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THE IMPORTANCE OF CAPITAL THEORY
You can’t get there from here if you do not know where “here” is.
This short treatise attempts a layman’s introduction to an academic subject, the Austrian Economics theory of capital. Why is this important now? Because the theory that distortions in the current capital structure are behind our current problems is, to us, a compelling one. From that it follows that the way out of the mess is to facilitate the reestablishment of a healthy capital structure. Yet, no non-Austrians are advocating policies which address that goal. Instead they press initiatives which continue the distortionary policies of old, piling on measure upon counterproductive measure.
As I have read countless analysts, including professional economists, offer “solutions” to the financial crisis, I have become more convinced of the importance of capital theory. You see this with the dichotomy people keep drawing between the financial markets and the “real economy,” a distinction that is useful for some purposes but which in this context often reinforces the idea that the stock market is really just a casino.
When the Paulson Plan was first being debated, even sharp, free-market thinkers who are otherwise very solid were recommending instead that “bank recapitalization” was the way to fix things. But if our troubles stem from a diversion of real resources into the housing sector – if too many and too big homes were built at the expense of other possible uses for those inputs – then government financial transfers per se will not do anything except redistribute the losses.
Once we understand how our present problems are due to a Fed-induced distortion in the capital structure, it becomes clear that the worst recommendation is for the Fed to cut interest rates and pump in ever more “liquidity.” It was artificially cheap credit that fueled the housing boom in the first place. Greenspan brought the federal funds target rate down to a ridiculous 1% – meaning the interest rate was actually negative, once we adjust for price inflation – and held it there for a year. He did this in order to (apparently) obviate the need for a harsh recession in the “real economy” after the dot-com crash. But in fact he sowed the seeds for our present crisis. If Bernanke continues shoveling in hundreds of billions to needy bankers, five years from now Americans (and the rest of the world) may look back fondly on the present the way the 2001 downturn now seems like a minor inconvenience.
Krugman and Cowen Ridicule the Austrian “Hangover” Theory
Rather than start from scratch, in this article I will illustrate the importance of a solid theory of capital by showing how very intelligent economists – one of whom is now a Nobel laureate – make elementary mistakes in their critique of Austrian business cycle theory (ABCT). For the sake of brevity, I will not recapitulate the theory here. In the links above you can see my own watered-down expositions, or go here for Roger Garrison’s amazing PowerPoint presentation, or here for a more comprehensive introduction. Now then, assuming the reader understands the basic Austrian story, let us quote Tyler Cowen’s recent discussion of Paul Krugman’s Slate critique of ABCT:
[Paul Krugman:] Here is the problem: As a matter of simple arithmetic, total spending in the economy is necessarily equal to total income (every sale is also a purchase, and vice versa). So if people decide to spend less on investment goods, doesn’t that mean that they must be deciding to spend more on consumption goods – implying that an investment slump should always be accompanied by a corresponding consumption boom? And if so why should there be a rise in unemployment?
[Tyler Cowen commenting on the above quote:] But I think the point is more effective in reverse. Why should the boom be a boom in the first place? The shift toward investment goods, and thus away from consumption goods production, should mean falling real wages, not rising real wages. In other words, the Austrian theory does not generate the very high degree of comovement found in the data.
These are actually two separate points, i.e., Cowen did more than simply “reverse” the argument, he slightly changed the point. To help the reader understand my response, let me paraphrase (what I take to be) Krugman’s and Cowen’s similar (but distinct) objections to the Mises-Hayek theory.
The basic Austrian story is that during the artificial boom, workers’ labor and other resources get channeled into investment projects that are not compatible with the overall level of real savings. Sooner or later, reality rears its ugly head, and the unsustainable projects have to be abandoned before completion. Entrepreneurs realize they were horribly mistaken during the boom, everybody feels poorer and slashes consumption, and many workers get thrown out of jobs until the production structure can be reconfigured in light of the revelation.
Now then, Krugman is saying that this story does not make sense. We can stipulate that certain producers (such as builders) expanded too aggressively in a boom, and then they suddenly discover that their customers no longer want to buy their products (urban office buildings, let us say). But, Krugman explains, people in the economy have to spend their income somewhere. If the income is not going towards $10 million office buildings, it must be getting channeled into movie tickets, or electric generators, or copies of Peter Schiff’s book. So it is not at all obvious, Krugman concludes, why massive unemployment should accompany the onset of the “hangover” from the credit binge. The jobs destroyed in the “higher-order” (in Austrian jargon) stages ought to be offset by newly created jobs in the lower-order stages.
Tyler Cowen’s objection is similar, but as I said, it is not quite the same. Cowen wants to know why people should feel rich during the Fed-induced boom, as the Austrians allege. In fact, because workers and materials are shifted into producing higher-order goods like tractor trailers and orange cones for road crews, the fact of scarcity implies that there should be fewer consumption goods (TVs, steak dinners, sports cars) being cranked out when the boom first sets in. If fewer consumption goods are being produced, then per capita real income has to fall, which again is the opposite of what the Austrians claim.
I have done my best to paraphrase what I understand to be Krugman’s and Cowen’s points. I must confess that even while typing out the above, the non sequitur in each objection jumped out at me. For Krugman, his argument relies on a static conception of income and spending. Just using that accounting tautology – without indexing for time – Krugman could also argue that real income can never change in an economy, even if the government announced that the most productive 10% of workers in every firm would be shot. (After all, total income would still equal total spending.)
As for Cowen, he seems to be assuming that “real income” is equivalent to “real consumption.” I do not know what to say except, “No it isn’t.” If a worker gets a job in a silver mine and gets paid in ounces of silver that he stores in his basement, he can have very high “real wages” even if his consumption is very low. In fairness, Cowen fired off the above on his blog, not in a refereed journal article. I would hate to see a collection of the dumbest things I have ever said on my blog. So let us assume that he meant to say that ABCT makes us expect real consumption (not income) to fall during the boom period. Cowen’s point is that this does not match with the data. During the boom, we see increased investment in new (and more “roundabout” in Austrian lingo) projects, and we see workers getting paid more and hence buying more consumer goods. But should this not be impossible, Cowen asks, if, as the Austrians claim, during the boom, resources are pulled away from consumption goods (like iPhones) and instead are devoted to the production of investment goods (like tractor trailers)? In the next section we will see what Cowen is overlooking.
A Sushi Model of Capital Consumption
Above I have pointed out some of the basic flaws in Krugman’s and Cowen’s arguments. (Other Austrians have responded to Krugman in the past. See the replies of Garrison and Cochran.) More generally, they are ignoring the all-important notion of capital consumption. This is why one needs to understand capital theory, as pioneered by Carl Menger and Eugen von Böhm-Bawerk, in order to make sense of what the heck just happened in the U.S. economy. Any talking head on CNBC who does not understand capital consumption is going to give horrible policy recommendations.
