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KNOWING WHEN TO HOLD AND WHEN TO FOLD
An interview with legendary value investor Robert Rodriguez.
Esteemed value investor Robert Rodriguez, 60, has the courage of his convictions. He is willing to make big sector bets and is willing to hold large cash positions if he cannot find anything interesting to buy. The best laid plans are not foolproof: His equity fund still lost 35% last year despite a large cash position and the avoiding the financial stocks that other value investors thought looked cheap. Looking through stock prices to the underlying assets, however, Rodriguez regards the hit energy stocks took as “just a deferral of performance,” as opposed to “a permanent loss of performance” suffered by financial stock investors.
Rodriguez also has a willingness to look at the macro picture through a filter of common sense often lacking in the mainstream investment industry. He went on a “buyers strike” in his bond fund when Greenspan drove yields down: “I was so upset and fed up with Greenspan, but I said it in obscurity. I was concerned about too much liquidity. At the time, Greenspan was still considered the maestro, so this is not about Monday-morning quarterbacking.” Rodriguez declined to reach for yield by buying longer duration or lower quality bonds just because misguided policies messed up the market.
And his assessment of of the federal government’s $787 billion stimulus package? “They are trying to restart consumption and lending, but I have a news flash: It was excessive consumption and excessive debt creation that got us into this mess.”
Rodgriguez’s equity fund is currently about 36% in cash, and about half of the equity holdings are energy-related. What is he waiting for before putting more money to work in equities? “This credit crisis still has a long ways to go.” We suppose this answers the question.
The typical value investor reluctance against making top-down asset allocation decisions is lacking here. The Stock Trader’s Almanac attributed to William Silber this quote: “If models are telling you to sell, sell, sell but only buyers are out there, don’t be a jerk. Buy!” Now one might well reverse the instances of “buy” and “sell” in the quote.
For Robert Rodriguez, 2008 was a tale of two asset classes: stocks and bonds. The FPA New Income Fund (ticker: FPNIX), which focuses on bonds, earned a total return of 4.3% last year and bested 86% of its peers. That strong showing led Morningstar to name Rodriguez its 2008 Fixed-Income Manager of the Year.
While his stock fund beat the S&P 500 by 2.2 percentage points, FPA Capital (FPPTX) was down 34.8% in 2008. Yet this mid-cap value portfolio’s 10-year annual return is 5.5%, putting it in the top quartile of its peer group.
Rodriguez, 60 years old, co-manages both funds from his Lake Tahoe, Nevavda, office (First Pacific Advisors, with $8.8 billion in assets under management, is based in Los Angeles.) His investment mantra is “winning by not losing,” and he has a lot to say about the bond market, equities, the economic stimulus package and more. Barron’s caught up with him last week when he stopped by our New York offices.
Barron’s: Before we look ahead, let’s review last year’s equity market. What is your take?
Rodriguez: The equity market did not surprise me. I warned that 2008 was going to be very tough – and that the second half was going to be a lot rougher than the first half when the realization hit that corporate profits were going to be substantially less than expected. I also expected that the credit crisis was going to not only get worse, but that it was going to extend through 2008 and into 2009, which was not what a lot of people were expecting.
What would you have done differently in the equity fund?
There is not really a lot I could have done here. Throughout 2007 and ‘08, we had just under $1.2 billion of redemptions in all of the equity accounts, including the mutual fund, so we were fighting a rear-guard action.
In the 3rd quarter of 2008, we had $300 million flow out from one account, a large banking relationship. The reasons given were that, all of a sudden, we had too much cash – and that was upsetting their asset-allocation modeling. Secondly, they could not decide whether we were a small-cap value manager or a mid-cap value manager. So I said, “May the pinheads of the world unite.”
Maybe we should have liquidated more of our consumer stocks – although over two-plus years, we eliminated more than 70% of our consumer stocks. We liquidated one of our energy companies, National Oilwell Varco, and we cut back on every one of our energy holdings. That is when the cash levels in the FPA Capital Fund hit 45%.
One of your best moves last year was to avoid the financials.
I looked at the portfolio and thought, we will probably get hit in some areas that we probably should have sold. But we have done probably about 95% to 98% of what we could have done, and it was up to the gods. There is a difference between value managers who got hit with [holding] financials and myself. For the value managers who owned, say, AIG, Lehman Brothers, Bear Stearns, Washington Mutual and on down the list, all of those are permanent losses of capital. But for the energy companies that we have owned and taken a hit on, they have cash, pristine balance sheets, virtually no debt, and their equipment is good for 25 years.
Could you give a few examples?
Ensco International [ESV] and Patterson-UTI Energy [PTEN] in the oil-service equipment sector. Some of these companies are back to valuations and prices of 2001 and 2002 variety. We see energy as just a deferral of performance, rather than a permanent loss of performance.
We also like Arrow Electronics [ARW] and Avnet [AVT], two of the world’s largest electronic distributors. They have the strongest balance sheets in their history.
What is your cash position in the equity accounts?
Some of Rodriguez’s Picks Company Ticker Recent Price ($) Ensco International ESV 25.50 Patterson-UTI Energy PTEN 8.68 Arrow Electronics ARW 17.19 Avnet AVT 17.71 Source: Bloomberg
Approximately 36%. Of the 64% that is invested in equities, about 32% of that is in energy.
So you have made a big energy bet?
Right. For more than one year, we did not make any stock purchases. Then, on October 7 of last year, we began a buy program that continued through December 23. It was the largest capital commitment we made in about six years.
From October 7, when the buy program began, through February 10, the Standard & Poor’s 500 was down 17%, the Amex Oil Index was down 3.2% and the Philadelphia Oil Service Sector Index was down 22.7%. That is a pretty negative period. The entire purchase program for that same period of time was down 0.4%, and the energy purchases were down 0.8%.
What made you jump in?
That was very close to the high-water mark of fear and depression in the equity market. If we had not deployed some capital, then the clients and shareholders and others, including the press, would be saying, “If that does not get you to buy, what will?” So we would always be on the defensive. And even if you were right longer-term, but you had a rally in between, you would look foolish. So I thought there is a business risk in there if we did not do something, and we thought a number of the securities had gotten pretty depressed. So we deployed some capital. Now I am sitting back; we have not made one purchase since December 23, though we are doing a little bit of selling.
What are you waiting for before putting more money to work in equities?
This credit crisis still has a long ways to go. For example, commercial real estate is just in the process of breaking. In many cases, commercial real estate could be down 40% to 50%.
Think of New York City. When were the real layoffs? They really just started about midyear and in Q4 2008. That reality has not hit. As for equities, my expectation is that earnings expectations are still too high. They are going to be ratcheted down this year. There was a movement into high-yield bonds in November and December, but the default rates are still ahead of us for 2009, 2010 and probably into 2011. So I am still cautious.
It has been suggested that while you have done a great job getting the macro picture right, you have had a harder time executing in terms of running a stock portfolio.
There is a bigger issue here, which is what style performed in 2008? Last year will go down as the year diversification did not work, whether it was international, domestic, large-cap, small-cap, mid-cap, growth or value.
For several years I have been arguing that there was far more covariance between the various investment styles and investment products. Another concern for me was U.S. consumers as a percentage of worldwide [gross domestic product]. I said, “When this breaks, you are going to tell me the international area is not going to be affected?”
I learned a long time ago that if I am going to get killed in something, I would rather get killed in something I already know than in something I am getting to know. In 1974, we got our cash levels up to 60%; this time around, we could not get there.
What will the shake-out be for asset managers?
The investment industry has some real issues and questions to answer, just like it did post-1974. Since that era, we went through all the slicing and dicing and we had all these little style boxes – but that has been blown away. For years, I kept saying that in equities I believe in the land of tall trees.
Could you elaborate?
We own only a couple of industries, and we ignore everything else. That was considered too risky, but I said, “Well, your diversification that you think you have is not really diversifying the risk.” I have been waiting for several years for what I would call a flushing out to finally demonstrate what I have been talking about. Thus, the investment industry over the next five to 10 years is going to look materially different from the investment industry pre-2008.
What has been your approach in your bond fund, FPA New Income?
Three years ago, I started talking about how we are no longer going to be Baskin-Robbins [ice cream] with 31 flavors of bonds. This has been a continuing process, and what we are really talking about is a difference in time frame.
Getting back to equities for a minute, if you are measuring performance over one year, yes, our stock selection could have been better. But if I extend that time frame over a longer period, maybe three to five years, we are going to see a different outcome.
For example, for four years, I opposed investing in financial-services companies. For three years, we looked like idiots as the other value managers’ returns were going up. Then, all of a sudden, it hits – and, gee, the reasons why we were not doing as well as some other value managers turned out to be correct. Was that underperformance really underperformance, or was it really that we recognized a risk that others did not see?
In terms of fixed income, you went on a so-called buyer’s strike in June of 2003, given your concerns about too much liquidity in the financial system and that spreads kept narrowing. You pulled in your durations and emphasized high-quality holdings such as two-year Treasuries.
