your mouse be the judge. Within months, search-term clicks became not just a cash cow for Google, but a stampeding herd.
Google's search for revenue led them to the cash register, and society has benefited.
In a decade, the company has gone from zero to handling more than 70% of all search queries. Market forces have delivered what nonprofit institutions only dream of. As Google broadened the terms of its motivating motto, “Don’t Be Evil,” to include commercialism, dazzling innovations arose and millions of users flocked to it.
Google's advertisers today pay for your search terms, your e-mail messages and millions of lifestyle clues lurking in terabytes of personal-data storage.
In their 1998 paper, the Googlers cited Prof. Ben Bagdikian's theory of Media Monopoly. Page and Brin swallowed the idea that U.S. media markets were controlled by a cabal of corporations, manipulating content to protect advertisers, and stifling competitive entry to protect their shareholders. According to Bagdikian, just four megacompanies share the U.S. Media Monopoly: Disney, News Corp., Time Warner and Viacom. ... Resistance was futile.
If Brin and Page had been deterred by the bleak forecast offered by Bagdikian, Google today would not be worth some 90% of the capitalization of the four media oligarchs combined.
"Gales of creative destruction," in Joseph Schumpeter's memorable phrase, drive the capitalist economy. The awesome result is the Free-Market Innovation Machine, as William J. Baumol's 2002 treatise [The Free-Market Innovation Machine: Analyzing the Growth Miracle of Capitalism] was titled. It delivers prosperity such as the world had never known. "Average growth rates for about one-and-a-half millennia before the Industrial Revolution are estimated to have been approximately zero," writes Baumol. "In the past 150 years, per capita incomes in a typical free-market economy have risen by amounts ranging from several hundred to several thousand percent."
This fountain of wealth inspires the globe. The University of Michigan's C.K. Prahalad trumpets the liberation of "the bottom billion," triggered by a "market based ecosystem" working to "eradicate poverty through profits." A key cultural element turns out to be the sanctity of contracts, and the remarkable wealth gains that have spread to places like India and China are only beginning.
Yet today's Silicon Valley wisdom that traditional property-rights regimes are collapsing: Open-source software and user-generated content are burying your father's economy. Don Tapscott's book Wikinomics, on the popularity of Wikipedia, Linux and YouTube, details "How Mass Collaboration Changes Everything." Its starting supposition: "Throughout history, corporations have organized themselves according to strict hierarchical lines of authority." While the book offers a fascinating read, the premise is economically blasphemous.
Corporations, whose history coincides with a phenomenal rise in living standards, have produced upheaval in hierarchies – and they are still doing it. They need not rely on the largess of barons. Businesses attract modest sums from diverse investors.
Capitalism provided a superior mode of economic organization. By sharing ownership, pooling resources and hiring expert managers, it pushed specialization to new frontiers. Rules apportioned rights and avoided tragedy. Limitless variations became available, including collaborative business models -- as Google now knows.
In July 2008, Google launched its own Wikipedia knockoff, Knol. A commercial enterprise taking aim at a nonprofit network of volunteer contributors to enhance the scope of its revenue-generating ads? Power play by a new Media Monopoly? Perhaps it is just capitalism.
Charles Schwab Is Not Your Father’s Discount Broker
This Barron's analysis of no-longer-just-a discount broker Charles Schwab finds the company's stock to be a worth purchase candidate near 17. It looks like it should be interesting to growth stock buyers.
No investment brokerage is truly built to thrive in a grinding bear market that withers portfolios and paralyzes retail investors. But Charles Schwab [SCHW] probably comes closer than any other, given its asset-gathering prowess, balanced and steady revenue streams and lean cost structure.
Add to it all Schwab's success over recent years in branding itself as the unconflicted "honest broker," and it becomes clear that the San Francisco company is well-positioned to withstand the tough environment and gain market share amid the industry tumult. ...
In the late 1990s and early 2000s, Schwab was disproportionately dependent on active retail-investor trading. As the tech bubble was ending nearly a decade ago, the company was overpaying for CyberTrader, a hyperactive-trader shop, and U.S. Trust, a private bank that it subsequently sold.
Following founder Charles "Chuck" Schwab's return to the sole CEO role in 2004, the company rediscovered its founding principles and retooled itself as a conservatively run asset-gathering machine, which it has remained under longtime Schwab executive Walt Bettinger, who became chief executive October 1.
Bettinger figures that difficult times could accentuate his firm's advantages in investors' minds. "In times like this," he says, "consumers become focused on the core strengths of franchises -- how firms operate, how they're financed, how they make money. We have a simple model: Clients bring assets to us, allow us to make a little money from them, and every day they decide whether to stay or leave." As such, the firm has modest balance-sheet leverage and does no proprietary trading.
Although still popularly identified as the founder of the do-it-yourself investing industry, Schwab garners 47.5% of its revenue from asset-management and administration fees, and another 33% from net-interest income. Schwab is one of the largest money-fund managers, and oversees Schwab Bank. This makes it nearly indifferent to whether investors choose to use the firm directly via a brokerage account or through an independent adviser, and whether the investor trades actively or sits in cash.
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