When thinking about this article, I went back and forth. I have decided that I should spell out a “model” of intermediate complexity, because if I simplify it too much, it might not really click with the reader, but if I go overboard with it, no one in his right mind would finish the article. Without further ado, let us examine a hypothetical island economy composed of 100 people, where the only consumption good is rolls of sushi.
The island starts in an initial equilibrium that is indefinitely sustainable. Every day, 25 people row boats out into the water and use nets to catch fish. Another 25 of the islanders go into the paddies to gather rice. Yet another 25 people take rice and fish (collected during the previous day, of course) and make tantalizing sushi rolls. Finally, the remaining 25 of the islanders devote their days to upkeep of the boats and nets. In this way, every day there are a total of (let us say) 500 sushi rolls produced, allowing each islander to eat 5 sushi rolls per day, day in and day out. Not a bad life, really, especially when you consider the ocean view and the absence of Jim Cramer.
But alas, one day Paul Krugman washes onto the beach. After being revived, he surveys the humble economy and starts advising the islanders on how to raise their standard of living to American levels. He shows them the outboard motor (still full of gas) from his shipwreck, and they are intrigued. Being untrained in economics, they find his arguments irresistible and agree to follow his recommendations.
Therefore, the original, sustainable deployment of island workers is altered. Under Krugman’s plan for prosperity, 30 islanders take the boats (one with a motor) and nets out to catch fish. Another 30 gather rice from the paddies. A third 30 use the fish and rice to make sushi rolls. In a new twist, 5 of the islanders scour the island for materials necessary to maintain the motor; after all, every day it burns gasoline, and its oil gets dirtier. But of course, all of this only leaves 5 islanders remaining to maintain the boats and nets, which they continue to do every day. (If the reader is curious, Krugman does not work in sushi production. He spends his days in a hammock, penning essays that blame the islanders’ poverty on the stinginess of the coconut trees.)
For a few months, the islanders are convinced that the pale-faced Nobel laureate is a genius. Every day, 606 sushi rolls are produced, meaning that everyone (including Krugman) gets to eat 6 rolls per day, instead of the 5 rolls per day to which they had been accustomed. The islanders believe this increase is due to use of the motor, but really it is mostly due to the rearrangement of tasks. Before, only 25 people were devoted to fishing, rice collection, and sushi preparation. But now, 30 people are devoted to each of these areas. So even without the motor, total daily output of sushi would have increased by 20%, assuming the islanders were equally good at the various jobs, and that there were plenty of fish and rice provided by nature. (In fact, the contribution of the motor was really only the extra 6 rolls necessary to feed Krugman.)
But alas, eventually the reduction in boat and net maintenance begins to affect output. With only 5 islanders devoted to this task, instead of the original 25, something has to give. The nets become more and more frayed over time, and the boats develop small leaks. This means that the 30 fishermen do not return each day with as many fish, because their equipment is not as good as it used to be. The 30 islanders making sushi are then in a fix, because they now have an imbalance between rice and fish. They start cheating, by putting in smaller pieces of fish into each roll. The islanders continue to get 6 rolls per day, but now each roll has less fish in it. The islanders are furious – except for those who are repulsed by the idea of ingesting raw fish.
Being a trained economist, Krugman knows what to do. He suggests that 2 of the rice workers and 2 of the sushi rollers switch over to help the fishermen. Now with 34 workers, the islanders are able to catch almost as many fish per day as they were in the previous months, even though they are now using tattered nets and dilapidated boats. Krugman – being very sharp with numbers – moved just enough workers so that the fish caught by the 34 islanders matches up perfectly with the rice picked by the remaining 28 islanders who go to the paddies every day. With this amount of fish and rice, the 28 workers in the rolling occupation are able to produce 556 sushi rolls per day. This allows everyone to consume about 5 and a half rolls per day, with a bonus roll left over for Krugman.
The islanders are a bit concerned. When they first followed Krugman’s advice, their consumption jumped from 5 rolls to 6 per day. Then when things seemed to be all screwed up, Krugman managed to fix the worst of the discoordination, but still, consumption fell to 5.5 rolls per day. Krugman reminded them that 5.5 was better than 5. He finally got the crowd to disperse by talking about “Cobb-Douglas production functions” and drawing IS-LM curves in the sand.
Because this is a family-friendly website, we will stop our story here. Needless to say, at some point the 5 islanders devoted to net and boat production will decide that they have to cut their losses. Rather than trying to maintain the original fleet of boats and original collection of nets with only 5 workers instead of 25, they will instead focus their efforts on the best 20% of the boats and nets, and keep them in great shape. At that point, it will be physically impossible for the islanders to prop up their daily sushi output. In order just to return to their original, sustainable level of 5 sushi rolls per person per day, the islanders will need to suffer a period of privation where many of them are devoted to net and boat production. (We can only hope that Professor Krugman has been rescued by the Swedes by this time.)
The 5 people looking for ways to synthesize gasoline and motor oil will have to abandon that task, because it was never appropriate for the islanders’ primitive capital structure. The islanders will of course discard the motor brought to the island by Krugman once it runs out of gas.
Finally, we predict that during the period of transition, some islanders will have nothing to do. After all, there will already be the maximum needed for catching fish with the usable boats and nets, and there will already be the corresponding number of islanders devoted to rice collection and sushi rolling, given the small daily catch of fish. There would be no point in adding extra islanders to boat and net production, because then they would end up building more than could be sustained in the long run. Hence, the elders rotate 10 people every day, who are allowed to goof off. They could of course go try to catch fish with their bare hands, or go gather rice that would just be eaten in piles by itself, but everyone decides that this is a waste of time. Given the realities, it is decided that during the transition, 10 people get the day off, even though everyone is hungry. That is just how bad Krugman’s advice was.
As our simple story illustrates, in modern economies workers use capital goods to augment their labor as they transform nature’s gifts into consumption goods. Because of the time structure of production, it is possible to temporarily boost everyone’s consumption, but only at the expense of maintaining the capital goods (the boats and nets), which are thus “consumed.” At some point, engineering reality sets in, and no “stimulus” policies can prevent a sharp drop in consumption.