When we announced a buyer’s strike, I was so upset and fed up with [former Federal Reserve Chairman Alan] Greenspan, but I said it in obscurity. I was concerned about too much liquidity. At the time, Greenspan was still considered the maestro, so this is not about Monday-morning quarterbacking. Has anything changed over the last couple of years that would have changed my decision on the buyer’s strike? No. We only had one period of time when 10-year Treasury rates went above 5% for any length of time.
But in 2005, 2006 and part of 2007, the bond fund had net redemptions. Just as we would not buy any financial-service stocks, we would not buy any of the alphabet soup like CDOs [collateralized debt obligations] or CLOs [collateralized loan obligations] to reach for yield.
It must have been difficult in 2005, 2006 and into 2007 to see spreads keep narrowing while you were holding plain-vanilla, fixed-income securities.
I did not worry about it. We do not manage bonds over a one-year time horizon. We think over a 3- to 5- year horizon.
Where do you see rates going?
In the 4th quarter of last year, new Treasury issuance was $677 billion, which equates to a $2.7 trillion annualized rate. That was my estimate, which does not look too far off the mark, given what has happened in Washington recently with the stimulus package. Whenever I ask people who was the #1 purchaser of Treasuries last year, they all say China. Then I ask who was #2? They all say Japan, which is wrong. It is the U.K. So I see some issues here with the growing supply of Treasuries and, hence, a steepening yield curve.
So you expect rates to go up?
Over time, yes. The federal government has manipulated the rates in mortgages. They have manipulated the rates in the short-term market, trying to get liquidity going. The Fed will be buying Treasuries, and that may push rates down for a period of time. My esteemed colleague Julian Mann uses this analogy: Imagine you are holding a basketball under the water. You can only hold it down so long, and then it pops up. That is what the federal government is doing.
On the bond side, you like short-duration and high-quality holdings. Can you be more specific?
We have a small area of the mortgage market that I will not disclose, because it is a micro area where we are getting some value – yields of about 3.5%, 4% – with an average maturity of about 2 1/2 to three years. We also like various forms of agency paper. We are very selective in mortgage-backed securities, though we will not buy any new-issue single-family mortgage securities. We do not trust the government, which is changing the rules of the game in terms of mortgage modifications.
What about corporate credits?
Not yet. When people were buying corporates and high yields in November and December, the general consensus was that in the second half of 2009, the economy would be recovering – but corporate profits are coming down.
Any interest in Treasuries or high-yield?
We entered 2009 expecting that it would be an incredibly difficult year for the bond market, especially in high-quality sectors and in the super-high-quality Treasury area of any duration. And a steepening of the yield curve would drive total returns into negative territory. If we put money to work in high yield, unless we were perfect, a small allocation could wipe out the income if we were wrong.
What is your assessment of the federal government’s $787 billion stimulus package?
They are trying to restart consumption and lending, but I have a news flash: It was excessive consumption and excessive debt creation that got us into this mess. The government is trying to act as the consumer of last resort.
Rather than giving an $8,000 credit to buy homes, we should be reinvesting this money to change part of the industrial dynamic of the U.S. economy. Over the next 10 to 15 years, exports as a percentage of GDP are going to have to go up. We are going to be in a donnybrook. If we do not increase exports to replace the contraction of consumption, we go to the government to be the consumer of last resort. And then GDP growth will be worse off.
Thanks very much, Bob.
A DOUBLE DISCOUNT AT LOEWS
The Tisch family’s New York conglomerate is trading at a sizable discount to its depressed asset value.
Loews is not as well known as Berkshire Hathaway, nor is it held in quite the same high regard. Nevertheless the controlling Tisch family has a long-term record of building asset values that any money manager would be happy to have. They like cheap assets and are willing to wait a good long time to realize the inherent values. It is safe to assert that the Tischs have a greater affinity for hard assets than Buffett, which is not to say they do not pay attention to cash flow – witness their longstanding and recently divested ownership in cigarette manufacturer Lorillard. Their major investments of the last two decades have been energy-related, notably buying offshore drilling rigs when they were selling for a song in the early 1990s. The long-standing albatross around the Loews neck has been its investment in mediocre – at best – property and casualty insurer CNA, which always looks cheap and whose performance turns out to justify the cheapness.
In good times Loews sells at a narrow discount to its estimated net asset value. Part of the discount is rational because the capital gains taxes that would be owed on an outright liquidation would diminish the NAV. Another part of the discount is due – as far as we have been able to tell – because people do not like CNA. The discount has averaged 20% over the past two years, according to this Barron’s article. In today’s not-so-good times Loews sells at an almost 40% discount to an asset value, which in turn is way down due to sizeable declines in CNA and drilling operation valuations – thus the “double discount” in the article title.
With a long list of buy candidates in today’s investment landscape, does Loews deserve to be near the top? We don’t know, and the rapid shifts in the landscape make today’s assessments moot a week later. The value of the energy investments and cash alone exceed the current Loews stock price. You get the CNA holdings on the Loews Hotels for free. The downside seems limited, absent a complete collapse.
Loews, the New York conglomerate controlled for the past half century by the Tisch family, long has rewarded shareholders through savvy investments in closely held and public companies. Since June, however, the company’s stock has tumbled 56%, to a recent 21, as the value of Loews’ (ticker: L) investments in public entities such as Diamond Offshore Drilling and CNA Financial have fallen sharply.
As a result, Loews now trades at about 39% below estimated asset value of $34 a share – a far steeper discount than the 20% average of the past two years. Fans argue that the stock actually offers a “double discount,” because shares of two of its three key equity holdings – CNA (CNA), a property-and-casualty insurer, and Diamond Offshore (DO), a provider of ocean-based oil rigs – are themselves depressed.
Accordingly, now may be a good time to jump in alongside the Tisches, who control about 30% of the company, in the expectation that Loews’ investments will rebound and the discount to net asset value will shrink.
At about 9, CNA is trading near its lowest price in decades, and fetches less than half its book value of 20 a share. Diamond Offshore has fallen to 62 from a peak of 138 last May, amid the crash in energy prices. It now trades for just six times projected 2009 profits, as investors worry that rig rental rates will plummet once current contracts expire.
Loews could rally to the high 20s in the next year, if it merely returns to a 20% discount to asset value. The stock could trade into the 30s if CNA and Diamond recover from current levels. Loews typically trades at a discount to net asset value – due in part to the potential tax bite that would come if any long-held investments, such as Diamond Offshore, were sold.
The stock’s downside seems limited because the combined value of Loews’ stakes in CNA, Diamond, and Boardwalk Pipeline Partners (BWP), which operates a natural-gas pipeline, about equals the current share price. That means that investors effectively are paying nothing for the company’s wholly owned assets, including Loews Hotels and Highmount Exploration & Production, a domestic natural-gas producer, and a net cash position (cash less debt) of $1.4 billion. That cash stash is worth $3 a share.
Lorillard (LO), which makes Newport cigarettes, used to account for a sizable chunk of Loews’ asset value, but Loews fully divested its remaining interest in the company last June in a “split-off,” in which Loews holders were offered the opportunity to swap their Loews shares for Lorillard stock.
Investors generally value Loews based on the sum of its parts, adding the value of the company’s publicly traded stakes in CNA, Diamond and Boardwalk to the estimated value of its wholly owned businesses. The [accompanying table] ... reflects, in part, published estimates of Morgan Stanley analyst David Adelman, one of the few Wall Street analysts covering Loews today.
Barron’s has been bullish on Loews in the past, but our praise for the stock was ill-timed in our most recent story, in late 2007 (“A High Loews,” Dec. 31, 2007), when the stock was in the high 40s.
Loews amounts to a bet on the company’s current investments, and the Tisch family’s ability to make successful new ones. Management is headed by chief executive officer Jim Tisch, 56, the straight-talking son of Larry Tisch – who took control of the company in the 1950s with his brother, Preston “Bob” Tisch. Larry Tisch died in 2003, and Bob Tisch in 2005. Jim’s brother, Andrew Tisch, is chairman of Loews’ executive committee, and Bob’s son, Jonathan, runs Loews Hotels. New York’s movers and shakers have long gathered for breakfast at its flagship property, Manhattan’s Regency Hotel.
Loews investors are lining up with the Tisches much in the way that Berkshire Hathaway (BRKA) holders have placed their faith in Warren Buffett. Yet, unlike Berkshire, Loews now bears the advantage of trading at a sizable discount to asset value. It is harder to peg what Buffett calls Berkshire’s intrinsic value, but it probably is not much above Berkshire’s current stock price of $80,000 a share.
Says Ken Charles Feinberg, a co-manager of the Davis New York Venture Fund: “Jim Tisch has proven to be one of the most shareholder-friendly chief executives around. He is a conservative, savvy value investor, and thoughtful about creating long-term value for shareholders.”
