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THE COSMOPOLITAN CREDITOR
Are you overweighted in U.S. Treasurys? There are other governments and other currencies out there.
One easy way to diversify out of the U.S. dollar is to purchase international bond or currency mutual funds or ETFs. The Templeton Global Bond Fund has a positive nominal return this year despite the strong dollar. How did they do it? By shorting the euro. In other words, the Templeton fund is a forex trading fund as well as a bond fund. The Templeton Global Bond Fund also shows the best t-year annualized returns versus the competitors this Forbes article lists in a table.
As markets crumbled this year, there was scarcely any safe haven outside U.S. Treasury paper. One fund that has done surprisingly well -- "well" meaning that it almost held its own in real terms -- is the Templeton Global Bond Fund. This $11.1 billion fund invests in government bonds the world over, while making side bets in favor of and against various currencies. For January 1 through November 11 it delivered a total return of 1.59%. Subtract inflation, and it is only slightly in negative territory.
Michael Hasenstab, the fund's 35-year-old portfolio manager, has delivered an average total return of 8% a year over the past decade. That comfortably beats the 4.29% annual return (in dollars) for the average international bond fund and the -1.25% annual return on the S&P 500. It is a reasonably good way for a long-term investor to stay in fixed income while diversifying away from the dollar and the inflation risk that now goes with it. We say "long-term" because the fund's 4.25% sales load makes it inappropriate for short-term holders. The fund also runs up a 1% annual expense burden. (We report mutual fund returns after expenses but before sales loads.)
Hasenstab's fund has avoided credit risk and boasts an average credit quality of A+, only a tad shy of the U.S. government's AAA rating. His risks have more to do with fluctuations in interest and exchange rates. Average maturity of the portfolio: 7.2 years. He has invested 34% of the fund in European bonds, with large holdings of Swedish, French and Dutch government debt. Bonds from the provinces of Manitoba and Ontario and elsewhere in North and South America make up another 21%. Asian government debt accounts for 28%.
The fund's 30 staffers aim to capitalize on large economic trends. One of their games is to target countries likely to have weaker growth and thus lower interest rates. That formula delivers capital gains, provided the borrower in question does not default. They have 7% of the portfolio in Mexican government bonds, which have fairly high yields (above 9%) at the moment, as the country has raised interest rates to suppress inflation. Cuts by the central bank to fight recession would lower those yields, providing capital gains to bondholders. Says Hasenstab: "Because of how this global recession is evolving, spreading from the U.S., it has not fully affected other parts of the world yet. Those markets have lagged. Our anticipation is that they will catch up."
Rate cuts in Australia and New Zealand and by the European Central Bank as part of a coordinated round of cuts by central banks around the world have buoyed the fund's returns this year. Another win came from shorting the euro, which has dropped 15% against the dollar since January. Unlike other international bond funds, Templeton's goes beyond simply hedging currency exposure. Hasenstab has bet on a stronger Japanese yen, for instance, but holds no Japanese bonds.
Buying government-backed debt has its risks. Latin American governments have been known to stiff bondholders. Russia's default in 1998 caused much havoc. Hasenstab's philosophy: You should usually overweight the debt and the currencies of countries that are net creditors to the world (Asian ones, for example), while underweighting the debtors. That explains his recent bets in favor of Asian currencies.
HIRE A DIGITAL MONKEY TO MANAGE YOUR INTERNATIONAL PORTFOLIO
A digital dart-throwing ETF or mutual fund will save you a lot in fees.
A paper submitted to the Journal of Finance on U.S. domestic portfolio managers, found that 1 in 7 active managers exhibited genuine skill before 1990, but by 2006 the figure had plunged to 1 in 166. This is an extraordinarily low number even to us Wall Street naysayers. Do similar numbers apply to international money management? Anecdotal evidence provided here indicates that is also the case. Returns come and go; death and fund fees are sure things. Why pay up to no benefit?
A quarter of a century ago Princeton economist Burton Malkiel theorized that a blindfolded monkey throwing darts at a newspaper's financial section could select a portfolio on a par with one picked by experts. This sort of thinking is behind the enormous success of the Vanguard Group, which has been selling index funds for the past 32 years.
But does dartboard investing work well with foreign stocks? Are they as efficiently priced as the 500 in the S&P Index? However much you might have wanted an active manager for your international portfolio a few decades ago, nowadays it is hard to believe that lots of bargains are being overlooked in Tokyo and Paris. Computers, hedge fund operators and mutual fund analysts are picking over all but the smallest stocks.
It used to be conventional wisdom that international markets were not efficient," says Nathan Gendelman, director of investments at the Family Firm, a Bethesda, Maryland company that manages $300 million. "But managers have not really been able to prove that they can beat international indexes."
There is a lot of money to be saved going the passive route. International stock funds typically sport expense ratios of around 1.5%. Some are as high as 2.5%. The exchange-traded index funds offered by iShares and the like typically charge less than half of that.
A percentage point or two looks small, but the savings snowball. If you assume an 8% gross portfolio return, a $10,000 investment in a fund with a 0.5% expense burden would swell to $42,000 in 20 years, while it would grow only to $31,000 if the annual cost was 2%.
Some anecdotal evidence that you do not get what you pay for in active international management: Since January the iShares MSCI Japan Index (ETF) is down 32%. By contrast the actively managed Fidelity Japan Fund is down 37%. The iShares MSCI Mexico Index is down 43% this year, while the handpicked Mexico Fund is off 51%.
Economists Laurent Barras, Olivier Scaillet and Russell Wermers, in a paper under review by the Journal of Finance on domestic portfolio managers, found that 1 in 7 active managers exhibited genuine skill before 1990, but by 2006 the figure had plunged to 1 in 166.
Skill, here, means beating a passive index fund, after fees, to a statistically significant degree. The authors suggest the drop was because of the departure of many top fund managers to hedge funds as well as the high fees charged by mutual funds.
If you want a passive foreign fund, you have two choices. One is an ETF like the iShares MSCI EAFE Index Fund, a fixed basket of roughly 800 stocks that charges fees of 0.34% annually. The other is an index mutual fund. Vanguard and Fidelity offer a range of global and regional funds for international markets with expenses as low as 0.1%.
The articles ends with a table comparing the results of various passive and active international money managers.
A NIGHTMARE BEFORE CHRISTMAS
As ever, Peter Schiff is warning that no good is going to come from running the U.S. money pump on overdrive, the vigorous rally in the U.S. dollar notwithstanding. He seems to think the deflation is going to end sooner rather than later.
Like many pragmatic economists I have always warned that rapid expansions of government debt would result in inflation and higher interest rates. The explanation was always simple: Rising supply of government debt inflates the money supply and weakens the government's ability to service its debt through legitimate means.
But In recent months, government has flooded the market with hundreds of new Treasury obligations and telegraphed its intention to increase the deluge even more. In response, both bond prices and the dollar have risen. This benign reaction has led many to the happy conclusion that the doom and gloomers are wrong and that bailouts and economic "stimuli" can be financed with deficit spending without any adverse consequences on interest rates or consumer prices. Recent action in the foreign exchange markets suggests these hopes will prove illusory. The renewed strength in gold, together with the long overdue rupture of the correlation between the movements of foreign currencies and U.S. equities, is further evidence that recent market dynamics are changing.
When the financial crisis of 2008 kicked into high gear in September, the U.S. dollar began to rally furiously. While America's economic ship was sinking from stem to stern, its currency was becoming the must have asset for public and private investors around the world. The dollar benefitted from the positive flows that result from massive global deleveraging. Treasuries got an added boost from a reflexive flight to "safety." As a result, politicians were able to fill out their Christmas wish lists with complete confidence that Santa would deliver. However, as these dollar-positive forces appear to be giving way, the Grinch is about make an unwanted appearance.
Last weekend Barack Obama announced his intention to implement a New Deal-style stimulus and public works program. What he somehow forgot to mention is that the United States is wholly dependent on the willingness of foreign creditors to supply the funds. But a weakening dollar makes continued foreign purchase of U.S. Treasuries a much more difficult decision.
Once the dollar begins to collapse beneath the weight of all this new deficit spending, accumulation of contingency liabilities, and the socialization of our economy, commodity prices and interest rates will head skyward. In addition, once all the going out of business sales at U.S. retailers are over, and excess inventories have been reduced, watch for big price increases at the consumer level as well.
Once the government runs out of foreign and private sector bidders for new treasuries, the Federal Reserve will be the only buyer, and the hyperinflation cat will be completely out of the bag. Sensing this, the Fed has recently indicated a desire to begin issuing its own bonds. However, since dollars are already recorded as liabilities on the Fed's balance sheet (dollars are in actuality Federal Reserve Notes) the Fed already issues debt. The difference now is that they are proposing to issue interest bearing debt. Perhaps the Fed feels this will make holding its notes more appealing. However, since the interest will be paid in more of its own scrip, I do not believe this con will work.
In the end, rather than filling our stockings with Christmas goodies, our foreign creditors will likely substitute lumps of coal. Of course given how high coal prices will ultimately rise as a result of all this inflation, in Christmas Future perhaps our stockings will be stuffed with nothing but our own worthless currency. It might not burn as well as coal, but at least we will have plenty of it.