Although the story of the sushi economy was simplistic, I hope that it illustrated essential features of a boom-bust cycle. When the islanders first implement Krugman’s advice, they all feel richer. After all, they really are eating 6 rolls per day instead of 5; there is no arguing with results. And they would have no reason to suspect an unsustainable restructuring, either: After all, they are using a new outboard motor. This is analogous to the arguments about the “New Economy” during the dot-com boom, or the confidence placed in the new financial instruments used during the housing boom. During every boom, people can always come up with reasons that “this time it’s different.”
In the sushi economy, this initial prosperity was illusory. Although there were indeed benefits from the new technology, the bulk of the extra consumption was being financed through capital consumption, i.e., by allowing the boats and nets to deteriorate. This is analogous to Americans’ consuming a massive amount of imported consumption goods during the housing boom, because they erroneously thought their rising house values would more than compensate. In other words, had Americans realized that their real-estate holdings would plummet in a few years, they would not have consumed nearly as much. They were consuming capital without realizing it, just as the islanders did not realize that their extra sushi consumption was largely financed through neglect of their boats and nets.
Note too that this aspect of the story answers Cowen’s objection: People consume more during the boom – i.e., the villagers eat more sushi per day – even while new, unsustainable investment projects are started. (In our sushi economy, the unsustainable project was looking for gasoline for the newfangled outboard motor.) Cowen is right that a sustainable lengthening of the capital structure initially requires a reduction in consumption. What happens is investors abstain and plow their savings into the new projects. But during a central-bank-induced boom, there has not been real savings to fund the new investments. That is why the boom is unsustainable, but it also explains why consumption increases at the same time. It is true that this is impossible in the long run, but in the short run it is possible to increase investment in new projects, and to increase consumption at the same time. What you do is neglect maintenance on critical intermediate goods, just as our islanders were able to pull off the feat for a few months. A modern economy is very complex, and it can take a few years for an unsustainable structure to become recognized as such.
Finally, our sushi economy showed why unemployment increases during the retrenchment. People do not like to work; they would rather lounge around. In order for it be worthwhile to give up leisure, the payoffs from labor have to be high enough. During the “recession” period, when the islanders had to cut way back on output from the fish, rice, and sushi-roll “sectors,” there were not 100 different tasks worth doing. In our story, we stipulated that only 90 people could be usefully integrated into the production structure, at least until the fleet of boats and supply of nets start getting restored, allowing more of the “unemployed” islanders to once again have something useful to do.
In the real world, this also happens: During the recession following the artificial boom period, resources need to get rearranged. Certain projects need to be abandoned (like hunting for gasoline in the sushi economy), and critical intermediate goods (like boats and nets) need to be replenished since they were ignored during the boom. It takes time for all of the million-and-one different types of materials, tools, and equipment to be furnished in order to resume normal growth. During that transition, the contribution of the labor of some people is so low that it is not worth it to hire them (especially with minimum-wage laws and other regulations).
Standard economics ignores trivial factors like time.
The elementary flaw in Krugman’s objection is that he is ignoring the time structure of production. When workers get laid off in the industries that produce investment goods, they cannot simply switch over to cranking out TVs and steak dinners. This is because the production of TVs and steak dinners relies on capital goods that must have already been produced. In our sushi economy, the unemployed islanders could not jump into sushi rolling, because there were not yet enough fish being produced. And they could not jump into fish production, because there were not enough boats and nets to make their efforts worthwhile. And finally, they could not jump into boat and net production, because there were already enough islanders working in that area to restore the fleet and collection of nets back to their long-run sustainable level.
People in grad school would sometimes ask me why I bothered with an “obsolete” school of thought. I did not bother citing subjectivism, monetary theory, or even entrepreneurship, though those are all areas where the Austrian school is superior to the neoclassical mainstream. Nope, I would always say, “Their capital theory and business-cycle theory are the best I have found.” Our current economic crisis – and the fact that Nobel laureates do not even understand what is happening – shows that I chose wisely.
THRIVING IN THE DOWNTURN: REMARKABLE ENTREPRENEURS WHO ARE PROSPERING IN THE DEPTHS OF RECESSION
Six remarkable entrepreneurs who are prospering in the depths of recession by offering unique luxury goods and services.
No matter have poorly the economy as a whole is doing there is always some segments which are growing and thriving. Forbes recently featured a group of inspiring companies that are doing just fine through these times. Common elements were unique project lines or services which customers were willing to wait and pay up for, and an obsession – not too strong a word here – with quality.
All of the businesses were labor-intensive and dependent on the skills of their owners, so there exist natural limits to how big they can ever get. But in no case does the temptation to sacrifice quality in order to achieve volume or cut costs seem to have reared its head.
Growth is like a drug, and it can kill like one, too. Reckless over-stretching to hit increasingly agressive quarterly financial results – at the expense of quality, even propriety – has hobbled plenty of companies, large and small.
Which is why it is encouraging to come across a crowd of small-scale entrepreneurs who took a more disciplined approach to running their businesses – and are prospering because of it. Like any small-business owner, this group runs on gumption and grit during the best of times, and embraces any imaginative means to survive in the worst.
What sets them apart? Among other things: a lineup of unique luxury products and services, lean staffs, obsession with quality, and the courage and conviction to do things their own way.
Could they stumble if the slump wears on? Absolutely. But with healthy order backlogs – some stretching a few years out – these five operations are safe for now. Lean staffs, a passion for their products and obsession with quality give them a layer of insulation that bigger outfits do not have.
Classy Chassis: Morgan Motor has banked on sleek designs and small production for a century.
While American auto titans go begging for their lives, England’s tiny Morgan Motor Co. keeps making snazzy, old-school roadsters straight out of Bugsy Malone. Founded in 1909 when Harry Frederick Stanley Morgan (a.k.a. H.F.S.) assembled his first 3-wheeled vehicle in a small repair shop, Morgan is the planet’s oldest privately held automaker. It has been a family affair ever since. Now at the helm: Charles Morgan, H.F.S.’s 57-year-old grandson, a tall man with a deep voice, hurried gait and taste for pinstriped suits.
Morgan cranks out only 700 cars a year at a modest 5-acre factory in hilly Malvern, where potholes are marked with fluorescent chalk. Its most popular model is the $37,500 4/4 Sport – in production since 1936, with a 14-month backlog – marked by a signature bulbous nose, owl-eye headlights, tiny windshield and 1.6-liter engine that rivals the 30% heavier Mazda Miata. The wait for the curvaceous $151,000 Aero 8 – with an all-aluminum chassis and better power-to-weight ratio than the Porsche 911 GT3 – is 9 months.
Peter Morgan, son of H.F.S., took the wheel during the second half of the century, keeping production steady while cultivating international demand. When sales flattened in the 1980s as Japanese companies got more of the British market, Peter’s son Charles decided to pitch in, ditching his job as a television cameraman to snag a degree in car manufacturing at Coventry University. “I was woefully unqualified to manufacture cars,” he admits.