Fund-manager Davis Selected Advisers is Loews’s largest outside holder, with 46.9 million of the company’s 435 million shares as of December 31. Feinberg thinks that the Tisch family will use Loews’s cash for “opportunistic investments and acquisitions,” or stock repurchases. The company has a current market value of $9 billion.
An investment in Loews is a little like putting money with a hedge fund or private-equity shop, in the sense that it makes public and private investments. In this case, however, there is no 20% incentive fee on any investment gains. Jim Tisch declined to be interviewed for this article, but has said in the past that management’s “singular goal is to create value for the holders of Loews common stock.”
Management has done that admirably. Lorillard was purchased for a few hundred million dollars in the late 1960s, a fraction of its current value of $10.7 billion, and Loews amassed the offshore oil rigs that eventually became Diamond Offshore at low prices in the 1990s. Boardwalk, formed by the merger of two gas pipelines bought by Loews earlier in this decade, is worth considerably more than Loews’s cost.
One of the main reasons Loews now is depressed is concern about the company’s longtime problem child, CNA. It recently reported a Q4 loss of $336 million, or $1.31 a share, largely due to losses on the company’s fixed-income and hedge-fund portfolios. Loews invested $1.25 billion last fall in newly issued CNA preferred stock, paying 10%, to bolster the insurer’s balance sheet.
CNA had been considered one of the worst-managed of the major property-and-casualty insurers, but its underwriting results improved in 2008. Its new CEO, Tom Motamed, was the No. 2 at Chubb and gets high marks in the insurance industry.
CNA has significant unrealized losses of $5 billion in its investment portfolio. That sounds like a big number, but the company notes that most of those losses stem from investment-grade bonds the insurer believes are depressed by weak markets but are not impaired. Tisch was asked on Loews’s earnings conference call earlier this month about the likelihood of further financial backing for CNA.
“I am certainly hopeful that CNA will not need any more support from Loews,” he replied, noting that fixed-income markets had improved in January. Motamed said on the CNA conference call the same day that he believes the company is adequately capitalized.
CNA bulls think that the stock could return to 20 a share in the next year, and trade commensurate with book value. If market conditions improve, it conceivably could rally to 35, equal to its book value per share, excluding unrealized investment losses. CNA is thinly traded because Loews owns 90% of the company’s 269 million shares. It owns half of Diamond Offshore.
Loews Q4 results were hurt by a $754 million noncash write-down of Highmount, due to lower gas prices. The write-down cut the value of Loews’s investment to about $1.7 billion.
Unlike many companies, which indiscriminately buy back stock, Loews usually is selective about the timing of its purchases. Its buyback program last year was concentrated in the 4th quarter, when it acquired a modest one million shares at $21 each, near the low for the year and around current levels. The company pays an annual dividend of 25 cents a share, for a yield of 1%.
Rampant selling has left many stocks cheap, but it is unusual to find stocks like Loews that offer a “double discount,” trading well below the value of assets that are themselves depressed. If financial markets merely stabilize, Loews could appreciate smartly. If the markets rally, investors could do even better.
SHIPPING STOCKS ARE STARTING TO REBOUND
Shipping stocks acted is if they were call options on some commodity price index in 2007-08. The Baltic Dry Index of shipping rates ran from around 2000 in early 2006 to about 12,000 last May, and then collapsed over 90% in couple of months. It is safe to say both the highs and the lows were more than a little overdone.
Shipping company stocks track the Baltic index directionally if not proportionally. Needless to say they all got hammered when the index collapsed. Now the index is giving signs of bottoming out and the stocks can be expected to rebound if this proves the case. The upside may be dramatic in many cases, as today’s article points out. If dividends are not cut, you earn 10%+ on your capital while you wait.
Which stocks would be good vehicles in which to participate in the industry, if one is so inclined? We posted an article last October on shipping stocks, here. The stocks recommended there were oil tanker company Nordic American Tanker (NAT), Ship Finance International (SFL) with exposure to dry bulk and container shipping, and Star Bulk Carriers (SBLK) which features – surprise – bulk carriers. There is a shipping ETF as well, Claymore/Delta Global Shipping (SEA), which has bounced about 20% off its recent lows.
The author of the posted October article has just started a “Shipping Stocks Blog,” which only has only a few postings so far. One of the postings says that Star Bulk Shipping suspended its dividend, which presumably calls his previous recommendation into question.
Has every ship run aground? Have all the oceans frozen over? You might think so if you have followed the dramatic tumble of the Baltic Dry Index – which had at one point fallen 94% from its peak just seven months ago. The index tracks the price to ship dry goods – everything from corn to cement – and unless the world suddenly stops eating and building, the odds are this index is ripe for a stunning rebound ... that looks already underway.
The Baltic Dry Index [chart here] is not a regular stock index like the S&P 500 or the Nasdaq. It is actually a composite survey of daily shipping prices around the world. And although it does not track underlying stocks like most market indices, its movement does affect almost every shipping company’s share price, as it is viewed as a proxy for the overall industry. As the index has plummeted, it has taken the share prices of most shipping companies with it. This provides new investors a chance to capture some of the most appealing yields that we have ever seen.
In May 2008, the Baltic Dry Index was riding high. Commodity prices were still on the upswing, and commodity buyers were insensitive to shipping costs. In preparations for the headaches of tighter port security surrounding the Olympics, Chinese companies had stockpiled raw materials, pushing shipping prices even higher. And the U.S. subprime crisis appeared to be contained at its borders – meaning the rest of the world’s trade went on unhampered. On May 20, shipping spot prices hit an all-time high.
No one, not even the shipping companies, considered the May highs sustainable. But few anticipated the perfect storm of downward pressure shipping prices would face over the next few months. How bad has it been? Rates for Capesize ships – so named because initially their large size prevented them from using the Suez Canal, forcing them to sail around either Cape Horn or the Cape of Good Hope – that were priced at $230,000 a day in late May have fallen to almost $20,000 a day. The Panamax-class shipping rates have seen a similar trend, tumbling from daily rate quotes of $90,000 a day to about $12,800.
There are a number of valid reasons why the Baltic Dry Index should be off its highs. In addition to being grossly overheated just a few months ago, the U.S. subprime mortgage problem blossomed into a full-blown financial crisis and has undoubtedly weighed on economies outside the U.S. When world economies slow down, the demand for shipping also slows. And the speculative bubble in the commodities market also has burst, making commodities buyers more price-sensitive when it comes to shipping.
Many of the short-term pressures weighing on shipping prices are already showing signs of abating:
Generous Yields at Unprecedented Highs
- Easing Credit Worries: The worldwide credit crisis that has made it harder for small companies and consumers to borrow money, has also made it harder for dry bulk buyers to get their cargos loaded onto ships. Now, the credit freeze has begun to thaw. Bank-to-bank lending has resumed. Governments around the globe have put up hundreds of billions of dollars to back the world’s banking system, and letters of credit appear to be navigating their way through the system again.
- Stabilizing Demand: In an effort to reduce pollution, China shut down hundreds of construction sites, coal-fired power plants, cement factories and chemical manufacturers a month before the Olympics and throughout the games. While this was only a temporary measure, the drop-off in shipping demand made an already nervous sector panic. But the temporary fits and starts from the Beijing Olympics are now long behind us. The Olympic cutbacks were not a real measure of demand any more than the pre-Olympic build up was, and these anomalies are now being seen for what they were.
- Short-Term Feuds and Still-Strong Growth: A tiff between China’s steel companies and Brazilian iron ore suppliers, which has resulted in limited shipments of ore between the two countries, had wreaked havoc on the index. This situation has cooled, with Brazilians backing down from the price hikes they were demanding. Bottom line: China will need iron ore and other materials to build out that growth. Brazil and other international suppliers with sell it, then ships will move it.
As many of the temporary pressures on the Baltic Dry Index are already starting to ease, it is hard not to believe the BDI has overshot its floor and will soon find a more rational level – certainly off its unsustainable highs but also above its equally unrealistic lows.
In fact, we are already seeing this. The BDI is more than 20% off its lows – but still nowhere near a rational level. And as normalcy returns to the index, investors still have a chance to profit from shipping’s worst fears. While you cannot trade the index itself, almost every shipping stock was pummeled by the fall, and most will follow it up on the rebound.
In the meantime, with many shipping stocks trading near their 52-week lows, already generous yields are at unprecedented highs. Investors not only have the opportunity to lock in 10%-plus yields with stocks like Navios Maritime (NM), they have the added potential for share price gains once sanity returns to this sector.
THE ARTFUL DODGERS
How common sense and due diligence kept some fund-of-funds from falling prey to Bernard Madoff’s Ponzi scheme.
While many people were scammed by Bernard Madoff many avoided being scammed by follow simple, common sense rules such as:
If you draw the conclusion there are lessons in the Madoff affair that are well applied to investing in general, you have drawn the right conclusion.
The question circulating within the hedge-funds-of-funds industry these days is not how so many got sucked into the alleged $50-billion Bernard L. Madoff investment Ponzi scheme, but how some avoided doing so.