For a more in depth analysis of our financial problems and the inherent dangers they pose for the U.S. economy and U.S. dollar denominated investments, read my new book Crash Proof: How to Profit from the Coming Economic Collapse.
FORECAST: A LONG, COLD ECONOMIC WINTER
It will take consumers at least five years – and probably more – to recover from this crisis.
For all the world this interview in Barron's sounds like it could have been with some inveterate gloom-and-doomer Austrian economist like Peter Schiff (who was interviewed in Barron's earlier this year). And a year and change into the worst bear market in several generations, it is about time for heretofore silent "I knew this would happen all along" types to be emerging from the woodwork. The interviewee here, however, has been bearish going back many years. Stephanie Pomboy, founder of MacroMavens, expressed concern about rising debt levels the housing bubble back in 2002.
Ms. Pomboy was looking at the same data, which was never obscured from view, as everyone else. It just took a surprisingly long time for the reality revealed by the data to assert itself. That is the nature of bubbles. Ms. Pomboy's outlook and recommendations have an Austrian flavor as well.
"Like the bubble in financial assets, the new real-estate bubble has its own distinctly disturbing characteristics," Stephanie Pomboy wrote in an April 2002 note titled "The Great Bubble Transfer." The founder and president of MacroMavens was on to something, even if she was early, and she worried about the big buildup of consumer debt fueled by rising home prices. Pomboy, whose Manhattan firm analyzes macroeconomic themes and their investment implications, remains bearish, convinced that a long period of paltry U.S. economic growth is in store -- akin to what happened in Japan in the 1990s. For more of her views and forecasts, read on.
Barron’s: How bad has the macroeconomy gotten?
Pomboy: It is certainly the toughest one any of us has lived through. My fear is that it is actually just in the early stages and that it is going to get substantially worse on the economic side, although all the government measures that have taken place so far might help to insulate some of the damage on the financial side.
What about the short-term outlook?
Having been bearish, for me the real challenge is to identify the turn. One thing at work right now is what I call the cattle prod -- essentially the Fed poking people to take risk. They are taxing cash by having negative real returns on cash. At the same time, yields on investment-grade and junk bonds are incredibly alluring. You can pick up 15 percentage points over cash buying junk bonds. Or you can pick up 8.5 percentage points on investment-grade paper. At some point, the cattle prod will get people moving, as it did in March of 2003 when the market turned.
What else do you see happening in the near term?
U.S. consumers are actually going to do the unthinkable – they are going to save.
With the government guaranteeing all manner of private-credit claims, many investors may decide to get long "socialism," for lack of a better term. Or, as some euphemistically put it, this is partnering with the government. So in the short run, we could see a rally in risky assets and a selloff in Treasuries. But the economic deleveraging has barely begun, and that is my longer-term thesis. It all revolves around the idea that U.S. consumers are actually going to do the unthinkable -- they are going to save -- and that we will be more like Japan than anyone believes is possible.
Hence, consumption declines.
Right. Wages have been silently crowded out by benefits as a share of total compensation, as companies look to offset rising health-care costs. The result is that the share of income that consumers can actually spend is at its lowest in the post-war period. It had not been a problem, because consumers would just borrow to fill that gap. But now, they do not have appreciating assets against which to borrow. So while we could get a rally in risk assets -- including high-yield debt -- it is likely to be a short-term rally within a context of a secular bear market.
Any other important longer-term trends you expect?
We are going to see a secular rotation from paper assets to hard assets like gold.
We are going to see a secular rotation from paper assets to hard assets like gold. The whole global competitive currency devaluation, including that of the dollar, plays right into that.
Do you see any asset classes besides junk bonds benefiting from a short-term rally?
There is a chance that equities participate in that rally as well, although I think investment-grade corporate credits look much more attractive than stocks. But when you think about pension funds that are trying to make 8% annual returns, they are not doing it by getting 1% on 2-year Treasury notes. They cannot use the secret sauce of leverage anymore.
If I was going to hold my nose and buy anything, I probably would buy higher-quality corporate credits. If you want to get long socialism, one of the next segments of the market that will be given a guarantee will be municipal bonds. That is because state and local governments are a huge share of total GDP and employment, and we cannot afford to have them down for the count.
One thing that caught our eye in one of your recent notes was the steep decline of Treasury-buying by foreigners. What are the ramifications of that?
We are acting as though there are no consequences to basically running the money off the printing press and handing it to the Federal government to backstop financial markets or bail out homeowners or what not. There is no consequence to doing this, unless or until the rest of the world says to us, "We don't like this game" and "We don't want to have all the dollar claims we are holding debased by [Fed Chairman Ben Bernanke] running his printing press."
So if foreign investors stop buying Treasuries, or even significantly pare their buying, that means higher rates in the U.S.
Either we are going to pay for our policy sins via higher interest rates or a weaker dollar, and the former choice is not an option.
That is correct. But then [Bernanke] will start buying Treasuries to arrest the rise in interest rates. I have always had a very simplistic view about this: Either we are going to pay for our policy sins via higher interest rates or a weaker dollar. And for an economy that is as levered as the one in the U.S. is, the former choice is not an option. We cannot pay through higher interest rates. We barely got to 4.5%/5% before the whole subprime crisis erupted. So a weaker dollar is the natural valve. But right now, we are enjoying some real competition in the ugly contest from the currencies of the European Union and the United Kingdom, and that will probably persist for a while because they are in pretty bad shape, and they are a little bit behind the curve relative to us.
Could you elaborate on that choice between higher rates or a weaker dollar?
If we rely on foreign creditors to lend us the money to sustain our lifestyles -- and that is what we do -- we need to compensate them for that risk of lending to us. As the economy weakens and our credit quality should theoretically be deteriorating, the only way we can really attract that same capital is by offering a higher interest rate or making our assets cheaper to them, in this case by having our currency be weaker.
How would you assess the job Fed Chairman Bernanke and Treasury Secretary Henry Paulson have done in responding to the financial crisis?
The asymmetric practice of capitalism got us to this place.
My preferred solution would have been to do nothing. I think it is the meddling of policy makers that got us into this situation in the first place, along with the asymmetric practice of capitalism where, as long as everyone is succeeding, it is wonderful thing -- but the moment someone fails, we need to revert to socialism. That is really how we got to this place. And [former Federal Reserve Chairman Alan] Greenspan's desire to constantly lubricate any pain by pumping money into the system really created this bubble. But since doing nothing was not a compelling option to [Bernanke and Paulson], I would have favored more aggressive action to arrest home-price deflation, which would have been tackling the disease. Instead, they have chosen to treat the symptoms. Having said all of that, Bernanke and Paulson are determined to mitigate the pain.
You were concerned about housing before it blew up. What worried you?
First, it was the incredible expansion in lending on housing. I was also focused on the share of household income that was actually spendable money, and it was puzzling how consumers could sustain consumption when their income certainly was not supportive of that. Clearly, the reliance on asset inflation as a substitute for income was a major source of concern for me.
It also shocked me that as a share of bank assets, exposure to real estate was at a record level. Almost 50% of total bank assets were either in first mortgages, mortgage-backed securities or investments in real estate, and that was unprecedented. And yet there seemed to be this general idea that "Oh, no, the banks had securitized and off-loaded all of their real-estate risk." Clearly, as we have discovered, that was not the case at all. Yes, they securitized a lot of mortgages, but then they turned around and invested it in mortgage-backed securities. Ultimately, they ended up sitting on record exposure to one of the biggest bubbles in our lifetime.
What kind of economic conditions do you see going forward?
It will not be exactly like Japan, but it will be Japanesque.
I expect that we will just have a prolonged period of subpar growth. I do not think it will be exactly like Japan, but it will be Japanesque. Clearly, we have been far more aggressive in the U.S., in terms of policy actions. But what will happen here is that credit is no longer the answer, because households decide they do not want to borrow. As a result, the government will really become more important as spender of last resort.
What domestic GDP growth will we get?
In terms of nominal GDP, I see it being around 1% for a long time, five years for sure. One thing to consider is that after the dot-com bubble burst, it took the corporate sector five years to get back to the 2000 peak for capital expenditures, and employment never got back to that level. And the tech bubble was nothing as a share of total assets compared to housing on household balance sheets. This is so much larger. If it took the corporate sector five years to recover from the bursting of the dot-com bubble, to suggest that it would take five years for consumers to recover from this seems like a very conservative call.
What about unemployment?
Having the standard unemployment rate at 10% is definitely a possibility, though it does depend on what is done in terms of the state and local governments, which are 13% of total employment. But they have been the only area that is growing right now in terms of employment.
Where do you see rates going?
I have been bullish on Treasuries, and I did feel silly sticking with that view, because I am really squeezing the last couple of basis points out of a multi-decade bull market. Having said that, looking back at the charts of JGBs [Japanese government bonds] in 1989, I am certain no one back then thought JGBs would ever yield under 1%. And here in 2008, even in the dark recesses of my bear cave with all the other growling bears in there, nobody believes that could happen here. There is this sense about how horrible it is that Treasuries have been able to get to these low yields, and I totally agree.