But Charles knew enough to focus on efficiency over expansion. Workers used to stand around, waiting for a parade of chassis to be completed before they worked on the body panels (strengthened, as they always have been, with frames of ash, a light wood that helps absorb shocks and cuts down on weight). Charles adjusted the assembly line so that more of each car was worked on at any given time. As a result, production time per vehicle fell to two weeks from three months, boosting output by a third, to 550 cars a year, and giving a quick lift to EBITDA, from 5% of revenues to 10%.
The next big challenge came in early 2000 when the European Union introduced a wave of safety and emissions standards (the U.K. has slightly looser laws). Morgan crashed 10 cars to meet the rules, a huge but smart investment as the continent now accounts for 60% of the company’s top line.
Despite the current crisis, Morgan is gaining ground. Charles figures sales will hit $38.5 million this year, up 14% from 2008. Morgan makes only cars to order. It sells via 18 dealers in Britain, 13 in Europe, 6 in the U.S. (only for the Aero 8) and a handful elsewhere. Customers must put down a nonrefundable 20% of the purchase price to secure a “build slot.” Cancelations are rare, about 5 a year.
Better yet, Morgan carries no debt and has not let go of a single one of its 155 employees in the recession. Meanwhile, British automakers Jaguar and Land Rover are seeking government handouts. Bentley, which makes 7,600 cars a year, recently cut back to a 3-day workweek on one of its lines, while Aston Martin in Warwickshire chopped its workforce in half to 600.
On the distant horizon: the Morgan LifeCar, powered by a hydrogen fuel cell supplemented by stored electricity. The British government paid half the $2.5 million in development costs to bring a working model to the 2008 Geneva auto show, while Morgan and four other partners, including the University of Oxford and British defense firm Qinetiq, covered the rest. Full production of the aluminum car, about half the weight of a conventional steel vehicle, is not planned for another 3 years.
This year Morgan Motor will be 100 years old. It might even outlive the hydrogen car.
[Also see “Ten Reasons To Buy A Luxury Car” slideshow.]
Heaven on Wheels: There is a 180-unit backlog on Sacha White’s hand-built bicycles. He is going to take his time filling it.
When Sacha White came to Oregon 12 years ago, he was one in a swarm of bike messengers in Portland – a city that, more than any other in the U.S., makes way for cyclists. That has helped White change from prole to patrician in the 2-wheeled world as founder of Vanilla Bicycles, which slowly turns out pricey, handcrafted machines. Bike couriers in Portland and San Francisco, when describing something as cool, now routinely say, “That’s sooo Vanilla.”
So popular, too, that White stopped taking new orders a year ago, after only 8 years in business. Vanilla’s waiting list stands at a stout 4 years. Economic turbulence, so troubling to the purveyors of most high-end toys, has not foiled demand for the bikes. “The calls and e-mails still pour in,” says White, 32. “Interest level definitely hasn’t ebbed.”
Vanilla has built just about everything – track bikes, road bikes, cross bikes, touring bikes, commuter bikes – but still keeps annual production to 40 or 50 a year. Like 1909 Honus Wagner baseball cards, Vanilla bikes are something everybody has heard about but almost no one has seen. Fewer than 500 specimens exist in the world, though you would not know from all the online chatter about White’s intricate metal carvings and joints made of silver.
Portland is a dense nest of custom bike builders, which makes White’s rapid ascent more remarkable. About half the cycles White and his staff of two create go to Portland folks, another 40% to people across the U.S., and the rest to international customers. Bikes start at $4,000 but average $7,000, including options like racks, gear sets and fenders. Some of Vanilla’s creations can soar past $12,000, but almost all of the bikes are sold to middle-class customers, White says. Vanilla nets roughly $100,000 a year on sales of $300,000.
White fell into his business after his own bike frame cracked in 1999. The frame builder, Timothy Paterek, offered a weeklong course on building for $1,250. White saved for a year to enroll and later spent 5 months making his first solo frame for his wife, then friends, then strangers who had seen or heard of his work via the spidery Portland cycling network. Taking off a month from his courier route to make bikes in 2001, White never carried another message.
When a customer’s wait ends White operates a bit like a tailor, spending 3 hours taking a buyer’s measurements in various positions to determine the geometry of the bike frame. (Faraway clients send in measurements and pictures of themselves on and off a bike.) That is followed by an optional 2-hour interview to nail cycle type and specs.
Some fancy bike frames are made from titanium alloys and weigh as little as 30 ounces. White makes a 40-ounce frame out of steel. He joins tubes by inserting the ends in “lugs,” like spool pieces in a Tinkertoy set. The glue to hold the tubes in place is molten metal, applied in a process called brazing. The usual brazing metal is brass. White uses a silver alloy that costs $24 an ounce, 20 times as much as brass. The silver forms stronger bonds than brass, and its lower melting point ensures that the heat of the operation does not compromise the steel tubes’ strength. Building the chassis represents 60% of White’s costs. The extra metal in the lugs allows him to flex his creativity. He carves designs into them, cutting their faces with a jeweler’s saw and honing them with hand files. No two bikes are exactly alike.
White once sent his frames out for painting, at $500 to $800. Now he owns a 3-employee shop that also paints bikes for 5 custom builders in Portland. The painters start with a thin layer of ground resin and pigment applied to the frame – a process known as powdercoating – which then gets baked at 450 degrees Fahrenheit. The powder gels and cures into a uniform and durable surface.
Joshua Simonds, 51, a computer scientist and bike coach, loves the Vanilla he bought. Its frame resembles off-road racers from the 1950s – and gets him from his home in Kensington, Maryland to his office 40 miles away, four days a week. Portland native Jordan Freeauf, a 46-year-old carpenter, got his bike in 2004 and took off on an 8,500-mile jaunt to San Luis Obispo, California, across the country to Georgia, then north to Quebec and back to Portland. “The bike was stunning,” he says. “I can’t tell you how many people asked me about it.”
White could ramp up production, but that, he says, is not what customers pay him for. They pay to get him. Says he, “If I ended up sacrificing what made Vanilla special just to make more bikes, that wouldn’t be worth it to me.”
Luxe Labradors: Mike H. Stewart breeds $12,000 dogs that can hunt and play.