While l’affaire Madoff burned hedge-funds-of-funds such as Ezra Merkin’s Ascot Partners and Access International, plenty of others would not touch Madoff with a 10-foot barge pole – and that had been their policy for years.
Other big investors in hedge funds tried to kick the tires more recently at “feeder funds” that funneled money to Madoff, and quickly determined they should stay away. The key was lack of transparency.
“Recently, I was introduced to a feeder into the Madoff fund, and after being told about this rare opportunity to get invested with a manager of very high regard [to many], low fees and consistent returns, I declined immediately,” James Newman, vice president of operational due diligence at Ermitage, a fund-of-funds, wrote to clients after allegations of the massive Ponzi scheme hit the headlines. “From the outset, I was denied the opportunity to perform a detailed due-diligence review. We take a very dim view on any fund, regardless of size, industry status, or ‘it is good enough for them’-type reasons, that restricts our due-diligence process,” he adds.
Bank of America was another skeptic. “None of Bank of America’s alternative investments had exposure to Madoff,” confirms David Bailin, president of the company’s Alternative Investment Asset Management. “It was impossible to understand or replicate the strategy,” he says, adding that there was “a lack of transparency.”
Ken Nakayama was one who avoided a personal investment in Madoff via a feeder fund, specifically the Fairfield Sentry fund. In April 2001, after studying Fairfield Sentry’s marketing materials and returns, Nakayama, an options expert and at the time Deutsche Bank’s chief equity derivatives strategist, was driven to express skepticism about Madoff to this reporter. His tip-off led to the May 2001 Barron’s article “Don’t Ask, Don’t Tell.”
“There seemed to be a strong inconsistency between Madoff’s stated strategy and his pattern of returns,” said Nakayama. He cautioned an executive with the Deutsche fund-of-funds business, and both agreed that there were far too many warning signs. “One guess was that Madoff was somehow funneling market-making profits into his funds,” which should have been completely segregated, recalls Nakayama. (Bernard L. Madoff Investment Securities was one of Wall Street’s top market-makers, as well as an investment firm.)
“The returns seemed ‘managed’ or ‘engineered,’ and showed little evidence of typical factor exposures you expect to see in hedge-fund returns,” he found. “And, equally oddly, despite his size, Madoff seemed to leave no footprints in the options market,” even though options played a big role in his stated investment strategy. Over the years, Nakayama followed Madoff’s returns with strong skepticism, meanwhile warning multiple others against investing.
In some cases, feeder funds offered by the likes of Tremont (a Rye, New York-based unit of MassMutual Financial Group) and Fairfield Greenwich seem to have “allowed Madoff to outsource all the regulatory headaches and the paperwork,” says Lita Epstein, an Orlando, Florida-based forensic accountant and author of books on analyzing financial statements. “Madoff paid them to be the front door, the registered investment adviser, while he operated the underlying strategy.”
Tremont spokesman Montieth Illingworth acknowledged that the firm is being sued by investors who allege failure to perform due diligence, but said, “We believe the suits have no merit, and will vigorously defend ourselves, while at the same time trying to recover investors’ assets.” As for Fairfield, a spokesman for the Connecticut-based firm said it “is not discussing its legal strategy.”
The eerily consistent returns did not worry some hedge-funds-of-funds.
“To most people, Madoff could not be a get-rich-quick-scam because he was offering 8% to 12% returns a year, which are certainly in the realm of possibility,” says Patrick Huddleston, founder of Investor’s Watchdog, which does risk analysis of investment opportunities. He compiles “safety” rankings for investors who want to examine a money manager, and says Madoff would have earned only a 40 out of a potential 80 on his ranking system. Why? “He had custody over all the assets. Self-custody and self-clearing of securities are immediate red flags.”
That is a lesson some investment companies embraced too late.
Switzerland’s Union Bancaire Privée, some of whose clients were burned by Madoff, has told the hedge-fund managers it uses that they must use independent administrators. Reiko Nahum, founder of Amber Partners, a London firm that conducts operational certifications on hedge funds, says “an independent administrator maintains the official books and records of the fund, and produces the investor statements.” The Swiss bank also now demands that the hedge funds it invests with keep custodial assets with independent third parties, rather than holding them themselves. Third-party custody makes self-dealing much more difficult and adds a layer of security.
Jim Vos, chief executive of Aksia, a New York hedge-fund research-and-advisory outfit, has issued the same warning. He notes that Fairfield Greenwich, Tremont and other feeder funds used auditors and accounting firms that generally are viewed as top-notch. Still, the bulk of their assets were held in custody by Madoff himself.
In a December 11 letter to clients, Vos noted the lack of an independent custodian at Madoff: “Madoff Securities, through discretionary brokerage agreements, initiated trades in the accounts, executed the trades, and custodied and administered the assets. This seemed to be a clear conflict of interest, and a lack of segregation of duties is high on our list of red flags.”
The Madoff scheme relied on a timeless human failing: gullibility, driven by a desire to imagine that something too good to be true just might be true anyway. As Nakayama says of Madoff, “If true, he would have discovered the money-management equivalent of cold fusion.” And, in the end, Madoff’s financial wizardry worked just as well as cold fusion has.
SYNCHRONIZED BOOM, SYNCHRONIZED BUST
Bad U.S. monetary policy had global consequences.
Marc Faber explains, in a Wall Street Journal opinion piece, how the ill advised monetary policy pursued by the U.S. Federal Reserve under Alan Greenspan and then Ben Bernanke spawned bubbles followed by busts all over the world. A useful summary of history. Interestingly, he dates the start of “bad policy” to the Mexican bailout of 1994. This led investors to believe that growing current account deficits could continue indefinitely. Faber does not say this, but perhaps he would deem the Tequila crisis to be the first exercise of the “Greenspan Put.”
So while Peter Schiff’s (and others’) predicted decoupling of the U.S. and rest of the world economies may yet come to pass, there is a lot of excess and malinvestment to work off first. Everything went up together, passing through the U.S. on the way, and everything is now going down together. It looks to us as though the financial flows have to be decoupled before the real economies can be.
The world has gone from the greatest synchronized global economic boom in history to the first synchronized global bust since the Great Depression. How we got here is not a cautionary tale of free markets gone wild. Rather, it is the story of what can happen when governments ignore market signals and central bankers believe in endless booms.
Following the March 2000 Nasdaq bust, the Federal Reserve began to slash the fed-funds rate from 6.5% in January 2001 to 1.75% by year-end and then to 1% in 2003. (This despite the fact that officially the U.S. economy had begun to recover in November 2001). Almost three years into the economic expansion, the Fed began to increase the fed-funds rate in baby steps beginning June 2004 from 1% to 5.25% in August 2006.
But because interest rates during this time continuously lagged behind nominal GDP growth as well as cost of living increases, the Fed never truly implemented tight monetary policies. Indeed, total credit increased in the U.S. from an annual growth rate of 7% in the June 2004 quarter to over 16% in early 2007. It grew five times faster than nominal GDP between 2001 and 2007.
The complete mispricing of money, combined with a cornucopia of financial innovations, led to the housing boom and allowed buyers to purchase homes with no down payments and homeowners to refinance their existing mortgages. A consumption boom followed, which was not accompanied by equal industrial production and capital spending increases. Consequently the U.S. trade and current-account deficit expanded – the latter from 2% of GDP in 1998 to 7% in 2006, thus feeding the world with approximately $800 billion in excess liquidity that year.
When American consumption began to boom on the back of the housing bubble, the explosion of imports into the U.S. were largely provided by China and other Asian countries. Rising exports from China led to that country’s strong domestic industrial production, income and consumption gains, as well as very high capital spending as capacities needed to be expanded in order to meet the export demand. An economic boom in China drove the demand for oil and other commodities up. Rapidly accumulating wealth allowed the resource producers in the Middle East, Latin America and elsewhere to go on a shopping binge for luxury goods and capital goods from Europe and Japan.
As a consequence of this expansionary cycle, the world experienced between 2001 and 2007 the greatest synchronized economic boom in the history of capitalism. Past booms – of the 19th century under colonial economies, or after World War II when 40% of the world’s population remained under communism, socialism, or was otherwise isolated – were not nearly as global as this one.
Another unique feature of this synchronized boom was that nearly all asset prices skyrocketed around the world – real estate, equities, commodities, art, even bonds. Meanwhile, the Fed continued to claim that it was impossible to identify any asset bubbles.
The cracks first appeared in the U.S. in 2006, when home prices became unaffordable and began to decline. The overleveraged housing sector brought about the first failures in the subprime market.
Sadly, the entire U.S. financial system, for which the Fed is largely responsible, turned out to be terribly overleveraged and badly in need of capital infusions. Investors grew apprehensive and risk averse, while financial institutions tightened lending standards. In other words, while the Fed cut the fed-funds rate to zero after September 2007, it had no impact – except temporarily on oil, which soared between September 2007 and July 2008 from $75 per barrel to $150 (another Fed induced bubble) – because the private sector tightened monetary conditions.