We are really abusing the privilege of dollar hegemony by printing all this money. But if I am right and the whole economic deleveraging is still to come, you might get a selloff in Treasuries on this short-term rally in riskier assets. Then, the next thing you know, people will say, "Oh, wait. Consumers are not coming back to the trough, this is a problem," and the market will sell off further. So on balance, I would not short Treasuries.
Where do you see opportunities?
Absolute returns are going to be very hard to come by. Look to hard assets and emerging markets for relatively good returns.
In terms of absolute returns, it is going to be very hard to come up with really compelling ideas. I like hard assets in this environment, gold in particular, where basically the major currencies are all being debased. I also think emerging markets, on a relative basis, are going to do much better than developed markets are.
We are all hanging on the edge of our seats to find out if China can pull off keeping its economy going while the rest of the world goes down the tubes. This shock-and-awe stimulus that China is applying to its own economy certainly speaks to its urgent motivation to ensure that its GDP growth stays at 10%-plus. So with the arsenal of foreign reserves they can continue to tap to support growth, I would be looking at going long equities in emerging Asian countries, including China, as well as commodities, which move hand-in-hand with emerging markets.
Why would China want to lighten its holdings of Treasuries?
It just seems to be a no-brainer that you would rather support local consumption than buy U.S. Treasuries. The interesting thing is that, contrary to most people's impressions, foreign holdings of Treasuries are really short term. 50% of foreign Treasury holdings have a maturity of three years or less, so foreign holders are constantly facing the decision of what to do with rolling over that paper. It can change very quickly.
What keeps you up at night?
I do worry about preservation of capital from the standpoint of how many more unconventional policy actions we are going to have. If I am correct about the economic deleveraging still ahead and that it will continue for many years, that is a legitimate concern.
The best way to protect capital? Gold.
That is why I am long gold. I view it as the best way to protect my capital. The other worry is unemployment and this vicious circle where as consumers spend less, companies make less money, and they cut back workers.
The unemployment rate continues to rise. It is very hard to figure out how you break out of that.
In this article it is noted that in the 3rd quarter, for the first time since records started being kept in 1952, Americans actually reduced their debt. Mortgage-equity withdrawal (which, it is noted, sounds much better than "hocking the house") went into reverse to the tune of $170 billion in Q3. Yet, even with all this deleveraging, the ratio of debt to GDP remains "sky-high" at 228.6% of GDP -- partly due to federal debt issuance, which grew at a 39.2% annual rate in Q3.
SEMI-ANNUAL U.S. ECONOMIC OUTLOOK: COLLAPSING ON SCHEDULE
We regularly feature the Forbes columns of Gary Shilling, most recently one titled “Leverage and Pain” which alone tells one a fair amount about Shilling’s outlook. The Forbes columns are necessarily limited summaries of his thinking. This semi-annual forecast for the U.S. economy, courtesy of John Mauldin’s “Thoughts from the Frontline” e-publication, most helpfully lays out Shilling’s thinking in considerable detail. (“Thoughts from the Frontline” also appears on the website SafeHaven.)
Regular readers of Shilling's writing are aware that Shilling has been forecasting something in the nature of what is now transpiring for a long time. He has been right on the big picture. A look at selected quotes going back to 2002 -- however biased the selection process -- from his Insights newsletter listed on Shilling's home page serve as an adequate substitute for newcomers. What does he say now?
Among the more out-there forecasts are that the U.S. dollar bull market will continue for another 5 to 7 years, and that S&P 500 earnings per share will fall to $40. A P/E of 15 on these trough earnings would leave the S&P off 60% from its October 2007 peak. Emphasized passages in bold below are our addition.
The recession is now running on all four cylinders. We are referring to the four phases of the downturn that we identified much earlier and discussed in numerous Insights.
Phase 1, the collapse of the housing sector, touched off by the subprime slime, as we dubbed it, and measured by the ABX BBBindex, started early last year with the $1.8 billion writedown of subprime mortgage securities by big U.K. bank HSBC in February. Phase 2, the spreading of the woes to Wall Street, commenced with the implosion of two big Bear Stearns hedge funds in June 2007. These first two phases are largely financial, and persist today.
Housing starts have nosedived from 2.3 million, seasonally adjusted at annual rates, in January 2006 to 791,000 in October, a post-World War II low (Chart 1). Meanwhile, homebuilder sentiment is now at record lows. Leaping foreclosures, among other forces, have pushed up the homeowner vacancy rate. Some of the victims of declining homeowner rates are moving into rental apartments as the bubble years' lure of homeownership fades or they lose their houses. But others are doubling up with friends and family, thereby adding to empty house inventories.
As lenders spilled foreclosed houses on the market, they were sold for only 70% of the unpaid loan balance in the 3rd quarter compared with 78% in 2007, and losses averaged 44% of the loan balance compared with 29% a year earlier. With about 40% of existing home sales coming from foreclosures, or "short sales" in which the mortgage amount exceeds the house's value, the prices for selling homeowners and builders are forced to decline to compete.
Existing home prices are down in October 20% from their peak in October 2005 as measured by the National Association of Realtors, and 21% from their second quarter 2006 peak according to the less-upward biased Case-Shiller index (Chart 2). Curiously, a survey found that in the second quarter, 62% of homeowners believed their houses had appreciated in the last year even though 77% had fallen over that time and only 19% had risen, according to Zillow. Another survey found that 91% believe that a house is the best long-term investment. A third poll revealed that 32% think this is a good time to buy stocks, but 51% believe it is a good time to invest in a home. We wonder if that optimism will persist if our long-held forecast of a 37% peak-to-trough decline holds.
At present around 12 million homeowners, a quarter of those with mortgages, are underwater with their houses worth less than their mortgages. Among those who bought their homes in the past five years, 29% are underwater. If our forecast of a 37% house price fall is reached, about 25 million, or almost half the 51 million with mortgages, will be underwater. Adding in the 24 million who own their houses free and clear, and 1/3 of the total will be in trouble. The destruction of the American Dream of homeownership for so many people will force a political response, even though the cost of subsidizing their mortgages down to their house values would be about $1 trillion.
The woes of financial institutions also persist, fed by bad mortgages and increasingly by other troubled assets. The extreme stress on the financial system here and abroad is manifested in two clear ways: first, the consolidation and disappearance of many previously impregnable financial institutions and second, by the need for huge and continuing government bailout in order to preserve the integrity of the financial structure and, hence, the world's economies.
The list of the departed is well known: Bear Stearns, WaMu, Lehman and Wachovia disappeared while Merrill Lynch arranged a shotgun marriage with Bank of America and Morgan Stanley and Goldman Sachs converted to the safety of bank holding companies.
The FDIC recently announced that the institutions it insures had only $1.7 billion in earnings in the third quarter, down from $28.7 billion a year earlier. And financial troubles are not confined to banks. Many hedge funds have suffered huge losses on their highly leveraged positions this year. And their sales of securities to limit further losses and to meet investor redemptions are adding downward pressure on many markets. In some, assets are down 50% while others are folding their tents and still others are limiting redemptions, only adding to investor restiveness. Redemptions are expected to jump early next year.
Many endowment and pension funds have been hard hit, especially those with heavy alternative investments in hedge funds, private equity funds, venture capital, commodities, currencies, emerging market stocks and bonds, real estate, junk securities, etc. Diversification is a great idea -- if it works! But as we have noted continually in Insights for more than 10 years, there are tremendous amounts of hot money flowing around the world. And whether it is managed on the basis of fundamental factors, momentum, technical analysis, etc., it all tends to end up on the same side of the same trade at the same time.
So when stocks get clobbered, as they have since October 2007 (Chart 3), and force out hot money, it will also retreat from otherwise unrelated long positions in, say, grains, to conserve capital. Many institutional investors believe in the Modern Portfolio Theory of diversification, but erroneously thought that alternative investments would have zero or better still, negative correlation with their basic equity holdings. They also became convinced that commodities and foreign currencies were asset classes like equities and bonds, and merited 5%, 10% or 15% of their portfolios. They are learning the hard way that all those correlations have proved to be close to 100% and that commodities and currencies are not asset classes but speculations.
The Overarching Reality
Washington policymakers do not appear to have understood the overarching reality -- the massive and painful deleveraging of the immense leverage accumulated by the household and private financial sectors over the last three decades (Chart 4). They were also initially preoccupied with a philosophy of non-intervention in the private sector and with concerns with creating moral hazard if they bailed out troubled financial institutions. Furthermore, they have been making up the game plan as they go along. Last summer, Secretary Paulson told Congress that the $700 billion bailout money would be used primarily to buy troubled mortgages and mortgage-related securities from banks. Somehow, that would encourage banks to resume lending, but we never understood how.
Even though the majority of the $700 billion TARP money is yet to be committed, that total is only a small piece of the $4 trillion-and-counting sum the federal government has made to bail out the financial sector.
Included in that total beyond the $700 billion TARP program is $350 billion in FDIC guarantees on bank-issued debt, and Goldman Sachs, JP Morgan Chase, Morgan Stanley and Bank of America quickly raised $26 billion with Citigroup and Wells Fargo planning to follow. Then there is an estimated $1.3 trillion from the Fed to buy frozen commercial paper, $540 billion to buy commercial paper and other short-term debt from money market funds to stop the run on them, the new $200 billion Term Asset-Backed Securities Loan Facility (TALF) to back credit card, auto, student aid and small business loans and the $600 billion to buy mortgage-backed securities and GSE debt.