William Behnke bought a black male English Labrador retriever named Ghillie from Wildrose Kennels in Oxford, Mississippi three years ago. A business developer at GCI, an Alaskan telecom company, Behnke has hunted with Ghillie for pheasant in Montana, quail in Texas and ducks in his home state. He also brings the dog to his office in an Anchorage high-rise. Together they attend business meetings and visit vendors. “He flies well, too, even in helicopters,” says Behnke, who has never resorted to using a leash or a collar with Ghillie. So taken is Behnke that he plans to fork over $12,000 for another Wildrose pooch named Opus, a male black Lab born in February. “I can’t imagine being without dogs, and I can’t imagine having dogs that are not well trained,” he says. “Wildrose has given me both of those things.”
Mike H. Stewart, 54, is Wildrose’s owner and head trainer. A tall, tanned former chief of police at nearby University of Mississippi (“College kids are just like dogs: They learn best from repetition and consistency,” he quips), Stewart has trained canines for 30 years. In 1999 he bought the business, then in liquidation, for a pittance. Now it is bringing in $1 million a year in revenue.
Wildrose deals only in English sporting Labradors, in black, yellow, chocolate and fox red (a darker shade of yellow). Stewart aims for what he calls “the 365 dog” – patient and obedient in the field, loving and playful at home. It is an unusual combo for a hunting dog, hence the demand. The backlog for new pups is 210 names deep, enough to keep this operation busy until 2010, and it is growing. Orders for Wildrose puppies have climbed to 45 per month. Most deliveries take place in the spring and fall.
Prices range from $1,275 for a black, yellow or fox red to $1,500 for a chocolate (the rarest type). Stewart also sells what he calls “finished” dogs – those that have lived and trained at Wildrose for 2 to 3 years and have hunted 1,000-plus fallen birds. He has already sold out this year’s allotment of 15 finished dogs and is taking orders for next year, at $10,000 to $12,000 apiece.
Stewart claims his English Labs are purer than the U.S. breed (the most popular in America since 1992), which has been cross-bred repeatedly, thus muddying the gene pool. Originally from Newfoundland, Labs fetched fish slipped from hauling nets without puncturing the skin. Their tender grip made them useful to British hunters looking to gently retrieve downed game birds. Stewart traces his dogs’ lineages to English hunting clubs, such as Queensberry Estate in Scotland and Arley Hall Estate in England, where hunts can cost thousands of dollars a day. “A misbehaving dog won’t be asked to hunt there again,” he says.
Wildrose stretches over 143 acres, with 66 kennels and various fields, creeks and ponds where pups are put through their paces. Many sporting dog trainers use shock collars and whips; Stewart prefers simple positive reinforcement, sternly delivering directions with a crisp “Good” or “No.” Pups get treats for good behavior, while older dogs earn companionship or the chance to retrieve. Bad behavior? Ignored. If a dog comes tearing out of the house, Stewart stands dead still until it calms down and sits at his feet. “Then we will go do what they love,” he says.
Owners need training, too. Before they pick up a puppy, usually at the 6-week mark, customers do a tour of the grounds, followed by a few hours of instruction in the commands and behavioral methods. With finished dogs, owners must spend a couple of days at Wildrose with Stewart and two other trainers. If the owner can handle the dog, Stewart lets him take the dog home. (Five times in a decade an owner has had to spend an extra day in training.)
Richard Adkerson, chief executive of the mining firm Freeport-McMoran, knows the drill. Adkerson owns two Wildrose black labs, 7-year-old Daisy and 18-month-old Carly. He says Stewart teaches owners to be the leader of the pack. “You have to master the commands, be consistent and look the dog in the eye,” he says. Like Behnke, Adkerson takes his pooches everywhere, even when strolling through the bustling French Quarter of New Orleans, where he owns a home.
Still, $12,000 for a dog? Stewart points out that people spend four times as much for a car they will get rid of in a few years. Raines Jordan, chief financial officer of Alexander Contracting in Columbus, Georgia, agrees. Battered by the recession, he recently bought a fox red Lab named Ti. “I’ve lost a tremendous amount of what I have worked for in my life,” he says. “I thought, hell, I might as well spend what’s left on some enjoyment.”
The Reel Deal: For $2,200 you can own a Bogdan. Slightly more if you want one used.
This exclusive club includes Bing Crosby, Benny Goodman, Ted Williams, Prince Philip, the Duke of Wellington and Paul Volcker. At one time or other they all cranked in silvery salmon with Bogdan fishing reels, known for their strength and distinctive styles: matte black plates, champagne-gold spools and S-shaped handles. Still handmade by 90-year-old Stanley Bogdan and his son Stephen, 59, the reels come in 15 sizes – to haul in Atlantic salmon or the smallest trout. They cost between $1,300 and $2,200.
The Bogdans are navigating this recession just as they have every other one over the last 7 decades: by staying small and doing things their own way. Every part of a Bogdan reel, save for the springs, is tooled by Stanley or Stephen, S.E. Bogdan Custom Built’s sole employees. In their garage-size shop in New Ipswich, New Hampshire stands a table littered with dozens of boxes, each containing different parts of a fly-fishing reel: discs of stainless steel, screws, brake shoes, anodized aluminum frames and spools. Armed with a 130-year-old Flather lathe and a 50-year-old Van Norman milling machine, the pair churn out only 100 reels a year and have a 3-year backlog. They hold no patents, take no deposits from customers (“That way they can’t bug me, and I have control,” says Stanley), store no files, designs or accounts on a computer (they do not own one) and do no advertising.
A short man with fine white hair, Stanley, who never attended college, made his first reel in 1940 while an apprentice at Rollins Engine Co., a steam-engine maker. At night he worked on his reels, going full-time in 1955. “I was petrified,” he admits, but soon was filling orders for Abercrombie & Fitch and, later, Orvis. Annoyed at surrendering 40% of the $100 retail price, Bogdan became his own sole distributor in 1977, taking orders by phone or mail. Stephen bought him out in 1996, but Stanley is still in the shop three days a week. “I’m quality control,” he says.
The beauty of a Bogdan is in the drag – the mechanical resistance that slows down a hooked fish. Stanley invented a double-brake system using two brake shoes supported by springs that clamp down on a disc. There are 10 settings to choose from, depending on the size of the fish. The result is a smooth drag with no hitches that could break off a fleeing fish. When taxed by a large salmon, the drag makes a distinct whirring sound – or, in the words of Royall Victor III, a retired Chase Manhattan executive who owns 6 Bogdans, “the muted joy of exultation.” To that add the powerful pull of exclusivity. Owning a Bogdan “puts you into the specially anointed of salmon fishers,” says former U.S. Federal Reserve chairman Paul Volcker. Bozo Ivanovic, a retired London ship broker, famed fisherman and owner of four Bogdans, sums it simply: “Finally getting your Bogdan is an event.”