In 2008, a collapse in all asset prices led to lower U.S. consumption, which caused plunging exports, lower industrial production, and less capital spending in China. This led to a collapse in commodity prices and in the demand for luxury goods and capital goods from Europe and Japan. The virtuous up-cycle turned into a vicious down-cycle with an intensity not witnessed since before World War II.
Sadly, government policy responses – not only in the U.S. – are plainly wrong. It is not that the free market failed. The mistake was constant interventions in the free market by the Fed and the U.S. Treasury that addressed symptoms and postponed problems instead of solving them.
The bad policy started with the bailout of Mexico following the Tequila crisis in 1994. This prolonged the Asian bubble of the 1990s, because investors became convinced there was no risk in growing current-account deficits and continued to finance Asia’s emerging economies until the bubble burst with the start of the Asian crisis in 1997-98.
Then came the ill-advised bailout of Long-Term Capital Management in 1998, which encouraged the financial sector to leverage up even more. This was followed by the ultra-expansionary monetary polices following the Nasdaq bubble in 2000, which led to rapid and unsustainable credit growth.
So what now? Unfortunately, Fed Chairman Ben Bernanke and Treasury Secretary Tim Geithner were, as Fed officials, among the chief architects of easy money and are therefore largely responsible for the credit bubble that got us here. Worse, their commitment to meddling in markets has only intensified with the adoption of near-zero interest rates and massive bank bailouts.
The best policy response would be to do nothing and let the free market correct the excesses brought about by unforgivable policy errors. Further interventions through ill-conceived bailouts and bulging fiscal deficits are bound to prolong the agony and lead to another slump – possibly an inflationary depression with dire social consequences.
POST-BUBBLE FACTS OF LIFE
We frequently posted pieces by Doug Noland, editor of the self-explanatory Credit Bubble Bulletin on the PrudentBear.com webiste, which chronicled the monetary and credit machinations and excesses behind the runup as it happened. What sayeth he now that the comeuppance he long warned about is here? Things like this: “There is essentially no possibility of ‘good’ policymaking in this especially unsettled post-bubble period. ... As much as booms create genius, busts are an absolute cinch for breeding contagious boneheadedness.”
Sureying the economic, political, and social wreakage, Mr. Noland observes: “There are no surprises today to those of us that have studied the post-1929 landscape.” Doug frequently analogized the 1990-2000s credit bubble conditions to those of the 1920s, so this is not some late in the day ad hoc comparison by him.
"Fundamentally, there is a complete lack of a coherent framework,” Mr. Noland continues, “for even an attempt at gauging whether individual policies will be constructive to system adjustment or whether they will instead compound the damage. Without a credible analytical framework, there is not even a beginning point for thoughtful discussion of policy alternatives. Instead, the debate is predictably fought on political fronts.”
It is hard to state the situation more cogently than that. It is doubtful the political process as it is now constituted can be counted on for wisdom. “We are in store for a messy and protracted adjustment period,” Mr. Noland concludes.
It was not all that long ago that Mr. Greenspan, Dr. Bernanke and their cohorts were communicating assuredly about post-Bubble “mopping up” policymaking. They mistakenly believed that astute contemporary central banking provided ample knowledge and ("helicopter") firepower to reflate any unfolding bust. There was also the implicit presumption that the benefits arising from the boom far outweighed the manageable costs associated with any possible bursting Bubble.
Today, things are a bloody mess. The credit system, economy and conventional economic doctrine are all a mess. Washington is a mess. Fiscal and monetary policymaking are messes. A CNBC commentator likened the process to watching sausage being made. I would counter that at least you have a decent idea what the end product is going to look and taste like. And following the theme that the greatest policy blunders were committed during the inflationary bubble period, I will suggest to readers that there is essentially no possibility of “good” policymaking in this especially unsettled post-bubble period. Today’s policymakers – of all stripes and persuasions – are poised to become forever tarred and feathered. As much as booms create genius, busts are an absolute cinch for breeding contagious boneheadedness.
The Greenspan/Bernanke Fed’s entire fanciful notion of a positive post-bubble “mopping up” exercise was a myth. And, importantly, we now have ample support for the thesis that risks rise exponentially during the final “terminal” phase of credit bubble excess. How about this: The dearth of policymaking competence during the downside of the cycle is proportional to the financial excesses of the preceding boom? I would be curious to know how the academic, Dr. Bernanke, modeled the political process when he fashioned his hypothetical “mopping up” abstractions.
There are incredible complexities in regard to the process of credit bubbles distorting asset prices, patterns of consumption and investment, and incomes and income distribution. Epic bubbles, as the one we experienced, impart profound changes on the social and political fabric. For one, they meddle whimsically with hopes, dreams and expectations.
Importantly, bubbles inherently evolve into destabilizing mechanisms for wealth redistribution. These various distortions tend to grow exponentially throughout the life of the boom, creating the imperative to rein in bubbles prior to their final, fateful phase of destructive excess. Extending the life and vitality of the bubble only ensures a more problematic scope (and greater consequence) of boom-time wealth transfer. And the more protracted the boom the larger the inevitable number of citizens suffering significant hardship – and the more acute becomes public angst. The bigger the bubble – the greater the outrage and political fallout. And there is simply no graceful, equitable, timely or orderly course when the gale force political winds are gusting redress for the perceived inequities meted out during the bubble period. Again, I am not sure how such pivotal post-bubble social dynamics were factored into “mop up” theorizing.
To be sure, today’s post-bubble facts of life create a serious policymaking dilemma. Unimaginable wealth was shifted to “Wall Street” and their client base during the boom, while millions of regular folk were saddled with unmanageable debt and, now, negative net worth. Those on the right side of the inflationary boom accumulated historic wealth, while millions on the wrong side destroyed their financial health. The runaway boom inflated expectations – and now comes the depressing phase of disappointment and growing despair. Of course the populace is ticked off, spurring politicians to vilify and seek amends and wealth redistribution. In this regard, there are no surprises today to those of us that have studied the post-1929 landscape.
Major credit bubbles evolve into ideological battlegrounds. During boom-times, free-market ideologues pound their chests and take too much credit for the expanding prosperity. Ditto those with the view that tax cuts are always a righteous and unfailing magic elixir. The boom period fashions a positive reinforcing backdrop for the “conservatives,” especially as federal coffers are filled to the brim with inflating tax receipts. As we have witnessed, however, the pendulum can swing rather abruptly back the other way. The “liberals” these days feel they have an unequivocal mandate to use big government to rectify our nation’s financial and economic transgressions. With unwavering conviction that it is in the best interest of the majority of the population, they seek to impose governmental influence throughout the financial sector and real economy.
Unfortunately, vilification and payback-time become natural impediments to the policymaking process. Of course, “soak the rich” – the class that benefited so conspicuously throughout the inflationary boom – becomes a focal point for the move to redistribute boom-time wealth. Of course, Wall Street “greed” is vilified, with the general public instinctively backing the powerful political movement to re-regulate the financial system. And, of course, fear of financial and economic catastrophe provides a fertile backdrop for the imposition of government influence and control throughout the real economy.
Hopefully, thoughtful analysis of today’s messes will alter the conventional doctrine of how best to deal with asset and credit bubbles. But it also helps to explain why Washington policymaking these days often appears less than coherent and policymakers less than competent. The harsh reality is that there is a serious lack of understanding on both sides of the isle (as well as throughout the economic community) as to the forces behind today’s crisis, the nature of the deep structural damage respectively imparted upon our financial and economic systems during the boom, and the desired policy path to foster system adjustment and repair. Twenty “experts” would ensure at least 20 conflicting plans.
Fundamentally, there is a complete lack of a coherent framework for even an attempt at gauging whether individual policies will be constructive to system adjustment or whether they will instead compound the damage. Without a credible analytical framework, there is not even a beginning point for thoughtful discussion of policy alternatives. Instead, the debate is predictably fought on political fronts. Ironically, in a period beckoning for cooperative bipartisan problem-solving, the process naturally regresses to irreconcilable ideological battles. When our Washington politicians come to a consensus view on the best course for post-bubble policymaking, they can then move quickly to resolve global religious conflict and the abortion issue.
My instincts are to want to cut Secretary Geithner and the new Administration some slack. Because we could see this coming. The timing was unclear, but I could have easily predicted some years ago that, come the inevitable arrival of the busting bubble, our Treasury Secretary (in this case, “Secretaries") was going to appear impotent and not up to the challenge at hand. The market expected far more from the Administration’s plan. But it is clearly a case of all of us hoping and expecting too much. There is no simple solution, and there is no palatable comprehensive plan. Put the two parties in a big chamber and there will not be any agreement on what to do. Place one party’s leadership around a large table and there will be no consensus. And, quite likely, have the Administration’s top economic policy team gather comfortably around a small table in the Oval Office and there will be similar – and perhaps even more heated – disagreement. We are in store for a messy and protracted adjustment period.