Of course, in what will probably be the worst financial crisis and deepest recession since the 1930s, it is not surprising that Depression-era bailout structures are being copied. The Reconstruction Finance Corp., instituted by President Hoover in 1932, bought positions in over 6,000 financial institutions to the tune of $50 billion, not adjusted for inflation or the growth of the economy since then. The government got senior voting rights to control these firms and barred dividend payments to shareholders until the government was repaid.
The worldwide recession is redirecting sovereign wealth money homeward. For instance, seven sovereign wealth funds in the Persian Gulf region are expected to lose 15% of their value, or $190 billion, this year, cancelling the likely $198 billion growth in crude oil revenues.
It is interesting that the Fed, with its new commercial paper program, is lending directly to nonbank corporations for the first time since the 1930s. But then the Fed can lend to anyone, you included, under "unusual and exigent" circumstances. The Fed is, after all, the nation's lender of last resort.
And do not worry about the remaining $370 billion in TARP money being committed. Detroit automakers want $25 billion. Homebuilders want money from somewhere for their $250 billion bailout, mentioned earlier. Banks not included in the initial nine to receive TARP money in the form of preferred stock purchases worry that if they do not ask to be included, they will appear too weak to qualify. Many of the nation's 6,000 small, non-publicly traded banks want their share of the government goodies even though they cannot issue preferred shares and warrants.
Spreading Domestic and Foreign Financial Woes
As consumers retrench and eliminate discretionary spending, they are increasingly regarding monthly payments on credit cards, auto, student and home equity loans as discretionary. When it is a choice between putting food on the table or making a credit card payment, financial responsibility is suffering. Delinquencies and charge-offs in these consumer loan categories are mounting with a 9% increase in auto loans 30 days past due in the second quarter vs. a year earlier and an 11% rise in those 60 days overdue.
Even upscale-oriented American Express, where over half its revenues come from fees paid by merchants, is suffering as charge volume falls and delinquencies and charge-offs on its credit cards rise, leaping 6.7% in September from 3.6% a year earlier. Consequently, the firm recently became a bank holding company so it could qualify for TARP money and hopes to get a $3.5 billion infusion. Credit card issuer Capital One has received preliminary approval for $3.55 billion in TARP money. Credit card issuers are also reacting to weakening volume and jumping charge-offs by raising interest rates and fees.
Student loans more than doubled from $41 billion in school year 1997- 1998 to $85 billion in 2007-2008, but almost all of the growth was in private loans, with subsidized federal aid relatively flat. And delinquencies are jumping in that segment. SLM, or Sallie Mae, the largest private student lender, reported a delinquency rate of 9.4% in September vs. 8.5% a year earlier. Parents, suffering from stock losses and the disappearance of home equity, are no longer able to bail out their debt-swamped offspring. Meanwhile, SUV and other vehicle owners who are now upside down on their auto loans due to weak used vehicle prices have limited zeal to keep up on loan payments. ...
Phase 2 of the recession, financial woes, are, of course, a global phenomenon. And so are the responses. The U.K. initiated the direct injection of government money into banks to buy preferred stocks. The British government had hoped to attract some private capital into HBOS and Royal Bank of Scotland, but collapsed share prices left the government with most of the new stock. Barclay's avoided government help, but with its stock down 70% this year, it may ultimately end up with a third of the bank owned by Middle East investors as it raises $10 billion. The Bank of Japan is injecting another $32 billion into the financial system by expanding lending and easing collateral requirements.
Switzerland depends heavily on her reputation as a super-safe haven for international money, and her financial services industry contributes 11.4% to GDP and employs 5.9% of her workforce. Yet the condition of her banks has deteriorated to the point that in October, her Economics Minister had to state publicly that the government would not allow big banks UBS and Credit Suisse to fail. The government is injecting $5 billion into UBS to back $50 billion in illiquid UBS assets. That bank has suffered over $40 billion in losses due to bad mortgage-related securities.
Credit Suisse is in better shape but suffered a $2 billion 3rd quarter loss due to writedowns on mortgage securities and unsold buyout loans as well as currency trading losses. The bank still holds $26 billion in leveraged loans and conventional mortgagerelated securities. Both banks are closing their bond funds for outside investors due to huge withdrawals following losses.
Meanwhile, the Netherlands agreed to inject $13 billion into the banking and insurance giant ING. In 2000, the Spanish central bank introduced its "dynamic provisioning" system that required Spanish banks to build up considerable reserves against potential future losses. As a result, Spanish banks began this year with 200% coverage of nonperforming loans compared with 59% for the average EU bank in 2006. Still, Spain recently set aside $41 billion to fund illiquid assets of her banks. And turbulent market conditions prompted Banco Santander, Spain's largest bank, to unexpectedly announce last month a $9 billion rights issue.
Russia has been floating on a sea of crude oil, but has sunk along with oil prices. Russians are fleeing the ruble for dollars and $83 billion left the country from August to October. The government has raised interest rates and spent heavily to cushion the currency's descent and avoid a repeat of its 1998 collapse. Still, the ruble is down 5% from its August high, and a halving of its current value is forecast. Meanwhile, plunging crop prices and a lack of credit is curtailing Brazil's soaring farm sector.
In Asia, Pakistan, which reluctantly sought a $7.6 billion IMF loan, really needs $10 billion to $15 billion to prevent economic collapse, government officials say. Dubai's pell-mell economic growth has been heavily financed by international debt that may be hard to refinance. South Korea, responding to shortages of foreign currency for her banks and businesses, in October announced a $100 billion government guarantee on foreign currency loans and a $30 billion infusion of dollars into her banks. More recently, that country has problems with high household debt, which leaped from 38% of GDP in 1997 to 66% last year and is probably higher today. And rising credit costs and falling stock and corporate bond prices are slashing the profits of Japanese banks and their ability to provide capital to the international financial system.
Central Bank Responses
Central banks have responded to the global financial crisis in three ways. First, the Fed cut the discount rate and then the federal funds rare repeatedly, starting in August 2007. The Fed has continued this traditional easing approach and other central banks have followed more recently and aggressively, including the European Central Bank, the Bank of England and the central banks of India, China, Australia, Norway, Sweden South Korea, the Czech Republic, Switzerland, Japan and even Indonesia.
Nevertheless, it became clear early on that rate cuts were of limited value since banks were so scared that they did not want to tend to each other much less customers. The spread between the London Interbank Lending rate on U.S. interbank loans and Treasury bills, which leaped in the summer of 2007, remains wide. Furthermore, central bank rates are approaching zero at which point, as we understand it, they will stop falling. So the ammunition of rate cuts is almost all shot off. The horse did not want to voluntarily walk to the water and, besides, the pond is almost empty. Fed Chairman Bernanke recently said, "The scope for using conventional interest rate policies to support the economy is obviously limited."
So the Fed moved quickly to step 2, leading the horse to the water. It introduced a succession of facilities to auction money to member banks, make it available to nonbank government security dealers, etc. The ECB and the Bank of England introduced similar facilities. Last August, the People's Bank of China, her central bank, relaxed credit quotas so most banks can lend 5% more this year and, more recently, allowed local companies to easily sell yuan-denominated debt of 3-to-5 years' duration. Then China, it increased quotes for state-controlled lenders by $14.5 billion this year, encouraged local governments to support credit guarantee firms and opened new financing channels including loans for mergers and acquisitions and for consumer finance.
India's central bank has repeatedly reduced bank reserve requirements as has China's. And the Fed has attempted to satisfy foreign banks' gigantic demand for Treasurys by mushrooming its currency swap agreements with foreign central banks and then providing unlimited dollars to the ECB, Bank of England and Swiss National Bank for lending to local banks. The top policymakers of the cautious ECB recently called for an "abundant and generalized" capital infusion into banks. But all these central bank efforts resulted in the proverbial pushing on a string. The funds have stayed in the banks and haven't been lent out and entered the money supply to any meaningful degree as banks want nothing but Treasurys. The central banks led the commercial bank horse to water, but he would not drink.
So it is on to step 3 with the Fed and other central banks, as well as governments, investing directly in Fannie and Freddie, AIG, banks, credit card issuers, insurers, etc. here and abroad, buying commercial paper and, most recently, purchasing indirectly credit card, auto, student and small business loan-backed securities and maybe extending later to commercial and residential mortgagebacked securities as well as subsidizing mortgage rates, as noted earlier.
Washington officials cringe at the suggestion that these measures amount to "quantitative easing," the Japanese policy initiated in 2001, because it failed to rapidly spur Japanese bank lending and the economy and arrest deflation. The Bank of Japan drove its target rate to zero with no effect and then tried to hype the quantity of money by buying government bonds, asset-backed securities and even stocks.
Current quantitative easing by the Fed may not be any more successful than it was in Japan since the global financial system is in a classic liquidity trap, as in the 1930s when bankers were defined as people who wanted to lend to those who did not need to borrow and did not want to lend to those who did. Today, banks do not want to lend to anyone but the U.S. Treasury.