Antsy anglers go to great lengths to try to speed up delivery. Some have offered double the price, says Stanley, but he rarely budges. At one party a man lifted his shirt to reveal scars from a recent bypass surgery as evidence that he had only a short time to live and thus should be moved up the waiting list. Bogdan fell for it. The man eventually got his reel, then lived another 15 years.
The Bogdans have made one concession to demand. A few years ago, after seeing what the used reels were fetching online, they doubled their prices overnight. That still did not close the gap: Even in the midst of the recession, used Bogdans are going for up to $3,000 on eBay – 36% more than the most expensive model sold new. “I thought [raising the price] would be the end of us,” says Stanley. “Turned out to be the best move I ever made.”
Maestro: How do you make a $130,000 violin? Practice.
In 2003 a violin built by Samuel Zygmuntowicz for Isaac Stern sold for $130,000 at auction, the highest price for one by a living luthier. Last year Yo-Yo Ma played a Zygmuntowicz cello worth an estimated $80,000 while on a 2-month tour. When it went back to the shop for a tune-up, Ma went back to his mainstay, a 1733 Domenico Montagnana (1686-1750) worth $2.5 million. “I want to give [Ma] a reason to leave his Montagnana at home,” says Zygmuntowicz, 52. “I keep thinking, what could be better.”
Zygmuntowicz is an artist’s artist. With intense dark eyes and large hands bearing the scars of his craft, he hews exquisite string instruments out of spruce, ebony and maple. “There are no more than six people who are at his level,” says Tim J. Ingles, director of musical instruments for Sotheby’s.
His obsession with instruments kicked in at age 13 in his parents’ Philadelphia garage, where he used a Swiss army knife and a round file to turn a discarded reed into a flute. By age 16 he started restoring violins at a workshop in town. At 19 he entered the Violin Making School of America, the first trade school of its kind, in Salt Lake City. Between semesters he served an internship under Carl Becker, an instrument maker who lodged the apprentice in a cabin without running water next to his summer workshop in Wisconsin.
After graduation in 1980 Zygmuntowicz landed a job with Jacques Français and Réné Morel, two dealer-restorers in New York City. The gig paid a paltry $180 a week, but he worked on instruments made by masters like Antonio Stradivari (1644-1737) and Giuseppe Guarneri (1698-1744). In the evenings he refurbished violins at home to make ends meet. The toil paid off in 1984, when he sold a homemade violin for $6,500 to one of Français’s former customers. Soon he was attracting accomplished fiddlers.
Eugene Drucker, a violinist and founding member of the Emerson String Quartet, is a fan. Drucker owns a 1686 Stradivari violin and a 2002 Zygmuntowicz, moving between the two, depending on the material, the performance venue and his mood. “In a large space like Carnegie Hall, the Zygmuntowicz is superior to my Strad,” he says. “It has more power and punch.”
Zygmuntowicz works on two floors of his 5-story brownstone in Park Slope, Brooklyn, which he shares with his wife, Liza Bruna, and two young sons. His apprentice, 25-year-old Collin Gallahue, lives in the attic. Zygmuntowicz meets clients in the “salon,” a wide-windowed room with mismatched antique chairs, a grand piano and cabinets housing diagrams of nearly every instrument he ever touched. One large pencil sketch of a cello – Yo-Yo Ma’s – hangs on the wall.
While routinely putting in 15-hour days, Zygmuntowicz makes only half a dozen instruments a year. His waiting list stands at 30, a comforting 5-year backlog. He charges roughly $53,000 for a new violin and $90,000 for a cello – low enough to keep the order book filled with musicians (as opposed to collectors) but rich enough to let him spend a lot of time on a single job. He takes a 20% down payment and signs a contract containing what he calls a Tahiti clause: “I hope to be able to complete your order in four years.” If clients lose patience along the way, they can have their money back. “I started to realize I was booked so far in advance, what if I needed a break?” he says.
Zygmuntowicz compares making violins to playing chess: “You need to understand how the moves you make now will behave further down the line.” First step is selecting the wood. He typically uses spruce from the Dolomite region of Italy for the front; curly or flamed maple from the Balkans for the back, neck and sides; willow for the interior blocks and lining; dyed pear and poplar from Italy for the inlay; and Sri Lankan ebony for the fingerboard. Pegs and tailpieces come from a supplier of mountain mahogany in Oregon. He then roughs out the parts with a 6-foot-high Rockwell band saw and an Inca jointer/planer. The finer work calls for tools handmade for the job. His knives, sharpened every hour as he works, barely poke through their wooden handles, allowing him to get close to the wood. As the instrument’s back and front thin down, he switches to a steel scraper, shaving only at night under a single draftsman’s lamp to pick up shadows and contours. He heats the maple with a bending iron to form the sides (or ribs).
Once pieced together, the violins sit under the sun or an ultraviolet lamp to settle before varnishing. Zygmuntowicz uses a 16th-century recipe, mixing a proprietary resin with linseed oil and heating the goop for several days. Slathering it on is a big moment: “That is when it crosses the border from a dead to a living thing,” he says. Finally, he adds the strings and bridges, followed by weeks of testing with numerous musicians. E presto.
[Also see video “Eugene Drucker Of The Emerson Quartet With His Zygmutowicz”.]
Skin Trade: Unlike many plastic surgeons, Dr. Yan Trokel is getting a lift during the recession.
Beauty is supposed to be only skin-deep. But for Dr. Yan Trokel it runs right to the bone. The 39-year-old Manhattan cosmetic surgeon is pushing a new face-hoisting technique – called the Y Lift – that requires no nips, tucks or monthlong healing time. While traditional face-lifts can involve 3 to 5 hours of invasive surgery that results in stitches, swelling and bruising, the Y Lift is performed while the patient is awake and typically takes 30 to 45 minutes. “My patients can fly in, get the procedure done and go out to dinner, to a business meeting – anything they want,” says Trokel. “They look amazing immediately afterwards, and in a day or two they look even better.”
After analyzing a patient’s bone structure, Trokel maps out the face and, with just a dollop of topical pain-numbing ointment, makes a number of small holes in different locations, say, on the forehead or jawline. He inserts a thin titanium tube loaded with a gelatinous filler (a common sugar found throughout the body called hyaluronic acid) into the holes that lifts the tissues and creates a space for the filler, which he often applies directly to the bone. Once cured, the filler becomes the new foundation for the face. By massaging the filler like clay, Trokel can accentuate cheekbones and jaw lines, and even smooth out wrinkles in the neck and around the eyes.