GOLD AMID INFLATION AND DEFLATION
Gold is alleged to be a hedge against inflation. This theory is immediately refuted by noting that gold declined in real terms over 85% between 1980 and 2001. It did not do so well in other inflationary periods in the 19th and 20th Centuries either. What gives?
When Paul Volker dampened – but did not kill – the virulent 1970s inflationary virus via a monetary policy which produced extraordinarily high real interest rates, it gave people the confidence to get out of gold and return to investing in real wealth-producing assets like debt and equities – assets, Adrian Ash notes, whose long-term appeal rests on stable costs and expenses, rather than a speculative guess at how the central bank might set its interest rates from one month to the next.
Lacking such confidence, investors hunker down and accept whatever will work to preserve their wealth while they wait for the crisis to pass. Out-of-control inflation and systemic deflation resulting from cascading defaults and credit contraction, which we have now, both represent crises in confidence in the monetary system itself. Planning for the long-term becomes a luxury and survival is the major consideration. Gold is the ultimate survival asset.
“Inflation and deflation are both a crisis in money. Which leaves gold as a secure store of wealth against both monetary panics ...”
The 1970s did not just curse the world with cheap German wine and the Bay City Rollers. That decade gave us soaring inflation, too.
Gold’s stellar run up to $850 per ounce, rising more than 24 times over, also came in the 1970s. So gold, therefore, must deliver its strongest returns when the cost of living shoots higher. Right?
Wrong. “In the long run, stocks have thrashed gold as great long-term hedges against inflation,” says Jeremy Siegel, professor of finance at Wharton University, Pennsylvania. What is more, the eight-year bull run in gold prices so far this decade has come against the lowest average consumer-price inflation since the early 1960s.
In short, the common opinion of gold as first and foremost a defense from inflation is wildly amiss. Just look at the last 30 years.
Consumer prices in the United States, even on Washington’s data, have pretty much trebled since 1980. But starting at what was then an all-time high of $850 per ounce, gold simply failed to keep pace. In fact, it dropped half of its purchasing power (monthly data) over that time.
At its lowest point, back in 2001, gold’s loss of purchasing power for U.S. investors reached beyond 85%. The broad S&P index, on the other hand, stood more than 11 times higher, even as the Tech Crash pushed U.S. equities into a nosedive.
Sure, things have reversed a little since then. But not enough to reverse the cold fact of gold’s losses during the long inflation of the late 20th century. How can we square it with gold’s huge returns amid the inflationary 1970s?
“Well,” you might guess, “perhaps gold only responds to rapid inflation – the nasty kind we got 30 years ago, rather than the ‘mild’ case our money has suffered ever since?”
But again, you would be wrong – or very close to it. Between 1980 and 1981, consumer price inflation in the U.S. destroyed 17 cents of the Dollar’s purchasing power, a severe depreciation by any reckoning. Yet the Dollar price of gold dropped 40% during that same period. Longer term over the 1980s and ‘90s – a truly horrific period of sustained inflation, then averaging 4.6% per year and vicious by any historical comparison – the real value of gold sank by more than 80%.
Look further back – even to when physical gold stored in government vaults underpinned the dollar, just as it underpinned all major currencies – and you will find that gold almost always made a poor hedge against rising prices. In the mid-70s, Professor Roy Jastram at the University of California at Berkeley found that gold failed to keep pace with the cost of living during seven inflations in Britain across more than three centuries. In the United States, Jastram spied six inflationary periods between 1808 and 1976. On average, they saw the purchasing power of gold fall by more than 1/5!
Only the final period in Jastram’s study – beginning in 1951 – saw the metal gain value, and it continued to gain purchasing power for the next 30 years. By the end of 1980, the average annual price of gold had risen more than 17 times over. But right from that top it was downhill for the next 20 years.
How come? [See gold vs. inflation chart here.]
What changed at the start of the 1980s? Two things in short order, which were entirely connected.
First, Paul Volcker – the famously tall cigar-loving chairman of the U.S. Federal Reserve – raised dollar interest rates to nearly 20%. So secondly, and as a direct result, the rate of inflation sank from that record peace-time spike above 14%.
Volcker’s strong medicine took nearly two years to slow the rate of inflation. But it killed the gold price almost instantly. Before Volcker hiked rates – and before he and his successors gained ample room to cut them year after year – “There was a kind of great speculative pressure,” as Volcker since said. The Fed noted how “speculative activity” in the gold market was spilling into other commodities. One official at the U.S. Treasury called the gold rush “a symptom of growing concern about world-wide inflation.”
So yes, people piled into gold as double-digit inflation and collapsing bond prices destroyed their savings at the end of 1970s. And yes, it took a record return paid to cash for the devaluation of money to slow down, allowing a cautious return to risk assets like corporate debt, listed equities and new private ventures – assets whose long-term appeal rests on stable costs and expenses, rather than a speculative guess at how the central bank might set its interest rates from one month to the next.
But now, in contrast, Britain stands on the brink, the United States will likely confirm it on Friday (2-20), and Japan’s pretty much there – yet again – suffering the horrors of inflation’s bleak evil twin, deflation.
How come gold just keeps hitting new record highs?
Before the 20th century, short periods of falling prices were as common as scurvy, and just as harmless for the long-term value of money and assets. Indeed, deflation is a good thing, for savers at least. Provided their savings institutions stay solvent. And provided their cost of living actually goes down faster than the value of the assets they have saved. Which is not what is happening today. And that brings gold’s other key feature – the one investors should note if they buy it as a tightly supplied metal that shot higher in price when inflationary panic struck in the late 1970s.
Because fact is, gold also offers a deep, liquid market (if held in its internationally tradable form of large wholesale bars) with no risk of counter-party default (if owned outright, rather than through a trust or a fund or a similar financial structure).
In our debt-deprived world today – where the outstanding value of what retirees and savers are owed is deflating much faster than costs – it is this attraction of gold ... its “off risk” advantage ... which is fast-gaining appeal amongst large funds and private investors alike.
Inflation and deflation – both a crisis in money – both also force business and growth to give up. What remains, paying zero and promising nothing, is the need to simply store wealth and savings for a better future, whenever it shows.
IS IT TIME FOR A BREAKOUT?
A few technical comments on the stock market indices and gold.
Amidst the headlines of the Dow Jones Industrials breaking below the low set last November, the S&P 500 and Nasdaq composite are holding above their old lows. This is both a technical nonconfirmation and, in the S&P’s case if the old low holds, would result in a satisfying double-bottom. We doubt these classic technical signals are truly reliable, but if the S&P refused to set new lows despite all the bad news it would get our attention.
Gold is overbought short-term, having run up 25% since its October/November lows. David Grandey warns that now is not the time to be jumping on board, especially with all the media exposure the metal’s price run is getting.
While the Dow Industrials busted to new lows, the S&P 500 retested its low and MAY have formed a Double Bottom, one of the first signs a change in trend (down to up) may be near. Meanwhile, the NASDAQ has been holding much stronger. While it too has pulled back, it has not done so near as much as the other indexes. But then again, the NASDAQ does not have the toxic waste the other two indexes have either. Also, the NASDAQ has formed another bullish pullback off highs pattern (POH) as shown below.
About the time you hear everyone on TV pounding the table on gold and you start to hear the words “Safe Haven Buying” for days on end you know you are near the end of the run. Why? Its emotional money saying “UH OH – the sky really is falling, I gotta get some of this” (AFTER the fact of course).
This tells us we are near a stall point. There is an old adage that has served us technicians well over the years and that is: “More often than not when everyone is talking about it, that is about the time it rolls over ...”
Don’t follow the herd! We all know what happened to those who followed the conventional Wall Street herd right? They added 7 years to their time horizon window just to get back to where they were in 2007.
While Gold MAY be working its way higher over time, technically it is overbought and at resistance. While we are not saying sell it, we are saying expect a pullback. Take a look at the chart below. Notice how it is bumping up against resistance. Also, notice that the full stochastics are overbought? Not time to jump on the bandwagon for now.
Just remember the market has a funny way of letting those who have to have it actually have it – in more ways than one, we might add.
A Barron’s columnist offers a more extensive analysis of the same two markets, stocks and gold. He comes to a pretty similar conclusion about gold..
A re-test is no fun when the answers are not much clearer than they were the first time. And a bank “stress test” reads like a good idea on paper, until the recognition spreads that those likeliest to fail are among the biggest.
Such observations derive from the Dow Industrials’ penetration last week of its November 2008 low point, and the Standard & Poor’s 500’s close approach to its bear-market worst levels, driven by the collapse of bank stocks amid utter confusion about the rules of rescue and government intentions.
While the indexes are in a dark and familiar place, they got here in different fashion this time. Rather than a manic and dramatic dive, the drop since early January has been a monotonous and numbing slouch. The selling has been of lower intensity, less inclusiveness, accompanied far less by panic than resignation.