The financial crisis spawned by the collapse of the residential mortgage market and the follow-on Wall Street woes obviously just had to depress the goods and services economy, and it has in Phases 3 and 4 of the unfolding recession. With the collapse in stock prices and evaporation of home equity, consumers have no other meaningful source of borrowing to fund their spending growth in excess of their after-tax income gains. Notice that home equity withdrawals through cash-out mortgage refinancing and home equity loans reached about $900 billion at annual rates, or around 10% of consumer spending. Now it is negative as principal repayment exceeds home equity withdrawals. So consumers' 25-year borrowing and spending binge, as witnessed by their quarter-century saving rate decline (Chart 5) and borrowing rate surge (Chart 6), is over.
In addition, Americans, especially postwar babies, have saved little for retirement as they concentrated instead on spending. The nosedive in stocks has only made retirement prospects more bleak. In the last 15 months, $2 trillion has disappeared from workplace retirement accounts, including 401(k)s, which now are the primary saving vehicle for 60% of employees.
As the housing and financial sectors continue to drop and U.S. consumers retrench, layoffs and unemployment will continue to mount. Payroll employment, which fell 533,000 in November (Chart 7), will probably continue to see monthly declines of 500,000 and the unemployment rate will likely exceed 8% by the end of 2009.
Housing and financial services job cuts are already large and more are coming. But job losses have spread well beyond housing and finance. Manufacturing jobs will continue to be lost as consumers buy fewer domestic goods and foreigners buy fewer American-made products. Retail jobs, normally the employment of last resort for the newly unemployed, are shrinking rapidly. Retail trade employs 10% of the total, but since November 2007, accounted for a quarter of jobs lost, or 320,000, as consumers cut their spending. And another 209,000 retail employees had their full-time hours cut to part-time. Estimates are that 6,100 U.S. stores -- ranging from mom-and-pops to major chains -- will fold this year, up 25% from 2007, and followed by 14,000 stores in 2009.
Impotent Monetary Policy
Conventional monetary policy ease through central bank target interest rate cuts at present is nearly useless, i.e., pushing on a string. Qualitative easing, now actively pursued by the Fed and the Treasury and by central banks and governments abroad, will probably at best only stabilize demoralized financial structures by substituting government securities for questionable assets with little near-term rejuvenation of lending and economic activity.
Also, bear in mind that in democracies, governments are almost guaranteed to be behind the curve in dealing with financial and economic crises. That is because voters elect them to respond to their concerns, not to act in anticipation of yet-unseen problems. Politicians are responders, not planners. In 2006, neither voters nor politicians wanted to prepare for a mortgage market collapse, but voters demanded and got swift action after the crisis unfolded in 2007 and this year.
This means that any resuscitation of the global economies falls on fiscal policy and, as usual, the effects will be delayed, influencing the recovery after the recession rather than shortening its normal course. The incoming Obama Administration is, of course, talking about a sizable fiscal package, perhaps $500 billion to $700 billion, or 3.5% to 5% of GDP.
That is a lot compared to the size of post-World War II recessions (Chart 8). Notice that the 1957-1958 recession, the most severe so far, has a peak to trough decline in real GDP of 3.7%, and the long and deep 1973-1975 downturn saw a 3.1% decline. We are forecasting the most severe recession since the 1930s with a 5.0% decline. You may think that a 5% decline is not a lot, but bear in mind that recessions are more interruptions in growth than economic collapses -- growth that business, consumers, employees and government assume will continue without interruption. Similarly, the 21% decline in the Case-Shiller house price index so far (Chart 2) is small compared with the more-than-doubling during the bubble years. Still, it is very painful for those who made small downpayments at the top and those who extracted their equity when prices were still high.
Even a $700 billion fiscal package would probably have limited impact on the recession, and not start to be effective until the end of 2009. And even then, the effects will probably barely offset the negative cumulative recessionary forces. Obama says his proposal will create 2.5 million jobs over two years. But as discussed earlier, payroll declines are likely to continue to run 500,000 per month, so his program would only offset five months of recessionary losses.
Phase 4 of the Recession, Its Globalization
Phase 4 of the recession, its globalization, is clearly underway with almost every major country's economy falling whether or not the official recession label has yet been applied. One indicator of weakness is the 2.4% decline in global semiconductor sales in October after a 2.1% fall in September from a year earlier, reflecting softness in computer and cell phone sales. The worldwide turndown is driven by housing slumps, notably in Ireland, the U.K., Spain, Australia and China. U.S. financial woes have spread to almost all major financial institutions worldwide. And consumer spending has been weak in Europe and Japan. U.S. consumer spending accounts for 71% of GDP but less than 60% in all other G-7 countries except the U.K. Sure, much more of healthcare and education expenditures tend to come from government, not consumer pockets in those lands, but households have traditionally been more cautious spenders than Americans, especially in recent years.
And this introduces another key reason for global recession -- retrenchment of U.S. consumers, which depresses U.S. imports on which the rest of the world depends for growth. The huge U.S. trade deficit is the counterpart of the rest of the world's huge surplus.
Obviously, the commodities boom is over (Chart 9). Prices of energy, base and precious metals and agricultural products are all down significantly from peak prices. The global recession has reversed the earlier excess of demand over supply.
Also, institutional and individual investors who earlier rushed into commodities under the belief that they are a legitimate asset class like stocks and bonds are stampeding out even faster. The financial crisis has also made investors wary of structured notes and other commodity-linked instruments -- and of the firms espousing them.
As noted at the outset, the first two phases of the recession were largely financial, the residential mortgage collapse and the following Wall Street woes. Then, like a tsunami in a swimming pool, that financial tidal wave rolled to the other side and inundated the goods and services economy, with Phase 3, consumer retrenchment, and Phase 4, global slump. Now the tsunami is being reflected back to the financial side of the pool in three ways.
First, retrenching consumers will keep pushing up delinquencies on credit cards, home equity, auto and student loan debt, which will result in big writedowns for their many institutional holders. Collectively, these four categories amount to $4.4 trillion, dwarfing the $0.7 trillion in subprime loans.
Commercial real estate debt is the second problem area, and of the $3.5 trillion outstanding, $800 billion is in commercial mortgage- backed securities and $2 trillion in commercial mortgages held in regional and community banks. As vacancies rise, big writedowns will follow.
Third is nonfinancial leveraged loans and junk binds. Delinquencies have barely risen from rock bottom levels, but will as anticipated by yield spreads and 20% junk bond yields. Recession-depressed revenues here and abroad, collapsing commodity prices and the leaping dollar that will turn earlier currency translation gains to losses, will all slaughter the corporate earnings of nonfinancial corporations, so far relatively untouched by the financial recession. So delinquencies and charge-offs of junk securities will leap and many investment-grade debts will be pushed into junk territory. Junk bond spreads vs. Treasurys now imply a 21% default rate, higher than in 1933 at the bottom of the Depression. Financial institutions also own a lot of the $3.7 trillion in leveraged loans and junk bonds.
If the tsunami moving from the goods and services side of the pool does considerably more damage to the financial side, it will again be reflected back and even tighter financing will devastate the real economy. Policymakers here and abroad, of course, are trying to erect baffles in the form of bailouts in the middle of the pool to dampen the waves. They are learning that they have to build those baffles bigger and stronger to prevent the waves washing over them. Their moves from Fed interest rate cuts to massive quantitative easing, described earlier, shows they are making progress.
Recession Ends When?
If policymakers succeed in containing the mortgage mess and bailing out financial crises related to consumer borrowing, commercial real estate and junk securities -- and other financial problems we have not explained in detail -- then the recession may well end at the end of 2009 as massive fiscal stimulus begins to take hold. If not, it probably will extend well into 2010 and perhaps beyond.
To end the crisis, four developments are needed, in our view. The elimination of excess house inventories will probably continue until at least the end of 2010, as discussed earlier. The writedowns and recapitalizations of financial institutions -- at least those related mainly to mortgage-related problems that have unfolded so far -- are well along.
Subsidizing the mortgages of underwater homeowners is beginning to develop. And of course the quicker the excess house inventories are eliminated, the more limited will be further house price declines and the fewer will be the additional homeowners who will slip under water. Bailouts of bad loans and securities in the three additional areas we have identified are big unknowns in terms of cost and feasibility. Nevertheless, policymakers are gaining experience as they grope their way through the current round of bailouts and may be real pros when further big problems surface.
The Dollar, Profits, P/Es and Stock Prices
At the end of last year, we forecast that the dollar would end its 7-year slump and rally later in the year against most currencies, but not the yen. And it did, starting in July. It was obvious a year ago that far too many were negative on the greenback. As with commodities, many institutional and individual investors considered foreign currencies as an asset class, worthy of a certain percentage of their portfolio.
Much more importantly, we were forecasting a major global recession and reasoned that, as usual in times of trouble, the dollar would be the global safe haven. We did not expect the U.S. economy to improve but that the rest of the world would join America in the tank. The greenback would be the best of a universally bad lot. We expect the dollar to keep rising for the next 5 to 7 years, continuing the long-run pattern.