The Y Lift – named for the letter, which Trokel says is the ideal shape of the human face – has become so popular that his calendar is booked solid for the next 6 months with actors, executives and other physicians from around the world. That backlog may not be recession-proof, but Trokel is faring a lot better than his old-school, skin-snipping competitors. Americans spent $11.8 billion on plastic surgery last year, down 9% from 2007, according to the American Society of Plastic Surgeons. Since 2000 the number of invasive cosmetic surgical procedures, such as cheek implants, chin augmentations and forehead lifts, is down 3%; meanwhile, the number of minimally or noninvasive procedures – hyaluronic acid treatments (that would be for wrinkles), laser skin-resurfacing and hair removal – leapt 81%. When it comes to vanity operations, patients prefer to pass on the knife if they can.
Born in the Republic of Georgia, Trokel immigrated to the U.S. with his parents in the 1970s. His father set up an art and antiques dealership, but Trokel knew early on he wanted to work on faces. That is why he went to dental school at Columbia University. “If you really want to understand the face, you have to know how everything works,” he says. “The jaw makes up three-quarters of the face.” Later he attended medical school at the University of Texas Southwestern Medical Center at Dallas and spent 8 years at nearby Parkland Hospital doing everything from cancer resections to facial-deformity reconstructions.
Trokel’s quicker, cleaner approach is based on a fundamental observation. “As people age, they do not grow extra skin,” he explains. “So we really do not need to be cutting the excess skin, because there is no such thing.” Over time our facial skin gets thinner, the muscles atrophy and the bone diminishes; that lack of total facial volume results in saggy-looking skin. The Y Lift essentially replenishes the volume. Trokel likens it to making a bed: “You can’t just throw on the duvet. You have to do all the layers to make it look really nice.”
Perfecting his technique after four years, Trokel brought his show to New York in 2006. As word of mouth spread, his 2,000-square-foot office – now with 10 other staffers (nurses, technicians and clerical folk) – was soon at full capacity, remodeling 8 to 12 faces a day. With the cost of his assorted procedures running $5,500 to $12,000 apiece, Trokel’s business probably pulls in at least $2 million a year in revenue.
The assembly-line ramp-up is not a good model in this business. “It is my brand and my name,” Trokel says. But he is pondering slow expansion within the limits of quality control: training classes for other surgeons looking to learn the procedure – for a handsome licensing fee, of course. Even a healthy business needs an occasional makeover.
Tattoo Artist: He will not do unicorns, but for snakes and skulls, tattoo artist Paul Booth charges $400 an hour.
The dungeon-like room, lit only by small fluorescent lamps above three chairs, greets the customer with piercing heavy-metal music that sends vibrations through the floor. Flickering red candles illuminate the black walls, adorned with paintings and sculptures of monsters, skulls and bleeding faces.
This is not the set of a Nine Inch Nails’ video. It is Last Rites Tattoo Theatre in Manhattan’s Hell’s Kitchen, where Paul Booth, 41, works his black magic. Much of his portly, 5’ 10” frame is covered in black tattoos. His favorite – running from the right side of face over the top and back of his buzzed-bald head – is an abstract design sketched by his mentor Felix Leu and inked by Leu’s son Filip (Felix died of cancer before he could finish the job). A hoop ring hangs from between Booth’s nostrils, and dark dreadlocks dangle from his nape to his knees – an incongruous presentation, given his warm smile and easy laugh. “I just see the darker side of life,” he says.
He also sees a brighter side to the recession, thanks to his lofty $400-an-hour rate and a waiting list he says runs 3,500 clients deep, not including the tamer throngs he turns away. “I won’t do unicorns,” he warns.
Yet for every Fred Durst (the ink-saturated front man for the rock band Limp Bizkit), and wrestler Mark “The Undertaker” William Callaway – both current customers – Booth says he serves at least as many doctors and lawyers. “Going to Paul is expensive but worth it,” avers Brandy Coco, a 27-year-old financial adviser from Gates Mills, Ohio, who waited just under two years to get in Booth’s chair. Three visits and $3,500 later, Coco says she plans to go back again to fill in more of the Medusa-and-snakes design that covers her back, shoulders and tops of her arms. “It’s the same thing as paying that much for plastic surgery: It changes your body for the rest of your life.”
Many customers spend an entire day at Last Rites. Some jobs take between 10 and 12 hours over several sittings. “I consult with the person for hours sometimes before I even touch them,” says Booth, adding, a tad eerily, “I want to get inside their head, find out their fears, what troubles them and what they are looking for in the image.” The chat is gratis, as is the preliminary sketching. The payment clock starts ticking when needle touches skin.
One loyal follower, named Ismael Millano, a window installer from Newark, New Jersey, was on Booth’s waiting list for three years before getting word last month that his turn would soon be up. Millano plans to give Booth his entire arm as a canvas, a $2,000 to $3,000 job. “Some people like fancy cars, clothes or jewelry,” says Millano, 30. “For me, a tattoo from Paul is that kind of an investment. It’s a piece of art that lives on my body.”
Booth attended Catholic school through 12th grade in Boonton, New Jersey, where teachers scolded him for doodling images of monsters and skeletons during class. After high school he tried his hand at graphic design, but that too proved a tough fit. In 1988 he apprenticed at a tattoo studio in nearby Butler, where he inked generic roses, cartoon characters and the occasional skull. His big break came three years later at a Pittsburgh tattoo convention where artists were abuzz over a black and gray demon Booth had emblazoned on the thigh of his then girlfriend.
Soon after, Booth started his own parlor out of his house in Boonton and by 1997 had saved enough to open a studio on Manhattan’s Lower East Side. At its height, Booth had six tattoo artists, including himself. After his move to Hell’s Kitchen in the fall of 2007 he had a falling-out with his crew. Even with a smaller staff, down to three, Booth says Last Rites is on track to exceed $450,000 in annual revenue this year, thanks, in part, to his recently jacking up rates to $400 an hour from $250 to $300. That is more than enough to cover jaunts to tattoo conventions in Beijing, Singapore, Berlin and Cape Town, South Africa.
Booth has his eye on more than the needle. “Even though I could make a lot more money just tattooing, I have other things to do too,” he says. In 2002 he started an eponymous film production company. Its first effort: a documentary about artists from around the world coming together to paint and sell their wares to raise money for art education programs. A second film takes viewers on a tour of Booth’s tattoo studio. Last month he put out an album of haunting keyboard music, called Inspirational Hymns, sold at Target and Barnes & Noble.
His next vision: a creepy, “dark arts” bed and breakfast, preferably at an old Victorian in the woods.
[Also see slideshow “In Pictures: Paul Booth’s Creepy Design Gallery”.