The number of new 52-week lows is vastly lower than last fall, when the indexes were here. While the Dow has punctured the November 20 low, only 2 of the 10 S&P 500 industry sectors are down since then (financials, a lot, and industrials, just a bit). The demand for downside option protection and speculation is well below what was seen three months ago. Yes, surveys of small investors are registering profound fear, of a sort that is often enough to foreshadow a bounce, but professional-sentiment and real-money mood indicators, not so much. This complicates the job of anyone seeking that sort of crescendo of fearful selling that familiarly has preceded the strongest of bear-market bounces.
A lower-intensity decline to former depths is not incompatible with a protracted market-bottoming process, as Steve Leuthold of Leuthold Group and others have been pointing out. Yet this is clear only in retrospect, and the market has plenty to prove, bereft as it has been of evidence of any strong, supportive investment demand.
An obvious difference on this trip is the time of year, which is cause for some caution. Market historian and author John Harris points out that before this year, the S&P 500 had only logged a year-to-date loss of 10% or more in a January or February three times (1933, 1939 and 2008). In 1933 the year’s low came in February, with a loss near 20%; in the other two cases stocks had a good deal more downside to go in subsequent months.
A sour but ultimately helpful result of the past two weeks’ sloppy, nervous, noisy action is that it has banished most of the hope that the next government measure, or the one after that, will do the trick. As noted here last week, hope – the raw material of which disappointment is made – in this context is dangerous. Fair to say the level of public disdain for the stimulus package, the hazy bank-support plan and the Obama mortgage-aid effort shows hope has turned to disgust. The recognition is spreading that these efforts are treating symptoms and not delivering miracle cures.
With allegations of fresh investment frauds, frequent news of official investigations of CEOs and all the rest jamming the news flow, it is logical to assume the sour taste will linger in investors’ mouths a while. This heightens the chance that when something sneaks up on us all and brings some improvement (the way the Fed programs of the 4th quarter quietly got credit markets functioning again), it will come as a pleasant surprise that could include a meatier rally, from whatever level.
Until then, the recent tentative signs that the market is becoming more selective in administering punishment – is sifting survivors from lost causes – imply we could be in for more of a two-way market mixing both opportunity and risk, even if the indexes fail this re-test.
What to do now with an ounce of gold – priced at more than $1,000, exchangeable for exactly 106 shares of General Electric, equivalent to more than 25 barrels of oil, a gold/oil ratio that has rarely been exceeded for any length of time during the past 35 years?
On the one hand, the logic behind owning some gold has rarely been more intuitive, as world governments threaten to deplete the global ink supply in their money-printing efforts, and faith in financial assets has been all but broken. The price action confirms this logic for now, with gold’s settlement Friday at $1,002 per Troy ounce, making for a 16% gain in the past month.
The fact, too, that the metal has been able to log such gains even with a firm-to-rising dollar is encouraging the true believers, who always bristle at the notion that gold merely rides the opposite end of the seesaw as the greenback. Yet, is it not a bit worrisome, at least short-term, just how popular gold has gotten in a hurry, and how an air of inevitability attends the commodity’s ascent as the beneficiary of market, economic and geopolitical calamity?
Granting that contrarian positioning often takes a long time to work in strongly trending asset markets, the wild flocking to the SPDR Gold (GLD) exchange-traded fund – which routinely turns over $2 billion worth of trading a day – ought to give slight pause. The GLD, which holds the real stuff, is about the biggest buyer of physical gold out there, its stash now topping 1,020 tons, up 20% in a month.
The Market Vane traders’ bullish consensus reading on gold recently approached 80%. Famously, the minters of gold coins have not been able to slake public demand. Radio ads are all over the AM band these days featuring commodity-brokerage houses talking up the appreciation potential of gold. (On the other hand, the ubiquitous and obnoxious Cash4Gold.com ads prod cash-strapped folks to come in on the supply side.)
The can’t-miss mentality is hinted at in the remarks of commentators quoted Friday afternoon in a Dow Jones Newswires market dispatch. “We are seeing investors rush into gold as a crisis of confidence continues to emerge,” said Ralph Preston, senior market analyst with Heritage West Financial. “Once these things start running, it is the herd mentality.”
And this: “There really is no other place to go,” said Leonard Kaplan, president of Prospector Asset Management.
Really? No other place?
Granted, as gold advocates have been arguing for years, with intermittent merit, it would take only a tiny reallocation of the world’s investment assets toward gold for the price of the borderline-useless metal to scream to new heights. The gold price is nowhere close to its highest ratio in history versus any equity index you could find.
Yet could one not look at the way gold has vastly outperformed any index of actually useful and necessary commodities in recent months and conclude this means gold already has done its job, in large measure – by proving its use as a store of wealth?
No firm answers to these musings are readily at hand. Yet it is worth noting that when gold and other commodity markets pull back, they often do so with violence and speed. Investors looking for at least a refreshing pullback in the gold bull run could, in such a case, make some hay with the ProShares UltraShort Gold (GLL) ETF, which delivers twice the inverse of gold’s daily price move.
BABY BOOMERS: 30% UNDERWATER
Many of those nearing retirement will have very little to live on thanks to an erosion of home equity.
The idea that all baby boomer would cash in their home equity and retire on the proceeds never made sense. If such a huge cohort was all downsizing at once, who would do all the buying? The severe post-bubble decline in real estate prices has rended that question moot before it got a chance to be tested. Now there is little equity left to hypothetically cash out of. A new study shows that 30% of all boomers have negative equity in their homes, and those that are still positive have still seen a lot of their retirement “savings” disappear.
It is easy to forget this in the trauma of a market bust, and may well get forgotten again when the next bull market rolls in, so investors would do well to post a sign to this effect over their office desk and leave it there: “A capital gain is not a capital gain until it is taken.”
What a turnaround for the American Dream! According to a report released Wednesday (2-25), the real estate market bust and stock market declines have carved a huge chunk out of the assets of baby boomers.
So much home equity has been lost that 30% of boomers, aged 45 to 54, are underwater in their homes, according to “The Wealth of the Baby Boom Cohorts After the Collapse of the Housing Bubble.” The report, released by D.C.-based think tank the Center for Economic and Policy Research, also found that 18% of boomers aged 55 to 64 would owe money at close if they sold their homes.
People who were renting homes in 2004 will have more wealth in 2009 than those who were owners.
The CEPR also found that people who were renting homes in 2004 will have more wealth in 2009 than those who were owners. That is true for all five wealth groups the study analyzed, from the poorest to the wealthiest.
“The collapse of the housing bubble, which led to the current recession, has already destroyed almost $6 trillion dollars in housing wealth for homeowners,” said report co-author Dean Baker. “This reality is compounded by the recent collapse of the stock market. Many baby boomers will only have Social Security and Medicare to rely on in their retirement.”
Boomers between 45 and 54 have lost 45% of their median net worth, leaving them with just $80,000 in net worth, including home equity, according to the report.
Older boomers have fared marginally better. Those between 55 and 64 have lost 38% of their net worth, leaving them with $140,000. But this group is rapidly nearing retirement age and they have few working years left to make up the losses.
To come up with their estimates Baker and co-author David Rosnick analyzed the assets of boomer-headed families and projected their wealth through September 2009. They used data from the November 2008 Case-Shiller 20 City Price Index as well as the 2004 Survey of Consumer Finance – a survey of the balance sheet, pension, income, and other demographic characteristics of U.S. families put out by the Federal Reserve. The authors then factored in stock and housing market changes since then.
Baker and Rosnick presented their findings by income group under three scenarios they considered most likely: House prices remain at November 2008 levels (the latest data they had), house prices fall by 5% from November levels, or house prices fall by 15%.
In all three cases, the vast majority of these families will have lost a substantial portion of their net wealth compared with 2004. “We have always boasted about how mobile we are as a society,” said Baker, “but this can make us a lot less mobile.”
Renting a better deal
Peter Schiff, president of Euro Pacific Capital, an investment firm specializing in overseas investments and a noted bear on housing market issues, thinks there is a good chance home prices will continue their steep decline.
“Real estate has to be priced like any other goods,” he said. “Home prices have to reflect the economic reality. You buy for shelter, not to make money. You do not need to own a house. I am a perfect example.”
He has rented for years and reports that the owners of his current home, after subtracting for property taxes and insurance, are receiving a cash-flow return on their investment of less than 1%. “Real estate is overpriced if owners get just a 1% return,” he said.
Baker pointed out that the stock market and home equity losses magnify the importance of safeguarding programs like Social Security and Medicare, the twin safety nets that could provide a higher portion of retirement support than many boomers originally bargained for.
“Now that tens of millions of families have just seen much of their wealth disappear,” he said, “it is especially important to pursue policies that ensure retirement security for those on the brink of retirement.”
WHERE TO READ ALL ABOUT IT
Financial blogs come of age.
There are hundreds of thousands of financial blogs out there. (We do not number the W.I.L. Finance Digest among them, although it has some blog-like characteristics.) Which ones to bestow your time and attention upon? This Barron’s piece might work as a useful starting point for those coming to the arena cold. For others (e.g., us) it has some additions worth considerating. We are glad to see, given the source, the inclusion of the Ludwig von Mises Institute in the mix. (They include the leftist Huffington Post for balance of a sort.)