Our forecasts imply S&P 500 operating earnings of $40 per share in 2009, down 35% from our $62 estimate for this year. That may sound extreme, but not for the most severe worldwide financial crisis and deepest global recession since the 1930s. At stock market bottoms, the S&P 500 P/E tends to be in the 10-12 range. But low interest rates normally push up P/Es and 10-year Treasury now yield 2.66%, and will probably be even lower later while 30-year Treasury bonds are now at 3.0%, our long-held target, and also a low in recent decades, but may drop further.
So a P/E of 15 at the stock bottom sounds reasonable, but would put the S&P 500 index at 600 then, down 32% from here and 61% below its record close on October 9, 2007. Wow! Earlier, we warned of the number 777, not the Boeing airliner model but the low on the S&P 500 in 2002. If it were breached, we noted, then the bear market that started in early 2000 would still be intact, and all of the rally from the 777 low in October 2002 to the peak five years later would merely be a rally in a bear market. Last month, the S&P 500 fell below 777. It has since bounced, but probably not for long as new lows lie ahead.
There are other reasons to expect considerable further weakness in stocks. High dividends can support stocks at least to a degree, and dividend yields in Europe are meaningful, averaging 5.2%. But not in the U.S. where the S&P 500 yield is a miserly 2.5%. And dividend cuts are coming fast and furious. In the U.K., dividends are constrained for financial institutions getting government bailouts, while in the U.S., the financial sector is slashing dividends.
Some 36 of the S&P 500 have cut dividends 46 times this year, axing $33.8 billion, with $30.8 billion coming from financials. Among those S&P 500 firms, about 20% of dividends this year are from financials, down from 34% in 2007. Elsewhere, REITs are cutting payouts, and GM eliminated its dividend. Only 202 S&P 500 companies have initiated or raised dividends 218 times this year, representing payments of $18 billion, with only $2.4 billion being from financials. In 2007, 298 did so and only 12 reduced or suspended dividend payments.
In troubled times, investors tend to withdraw from foreign markets to concentrate on the home scene they know best. That is why bear markets tend to be uniform. U.S. investors sold a net $92 billion in foreign stocks and bonds in the July-September period, a record flight from overseas investments, while foreign investors pulled over $100 billion from stocks in Japan, South Korea and India so far this year. U.S. stocks are actually falling less than most foreign markets.
For years, we have been forecasting that chronic deflation of 1% to 2% per year would start with the next major global recession. Well, it's here! In October, the U.S. producer price index fell 2.8% from September and the CPI dropped 1.0%, the biggest decline since before World War II. Sure, the big driver was the decline in energy costs, but even excluding food and energy, consumer prices dropped 0.1%.
The Fed worries that in deflation, offsetting monetary policy is difficult since its target rate has to stop declining when it reaches zero. Of course, the Fed has other tools as witnessed by the quantitative easing discussed earlier. Nevertheless, all these measures amount to leading the horse to water, as discussed earlier, and he may not drink. The deflation in Japan in the 1999-2005 years worried the Fed when it appeared imminent in the U.S. early in this decade, and it still does. Japan again faces chronic deflation, and the Bank of Japan forecast zero change in the CPI (ex-food but not energy) for the fiscal year ending March 2010. Fed Vice Chairman Kohn said the lesson from Japan was that "we should be very aggressive in combating deflation."
Deflation encourages saving since money is worth more later. It also spawns deflationary expectations. Buyers anticipate lower prices later by waiting to buy. That sires excess inventories and capacity, which forces prices down. Buyer suspicions are confirmed so they wait even further to buy, generating a self-feeding downward price spiral, as now seen in autos and houses. Deflation also elevates the cost of debts and debt service since both remain fixed in nominal terms but the revenues and incomes used to repay them tend to fall with overall prices.
Deflation fears and other forces have also reduced reducing 30-year Treasury bond yields to our long-held target of 3.0% and completed what we dubbed in 1981, when the yield was 14.7%, “the bond rally of a lifetime.” The recent financial crisis has also helped as investors abandon everything else -- stocks and fixed income alike -- in favor of Treasurys.
Deflation results from overall supply exceeding general demand. We have been forecasting the good deflation of excess supply, as in the late 1800s and in the 1920s, due to today's confluence of semiconductors, the Internet, computers, biotech, telecom and other productivity-soaked technologies. But we have allowed for the bad deflation of deficient demand, as in the 1930s, if one of two adverse conditions develop -- widespread financial crises and worldwide protectionism. Sadly, both are real possibilities.
Many, of course, worry not about deflation but inflation due to all the money being pumped out by central banks and governments globally. They no doubt are biased since most have lived only in an era of inflation and do not agree with us that inflation is the result of excess government spending in wars, both hot and cold. In peacetime, deflation reigns. Starting with rearmament in the late 1930s, then World War II and the Cold War with its hot phases, Korea and Vietnam, wartime and inflation persisted for 60 years.
For now at least, all that money from central banks and governments is not getting outside financial institutions. We are in a liquidity trap. The horse is not drinking, thank you very much. And if lenders do start to lend, central bankers, with their congenital fear of inflation, will no doubt reel in all that extra credit.
Even if the bank reserves stimulate the money supply with the usual multiplier effect, the credit created will pale in comparison to the destruction of derivatives and other privately-created liquidity due to persistent deleveraging and writedowns.
Finally, the consumer saving spree we are forecasting will probably increase the saving rate by one percentage point per year on average for the next decade. That would generate a cumulative $5.5 trillion and go a long way to offsetting the intervening fiscal stimuli, and then some.
DEFLATION BEAT JAPAN, NOW US
Japan has been trying all manner of fiscal and monetary stimulous for the last 20 years to avoid the aftereffects of its late 1980s bubble. To no avail. Effectively, Japan has tried everything except that which is needed, i.e., that which would allow a healthy reconfiguration of the economy. Now the U.S., in a vastly inferior fiscal situation than Japan in 1989, a weaker economic base, and without a vibrant world economy to latch on to, intends to right its economic ship doing much the same thing Japan did. Anyone see anything wrong with this picture?
A Wall Street Journal editorial on Tuesday (December 16) tallied up the approximately $1 trillion that Japan injected into the economy during the 1990s in a failed attempt to overcome deflation. That amounts to ¥118 trillion, and we doubt that anyone could have imagined it would not be enough to do the job. The initial $85 billion stimulus, by far the largest in Japanese history, came in August 1992. But when GDP and investment continued to fall and unemployment to rise, another package totaling $117 billion was enacted in April 1993. Still, the economy worsened. And so, in September 1993, a "modest" stimulus of $59 billion was added, along with some token deregulation. In retrospect, however, these outlays were just a warm-up for the fiscal packages that followed: $122 billion in February 1994; $137 billion in September 1995, $128 billion in April 1998; $195 billion seven months later; and another $146 billion in November 1999.
What Japan got for its money, the Journal noted dryly, was "better roads" -- along with anemic growth and an explosion in debt. What the Journal did not emphasize was that Japan's failed attempt to re-inflate the economy occurred at a time when its export business was thriving and the global economy humming. It is this fact that raises very serious doubts about whether fiscal stimulus can lift the U.S. economy from its trough. For how can we possibly expect to succeed if Japan, with its manufacturing prowess and deep-pocketed savings, could not, even during supposedly good times?
An Idiotic Idea
The global economy was relatively healthy when Japan was mired in a decade-long wallow. Now, in sharp contrast, manufacturing, trade and finance are in a worldwide state of collapse. For the U.S. in particular, the economic drag is compounded by a manufacturing sector in its worst shape ever. And yet, policymakers would have us believe they are going to end-run these problems by pumping up domestic consumer demand with looser credit. Officialdom and CNBC guests aside, is there anyone in America who actually believes this is the path back to economic health and prosperity? And, can anyone think that the Government's increasingly desperate attempts to induce buyers to pay more for homes will get us out of the hole?
This is surely one of the most idiotic ideas ever to captivate the popular imagination, and we can only hope that our populist President-elect understands this. Triggering off another credit binge, even if it were remotely possible, cannot possibly fix an economy that is drowning in debt. We can only hope, as our colleague Bob Hoye does, that Obama has the good sense first of all to do away with the Federal Reserve. That would be the single most effective and powerful step the Government could take to return control of the economy to the risk-takers and innovators who helped make the country great. More specifically, it would ensure, for the first time in more than a generation, that savings are channeled into the most economically productive enterprises, rather than into mortgages and other financial "products."
“BAD” RECESSION HARD TO DEFINE
At what point does a recession become a depression?
How bad could unemployment get in this economic slowdown? The author here argues we will see nowhere near the numbers of the 1930s depression. That is what the official statistics would indicate. But this does not mean incomes will maintain for those who keep their jobs. We could see under-employment becoming a much bigger economic problem than it was during the 1930s, where people are working hours well short of what they wish. Some interesting unemployment vs. slowdown severity projections are provided, notwithstanding the under-employment effect.
Our colleague Bob Bronson of Bronson Capital Markets Research notes that there does not appear to be a hard set of rules to help answer this question. "As far as we know there is no theoretic or empirically defined gradient for quantifying the full range of economic declines from recession to depression," Bronson notes in a recent email. "Please advise if you have information otherwise."
Anecdotally, a recession supposedly is signaled when your neighbor loses his job, a depression when you lose yours. There is a painful truth in this, since the economy, bad as it is, undoubtedly looks much worse right now to someone who has been unemployed for a few months. But when we consider the big picture, unemployment is nowhere near the levels of the 1930s. In fact, by 1933 slightly less than 27% of all wage earners -- about 15 million workers -- had been fired or laid off.
Could things get that bad this time around? It seems doubtful, since so many workers have relatively secure jobs in local, state and federal government. But we see under-employment becoming a much bigger economic problem than it was during the 1930s. While even in the worst of times the vast majority of workers may be able to avoid filing for unemployment benefits, their incomes could nonetheless fall to subsistence levels.
Indeed, many, if not most, of the country's top earners are unlikely to show up statistically as unemployed, even if they are down-and-out. In New York City, for instance, a complete economic collapse looms because such high-wage categories as investment banker, stockbroker and, soon, realtor, have crashed and burned. But we would be surprised if even a small fraction of those whose incomes went to zero after they had grossed more than $1 million per year in good times are collecting unemployment benefits now, or will collect them in the future. Why would some high-powered consultant who cleared a million dollars last year want to go on the dole if he thinks he can "beat the draw" of weekly unemployment benefits totaling $500-600 at most?
Under the circumstances, we could see huge under-employment in this country without a rise in official unemployment much above 10%. Be that as it may, below is a scale worked out by Bronson that could be useful in qualifying the pain of hard times based on unemployment levels. "The idea behind this exercise," he explains, "is that using the word 'depression' loosely is not meaningful or helpful without a reasonable definition. While we warned more than 10 years ago of a coming ultimately deflationary economic Supercycle Winter, we still do not see it becoming a 'depression' by any reasonable definition -- hence the table below -- notwithstanding that the last such Supercycle Winter included The Great Depression."
INTREPID INVESTORS ARE BUYING HOUSES OUT OF FORECLOSURE AND RENTING THEM OUT AT A PROFIT
How do 9% cash-on-cash yields while you wait for a recovery sound?
In an asset bubble the expectation of capital gains gets embedded in the asset's price to an unreasonable degree. What is unreasonable? In depends on the market. Let us take a look at housing. The value of a nation's real estate stock cannot grow faster than the national income indefinitely. A certain percentage of the national income can go into living expenses such as housing but no more, so there are inherent limits. During the housing bubble one could compare rental values with asking prices and the huge gap was clear. The prices would not make sense absent huge annual increments in rental rates which would accompany virulent inflation ... or if housing prices were going to keep rising much faster than GDP indefinitely. As mentioned, this was impossible.
Now, well into a housing bust, investors are noticing the rental/purchase return gap has vanished. If you can buy a house out of foreclosure and get a rental return that is greater than your carrying cost you have a low risk investment opportunity ... if the risk of capital losses is low. Intrepid early investors wading into the foreclosure market are attempting to mitigate that risk by choosing their shots wisely, as one expects with smart contrarian money. Later entrants will not be as careful, although the next time around they will not have as much stupid money backing them as last time.
Randy L. Perkins amassed a nice fortune in real estate, life insurance and investment banking in southern California over the past 30 years. Since May he has sunk $5 million of it into the one place most investors least want to be: housing.
Perkins has bought two dozen homes in the San Diego area through his Westview Financial Group. One was a dilapidated 3-bedroom stucco in Escondido for which Westview paid $158,000 -- a 61% discount from the previous selling price of $408,000.
Westview chased out a couple of squatters. Then, even before it could finish fixing up the place, prospective renters started showing up on the doorstep. Many were people looking for a place to live after losing nearby homes in the property bust.
Westview eventually spent $40,000 on acquisition costs and improvements. Then it rented the home for $1,800 a month, is a 9% return on the acquisition cost before income taxes (which are modest on real estate, thanks to depreciation writeoffs). If Perkins is condemned to sit on this property for a long time, waiting for the market to come back to life, he will not suffer. That 9% cash-on-cash yield is more than triple the 2.9% dividend yield on the S&P 500.
"I got my real estate broker's license at age 21," says Perkins, now 54. "I've seen these cycles before, but I have never seen price drops this dramatic."
San Diego had one of the bubbliest markets of all, with home prices tripling in the decade through 2006. Since then it has been all downhill. The Fiserv Case-Shiller index says prices have fallen 31% in the past two years. Currently one in every 32 San Diego homes, a total of 34,854 units, is in foreclosure. That ranks it as the 21st-most-troubled housing market in the nation (California's Stockton area gets the booby prize, with one in 12 homes in foreclosure).
Now first-time buyers and investors like Westview are offering a glimmer of hope. In September the number of San Diego homes sold rose 56% from a year earlier to 3,366, according to DataQuick. More than half were bought out of foreclosure, indicating that Perkins is far from alone in seeing promise amid the wreckage.
"San Diego is a microcosm of the California market," says Christopher Thornberg, founder of Beacon Economics, a Los Angeles economic consulting firm. "It was one of the first to crack and is now one of the first settling into a landing pattern."
Perkins and his son, Robert, stumbled upon the idea of buying busted homes when a friend showed them two residences in a town in northern San Diego County that he had bought from banks, fixed up and rented out. Robert, 26, put together a business plan and showed it to agents and others knowledgeable about the market.
Robert hired his former college roommate, Brian Archambault, to spend two months chatting up barkeeps and shop owners in various neighborhoods to get a feel for the market. Westview used that intelligence to home in on the northern San Diego neighborhoods of Escondido and Oceanside, where Camp Pendleton, the Marine Corps base, provides jobs and limits urban sprawl. Currently on Westview's do-not-go list: southeastern San Diego, especially Chula Vista, where the skeletons of unfinished homes dot the landscape.
Westview has paid an average of half the previous selling price (in cash) for its two dozen homes over the past six months. It has also hired two more employees, Harlan Wilkie, Robert's brother-in-law, and Jeffrey Badelt, a 25-year real estate veteran, to help scout, buy and oversee renovation of its holdings.
Guidelines: Properties must be free of graffiti, which can be a sign of gang activity; separated from multifamily housing, with its noise and high turnover; and on a block where residents care enough about appearances to display potted plants and keep up paint jobs. Westview avoids houses selling for over $300,000, which are hard to rent at a profit.
Others see promise in the market, too. Brokers say homes listed below $200,000 are attracting multiple offers. Westview recently competed with 25 bidders, nearly all investors, for a 3-bedroom home in Escondido.
Most of the agents on an October home tour said they represent clients looking to buy multiple foreclosed properties. Six months ago such clients were scarce. Gregg Alexander, a ReMax agent, is touring foreclosed homes with a half-dozen potential investors. He has also purchased five for his own portfolio this year.
Silver Portal Capital, a San Diego real estate investment bank, is raising $100 million to $200 million in institutional capital to buy 1,500 homes. It is biding its time for the next month or two, however. It expects San Diego's unemployment rate to rise from its current 6.4%
"Some areas have probably bottomed," says Burland East, the firm's principal. "But this is not like a one-day sale after Thanksgiving. We are expecting a shallow, saucer-shaped bottom."
Westview, meanwhile, is doing just fine renting out its properties. Most are in lousy shape when it takes ownership. One in Escondido had lost copper plumbing and wiring to scavengers. At another the deck was stripped to concrete and chicken wire.
The company has assembled four crews to replace fixtures, apply paint and restore garages (several of which had been converted into rental rooms by former owners in last-gasp bids to keep up with mortgage payments). Upgrades add as much as 20% to purchase costs. Badelt, Westview's real estate veteran, makes sure to upgrade kitchens to appeal to prospective female tenants.
One of the biggest impediments to moving homes more quickly: chaos at the banks, which are swamped with real estate workouts. "I have seen banks refuse an offer and then a few weeks later lower their asking price to that same offer price. It is absurd," says Glen Brush of Brush Real Estate in San Diego. "Often it takes months for these guys to respond to an offer. By then the buyer has moved on."
Perkins the younger says Westview will pick up its buying pace this winter. He expects it to be in the rental business for 5 to 10 years and eventually sell its homes at a substantial profit. "Lots of multimillionaires will come out of this," he says.
The article concludes with a useful table comparing capitalization rates -- a real estate term defined as net operating income divided by property cost (excluding debt servicing) -- for multifamily housing units in several major U.S. metropolitan areas. The highest rates shown are for Detroit and Cleveland. Our guess is that buyers are factoring in further capital losses there.
$50 BILLION PONZI SCHEME IS NOT THE BIGGEST, OR LAST ...
Exposure of the largest Ponzi investment scam in history, run by one Bernard Madoff, has recently hit the news. The $50 billion in investor losses incurred reduces scammer legends of yore such as Robert Vesco and Bernie Cornfeld to the realm of absolutely amateur pikership -- just as this year's $700 billion financial system bailout to nowhere reduces the $500 million "Bridge to Nowhere" semi-scandal of yesterday to rounding error.