Our favorite souces of information include a mix of traditional mainstream publications such Barron’s and Forbes and more out-there sources with a strong free market/Austrian economics orientation. Neither of the former will advocate radical overhauls of the system as we might – they are children of the ruling class, after all – but both have a no-nonsense orientation to reality we have come to appreciate over the years.
These are the times that try men’s (and women’s) souls – especially those with money at risk. Where can you get some clues about this crazy market?
Many investors seek answers on financial Weblogs (blogs), where opinions and suggestions fly fast and furious. Barely formatted text strings a few years ago, many of these sites have blossomed into sophisticated information destinations with big-time venture funding and professional staffing. Some are more trafficked than the Websites of traditional publishers, and many, like RGE Monitor, are mixed-media tours de force. RGE highlights the TV appearances of co-founder Nouriel Roubini, a New York University economics professor, which I guess makes it a vlog (video blog).
RGE often makes the best website lists of mainstream business publications like The Wall Street Journal. It features granular coverage of the global financial crisis, and is steeped in macroeconomic expertise. A former White House adviser, Roubini headlines a collection of deep thinkers like former Harvard University President Lawrence Summers.
RGE Monitor links to the blogs of its commentators, including the Big Picture’s acerbic Barry Ritholtz (acerbic as in references to the Fed as “Wall Street’s bitch” and U.S. Treasury Secretary Paulson as “Hank the Destroyer"). A frequent CNBC commentator, Ritholtz is CEO at quantitative-research firm FusionIQ. He opines on everything from trading tactics to macroeconomics (sometimes to Barron’s) on a site that averages more than 65,000 daily visitors.
A good way to have Ritholtz and other commentators delivered to your inbox free daily is via blog aggregator Seeking Alpha. You can configure its mailings to focus on just the topics you want. And then there’s Seeking Alpha’s unbeatable free archive of earnings-call transcripts.
Need a lift? The Ticker Sense Blogger Sentiment Poll of Birinyi Associates was off-the-chart bullish recently after being off-the-chart bearish in October. The market researcher draws from a list of stellar financial bloggers, making it a good place to start your blog shopping or find links to other good financial sites. Founder Laszlo Birinyi warned in August 2007 that our markets were set up for “systemic failure.” I should have listened.
Other blogs that are favorites of Barron’s editors are Bespoke Investments, Minyanville and RealClear Markets. Market researcher/money manager Bespoke serves up brief and pointed comment on market twists and turns, usually flowing from a hard data set.
Minyanville is a nice change from the usual economic fare. Cartoon characters Hoofy and Boo opine via Flash and podcast on everything from Bernanke to bailouts, joined by others blogging on the economy, personal finance and trading. Founder and former derivatives trader Todd Harrison calls it “financial infotainment.”
RealClear Markets is another perch for a Who’s Who of academics and institutional investors – who presumably know a little more than us plain folk. Editor John Tamny is a senior economist with H.C. Wainwright Economics, while others like Kairos Capital Advisors’ Russell Redenbaugh and James Juliano connect the dots between Washington’s ethanol mandates and Third World famine.
In that vein, we do not have a market problem; we have a policy problem, argues Thomas DiLorenzo, a Loyola College economics professor. He blogs at the Ludwig von Mises Institute that the headwaters of the credit crisis can be traced to congressional pressure on the banking industry. Von Mises founded the Austrian School of Economics, promoting unbridled free-market capitalism and the gold standard.
Those who prefer the other end of the political spectrum can mouse over to the ultra-slick Huffington Post. Possibly the Web’s most successful dispenser of political economics, the initial text blog has grown into easily digested news, views, videos and slide shows. In October, HuffPost took the #1 spot on Technorati’s Top 100 blogs based on the number of Websites linking to it. It claims 20 million readers!
A daily paean to Upper West Side of Manhattan revolutionary chic, it is hard to top the Post’s description of itself as “a progressive news hub where outraged people go in order to get more outraged before going to have dinner at Nobu.”
Prechter on T-Bonds, Gold, and Deflation
In certain types of economic scenarios, certain types of investments are supposed to move in opposite price directions: for example, Treasury bonds and precious metals.
In an inflationary economy gold prices should go higher, while in a deflationary environment Treasury bond prices should go higher. These assumptions are rational. What is more, the logic behind these assumptions explains why virtually no one should go along with the idea that gold and Treasury bond prices could simultaneously decline.
The problem is, financial markets are often irrational, and appear to take perverse delight in punishing “rational” assumptions. Just look at the past decade: if gold and Treasury bond prices cannot simultaneously fall, how did they manage rise together for 10 years?
There Is No Value, Only Growth
We are not suggesting that there is no value in stocks, more that there are no “value stocks.” The chart below highlights the performance of several style indices provided by S&P and Birinyi Associates. The “Birinyi Dividend Index” is constructed of S&P 500 stocks that yielded between 4 and 10% on 12/31/2008 (112 issues and not all financial). As shown, these dividend stocks and the S&P 500 Pure Value index have performed worst of the seven styles shown – -62.7% and -67.5% respectively; the S&P 500 Financial Sector is down 78.4% by comparison.
In short, the values have gotten better, the yields have gotten higher and the market does not care. P/E ratios, price to book, and other valuations do not matter in this market. At the end of the day any valuation based on trailing earnings has no bearing going forward, and estimates for these supposed “value” companies are so uncertain that they have become useless. Google with a P/E of 20 is up 34% on the year, and GE with a P/E of 4.7 is down 44%.
It Is Time to Buy Coffee
The parabolic price runups in so many commodities in 2007-08 proved to be as sustainable as parabolic price runups usually are, i.e., not. They collapsed along with financial asset prices last fall. Price action notwithstanding, we find ourselves sympathetic to many of the long-term bullish cases for specific commodities, e.g., grains and energy. As for coffee, we do not know, but it looks as though it is headed for one of its periodic bad crop/price spike cycles.
Coffee roasters are eyeing a supply deficit of top-quality beans out of Latin America – giving an already bullish coffee-price scenario another jolt.
Prices have been forecast to rise this year on expectations of smaller harvests for the developing 2009-10 marketing-year crops from Brazil and Peru. But late, small harvests out of Central America, Colombia and Mexico for the current 2008-09 cycle have spurred renewed bullish interest. And demand for coffee is still percolating, despite a global economic slowdown.
So the lack of the top-quality beans known as mild-washed arabica has some industry watchers suggesting that ICE Futures U.S. coffee could soon break the $2-a-pound mark. On Friday, the May contract settled at $1.1120 per pound, down 3.3% on the week, as traders acted on global economic jitters and speculative selling.
Already, premiums paid for these types of beans in physical markets have risen to levels not seen since June 1997, when coffee futures surged to 20-year highs above $3 a pound. Supplies of those beans will continue to be under pressure until the next main Latin American coffee harvest starts in October.
Before the 1997 rally, it was a similar combination of an extended supply squeeze, rapidly shrinking global stocks and growing demand for oversold, high-quality beans that sent premiums sharply upward.
“It was seeing how differentials were rising in the fourth quarter of 1996 that got me wildly bullish on the market at the time,” says Judith Ganes-Chase, who was senior softs analyst for Merrill Lynch at the time, and now runs J. Ganes Consulting. “The situation is more precarious today than it was in 1997, and this market is headed sharply higher. I do not think that passing the $2-a-pound mark is going to be a challenge.” ...
Says Ted Lingle, executive director of the Quality Coffee Institute: “There has been a growing deficit for [this type] of coffee, and now this coffee is simply not there.” Adding pressure, too, notes Lingle, is the fact that these high-quality beans only make up between 8% and 10% of total world coffee output, and are not easily replaced with other coffees. ...
With supplies coming down and demand still growing, there is little to suggest improvement in the deficit balance. Meanwhile, roasters are reportedly paying up to move their contracts forward, in order to ensure they will have supply later in the year. It is time to buy coffee.
3 Stocks for Bottom Fishers
On Friday I noted stocks were arguably cheap, but that they might nonetheless fall well further based on two historic measures. For two centuries stocks have yielded an average of 5%, and now pay 3.3%, leaving investors with too much to hope for in price gains and not enough to pocket in cash.
Also, for about 130 years stocks have traded at an average of 14.5 times trailing earnings, and stand now at 13.5 times trailing earnings after Monday’s dramatic selloff. But the market has also spent several multiyear stretches at single-digit price/earnings ratios. With stocks having traded at more than 20 times earnings for most of the past two bubbly decades, it seems plausible (if far from certain) that they could dip to 10 times earnings.
What might the market look like at such a valuation? It is not hard to imagine, since some stocks are already there. Consider the following three, which sport dividend yields of more than 5% and P/E ratios at or near single digits — perhaps just the thing for investors looking for shares that might have already bottomed out.
The article goes on to recommend Baldor Electric (BEZ), Merck (MRK), and Philip Morris International (PM).
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