Rick Ackerman notes that Madoff's victims were rich people -- "qualified investors" in SEC parlance -- who had too much money burning holes in their pockets. There is some obvious irony in the requirement to be rich enough to qualify for being scammed. Meanwhile, the Ponzi Social Security system is to Madoff as Madoff is to Vesco, or something like that. And no one has to qualify to participate in that scheme. In fact certain parties take rather strong exception if you tell the SSA, Sam Goldwyn style, to "Include me out." Unfortunately there is no irony there, so it is not even good for a hollow laugh at your own expense.
The $50 billion Ponzi scheme that rocked the investment world last week makes swindlers from the good old days look like pikers. Even after adjusting for inflation, the $220 million that Robert Vesco supposedly stole would amount to only a billion dollars. Bernie Cornfeld? Tito D'Angelis? Stanley Goldblum? These con artists of yesteryear no longer rate even a dishonorable mention in the Guinness Book of Records now that Bernie Madoff has come along with a scandal truly worthy of these times.
The celebrated money manager and Palm Beach socialite had boasted 10% returns stretching back through good times and bad as far as anyone could remember. Some were skeptical of his success, and in 1999 one of his competitors, Harry Markopolos, asked the SEC to investigate Madoff's impressive streak, claiming no one could have compiled such an impressive track record honestly. "Bernie Madoff's returns aren't real, and if they are real, then they almost certainly would have been generated by front-running customer order flow."
Markopolos did not know the half of it, since front-running is one of the least-prosecuted crimes on Wall Street. Nearly everybody does it, and for Markopolos to accuse Madoff of mere front-running was like accusing a tavern owner of watering drinks. Madoff was able to shrug off the accusation publically, telling Barron's in 1991 that the charges were "ridiculous." And so they were, to the extent they egregiously underestimated the brazenness of Bernie Madoff's thievery.
Madoff has already copped to the crime, and it was his own sons who turned him in after hearing the full story straight from the horse's mouth. As details emerge concerning who among the rich-and-famous got burned, and for how much, the Madoff saga promises to be the most entertaining story out of Wall Street since Enron. Those who even qualified to park funds with him were bound to have more money than they knew what to do with, and their sob stories are going to be about as touching in print as those of the late, unlamented Leona Helmsley.
Meanwhile, does anyone appreciate the irony here -- that we are all in the same boat, more or less, as Madoff's clients? Their great misfortune was to have qualified financially for an investment opportunity that was much too good to be true. But the rest of us will continue to support an even bigger Ponzi scheme -- the Social Security System -- for the rest of our working lives. In the end, the deflating away of illusory wealth will bring rich and poor alike to the maw of penury: the former, because they leveraged their considerable savings in ultimately worthless paper; the latter, because they had relatively little in savings to begin with -- other than inflated real estate.
Literally overnight, revelations of criminal misdeed have reduced the value of Bernie Madoff's portfolio to zero. But -- let us not kid ourselves -- when the assets held by the rest of us eventually are marked to market, it is quite possible they will turn out to have performed no better than Madoff's criminally mismanaged portfolio.
11 profitable companies with stocks trading below $10 a share – less than the cost of two lattes.
Barron's screened through the low-priced nether-regions of the S&P 500 universe and came up with 11 possible buys: Starbucks [symbol: SBUX], Southwest Airlines [LUV], Tyson Foods A [TSN], Boston Scientific [BSX], Jabil Circuit [JBL], Eastman Kodak [EK], Compuware [CPWR], Motorola [MOT], Tellab [TLAB], Interpublic Group [IPG], and Genworth Financial [GNW]. Not exactly a shabby bunch of names.
The S&P is on sale, and there are bargains to be had among the stock market's lowest-priced issues. To find them, Barron's first screened the Standard & Poor's 500 for stocks trading below $10 a share -- a group that currently numbers roughly 80 issues, or 16% of the index. Most are down more than 50% this year, amid the worst bear market in years.
To separate the potentially troubled from the merely cheap, we then screened for companies likely to increase earnings per share -- even if only by a penny -- in 2009. And, to weed out the dangerously debt-encumbered, we looked for companies with long-term obligations of less than 50% of total capitalization. You will find the "survivors" -- an eclectic 11 -- listed nearby.
Sugar markets have trouble finding sweet spot as demand shifts.
Markets make opinions, especially with commodities. Today's soaring prices accompanied by forecasts of indefinite capacity constraints turn on a dime, giving way to surpluses and plunging prices. Sugar is not atypical here. Bullish prognosticators from earlier this year have pulled in their horns. Those who forecast shortages now believe the market may turn out to be in balance after all.
The near-term outlook for the New York sugar market is none too sweet, with demand shaky, a recession under way and many investors continuing to pile out of commodities.
Redemptions at hedge funds, one of the major forces in the market, persist as commodity prices have fallen across the board, and sugar in particular is facing significant selling because of annual index-fund rebalancing. Index funds reweight their allocations based on market trading: They may withdraw from investments in commodities that have risen in value, as they invest in those that have fallen. Given sugar's gains earlier in 2008, traders estimate that about 40,000 sugar contracts on ICE Futures U.S. will be sold by commodities indexes in January's first week, when the rebalancing normally occurs. ...
European bank Fortis predicts that March sugar will fall to 10 cents a pound in December, on redemptions and reweighting. On Friday, ICE futures U.S. March contract sugar settled at 11.64 cents a pound, up 1% from a year ago and up 10.1% on the week thanks to declines in the U.S. dollar and an estimate of a slightly smaller crop in Brazil's key center-south producing region. ...
Yet even after fund-reweighting pressure lifts, the outlook is likely to stay sour on demand contraction amid the global economic slowdown. Analysts who were bullish on sugar prices earlier this year -- they were predicting a shortage in 2008-09 following several years of surplus -- now are less optimistic. "There is deep uncertainty regarding demand right now," says Fortis. "If demand growth turns out to be flat during the current season, the putative deficit will disappear, and the market will turn out to be in balance." ...
But sugar may revive: Tight credit is likely to hold down production gains, helping to support prices. And the number of sugar mills set to open next year in #1 producer Brazil has dropped, and some of the cane in the coming 2009-10 crop might be left unharvested as the credit crisis stalls milling-capacity expansion, says Plinio Nastari, president of Brazil-based analyst Datagro.
A Case Against Option Selling
Anyone who has ever bought a stock option contract and then watched the premium melt like ice on pavement in the summer sun might well conclude that the real money is made by options sellers, assuming they diversify and have the capital to take the occassional hit. Academic research has supported this idea.
Not so fast, say two equity-derivatives trader/analysts from Credit Suisse. If you are trying to forecast the future rather than the past, they believe that "buying options, rather than selling, has a certain logic."
In January, the Chicago Board Options Exchange's market volatility index, or VIX, was at 22, a level everyone thought was extremely elevated. Now, on the cusp of 2009, the VIX is at 55 -- a 350% premium to its historical levels since 1954, when the Standard & Poor's 500 began trading.
So conventional wisdom says that volatility, and thus options pricing, should decline from here. That is why there is much with fascination with option-selling strategies, which assume that market volatility eventually snaps back to historical norms.
But investors must question the crowd and ask: Is VIX at 55 priced right? Is the options market fully expressing the daily, dramatic changes coming out of Wall Street and Washington?
We say perhaps not, and believe a case can be made for holding, if not buying, options.
Advocates of short-options/short-volatility strategies point to academic research based on past -- and comparatively more subdued -- movements in stock prices as an indicator of future market volatility. In our experience, relying on this metric is like driving your car using rearview mirrors -- and hoping the road does not curve.
Plunge in the Dollar Could Get Serious
Rick Ackerman thinks the the dollar's recent fall vs. other currencies is more than just a correction within a bull market. Others disagree with him -- see the Gary Shilling post above -- but here is Ackerman's dissenting opinion to that opinion.
Is the dollar finally starting to crack? It surely looks that way, although we will need to see another day or two's worth of action before we can be more certain. The carnage so far has crushed two key supports on the Dollar Index's daily chart, and it will not take much more selling to obliterate a third, greatly compounding the technical damage thus far. That would occur if the steep plunge begun on December 4 surpasses the 80.75 low labeled in the chart below. If this were to occur without an intervening correction lasting more than a day, it would make the selloff the most powerful we’ve seen since the dollar embarked on a huge short-squeeze rally in July.
We have written extensively about the seeming anomaly of an intrinsically worthless dollar moving relentlessly higher, as it had been doing until late October. This was not a flight to safety, as mainstream reportage had it, but a massive short-squeeze powered by borrowers of dollars who have been finding it increasingly difficult to keep rolling their loans. Although we might have expected the dollar to climax more spectacularly, putting a decisive end to the dollar's reserve currency status, we are open to the possibility that its last gasp is taking the form of a garden variety head-and-shoulders formation (also shown in the chart).
Whatever the case, buyers of gold and silver have not been timid about discounting the dollar's fall. Yesterday, Comex contracts for both metals exceeded minor Hidden Pivot rally targets, raising the odds that they will soon achieve even more-ambitious targets that come from the larger charts and which were spelled out Sunday night in the touts section of Rick's Picks. The higher targets are well shy of new record highs, but if they are achieved it would imply that there is sufficient buying power to refresh the bullish trend for yet another run (in Gold) to $1,000.
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