Bespoke Perfumer: Want to smell like your rose garden? Or even your Bentley? Call Francis Kurkdjian.
Last summer some 70,000 visitors to an evening festival at the palace at Versailles took in a concert of a different sort. Issuing from 16 machines tucked beside the fountains was an explosion of scented bubbles in Louis XIV’s favorite fruits – melon, pear and strawberry.
This “olfactory installation,” as its creator calls it, came courtesy of Francis Kurkdjian, a 39-year-old bespoke perfumer with a ballerina’s physique and a prominent Roman nose whose fragrances start at €8,000 ($10,500) for two 2-fluid-ounce bottles.
Kurkdjian spends 3 to 12 months on one perfume – “People wait,” he sniffs – and whips up 12 to 15 scents year. (Some customers buy more than just two flacons, though Kurkdjian will not reveal total volume figures.) He demands half his fee in advance to cover the cost of materials. With five customers on his waiting list, the backlog works out to about a year, he says. Meanwhile, Kurkdjian also contracts his nose to Takasago, a Japanese chemical company that makes scents for the likes of Lanvin, Ferragamo and Kenzo.
While sales for the $39 billion global fragrance industry are flat, big players like Cartier, Guerlain, Jean Patou, Roja Dove and Lyn Harris are piling into the bespoke business – at dizzying price points. Cartier charges a reported $75,500 for 20 ounces; Guerlain starts at €35,000 ($47,330) for 60 ounces.
Kurkdjian holds his own with lots of theatrical marketing. In 2003 he literally created the smell of money (a U.S. dollar bill) for the French writer and installation artist Sophie Calle, part of a retrospective at the Pompidou Center in Paris. In 2006 he laced his scents into a sorbet of strawberry, orange flower and banana for award-winning French pastry chef Christophe Michalak. Last year he again shot bubbles – this time into the entrance of the French embassy during the Fête de La Musique, an international music festival.
Denied entry to the Ballet School of the Opera de Paris at age 13, Kurkdjian later found his calling at ISIPCA, a trade school for perfumers in Versailles. He designed his first perfume – Le Male (Jean Paul Gaultier’s best-selling masculine fragrance for the last 9 years) – at age 25 as a nose for hire. In 2001 Kurkdjian mustered the courage and savings to go the bespoke route after a friend asked him to donate some perfume to a charity auction to benefit AIDS research. Kurkdjian raised $10,000 for his nose instead.
Kurkdjian’s big show with clients starts with an hour-long phone call to find out what fragrances they wear, the occasion they want it for and what type of smells they like. (He calls it a “perfume map.”) One American client wanted the scent of his white Bentley. When another aimed for a whiff of vetiver grass, Kurkdjian asked him to specify which type of vetiver – from Haiti, China, Java or Bourbon.
Next, Kurkdjian schedules a face-to-face meeting, to which he brings his traveling lab – a 45-pound, green leather steamer trunk of ingredients, from rose and jasmine oils to cloves and ambergris (rare sperm whale secretion). In all, Kurkdjian uses some 1,200 substances to whip up his scents. Prices range from $9 a pound for lavender oil to $10,500 a pound for ambergris.
Not that mixing perfume is high science. Armed with a dropper, bottles, blotters and a small scale, Kurkdjian keeps mixing ingredients until he hits just the right note. He sends samples that customers can test out for a few weeks. If they are not happy, he tweaks the recipe and they try it again – as many times as it takes.
“You don’t do chemical reactions in the lab, you do the assemblage,” says Kurkdjian. “The ingredients are like the colors on a palette.” What if a client gets fed up and bails on the purchase along the way? “We would bill for only half the amount – if such a thing should occur.”
Snobbish as he comes off – and fickle as the retail masses are – Kurkdjian is not looking down his nose at them. This September he plans to launch a new fragrance line – at $110 to $250 a bottle.
[Also see gallery “Seven Top Bespoke Perfumers” and video “Perfume Rock Star”.]
Hiking-boot Maker, Intervale, New Hampshire
In a tin-roofed, 1790s barn, Peter Limmer makes boots the way his grandfather, founder of Peter Limmer & Sons, made boots. Eager buyers spend two years on a wait list to pay $650 for a pair of Limmer custom hiking boots (they must plunk down $50 just to get on the list). The suckers do last: Limmer does repairs and sole replacements on pairs as old as 40 years. He creates a wood and foam model from each of the customer’s feet and builds the boots around them. He only guarantees the fit if customers show up in person for measurements. One traveled 48 hours on three flights from Tasmania to get fitted. Limmer has been approached several times by companies looking to slap his name on a mass-produced line. “We’re the Grateful Dead of bootmakers,” he says. “We are not about to change how we do things.”
Furniture Restorer, Hoboken, New Jersey
When Steinway wanted to recreate one of its 1877 model pianos, it called on Eric Chapeau, 46 to handle all of the wood finishing. Completed in 2002, the project took 5,000 hours, and the piano sold for $675,000. A woodworker by trade, Chapeau pulls in roughly $2 million in sales annually restoring furniture and instruments, as well as outfitting exotic residential interiors. His schedule is booked for the next year. His latest masterpiece: a mural pieced by hand for about 18 months from shells of 42,000 hardboiled eggs that runs the length of a dining room. A Manhattan hedge-fund manager shelled out $500,000 for it.
[Also see video “Woodworkinig With Master Craftsman Eric Chapeau”.]
CENTRAL BANKS UNLEASH THE NUCLEAR OPTION
With increasing regularity, central bankers are engaged in the most extraordinary currency devaluations ever witnessed.
Gary “SirChartsAlot” Dorsch tracks the extent of central bank “quantitative easing” – a euphemism for printing money. He does not seem to totally object to the idea in principle, even while expressing extreme skepticism about central bankers’ willingness to tighten up again when appropriate.
Desperate times call for desperate measures. As the global “credit crunch” has grown increasingly severe, central bankers are examining the Great Depression of the 1930s for possible parallels that are relevant to today’s situation. Most worrisome, is the synchronized meltdown of the global stock markets, which had wiped out $32 trillion of wealth, on top of another $10-trillion in losses in real estate.
Many of world’s largest banks have become “zombie banks,” and are no longer able to survive on their own without artificial life support from the federal government and the taxpayers. Banks are holding hundreds of billions of dollars of toxic assets in their vaults, with no idea how much they are worth, and this uncertainty has stopped banks from lending to businesses and individuals, resulting in the most severe credit crunch since the 1930s Great Depression.
Lessons from the bursting of the Nikkei 225 bubble in the early 1990s, and Japan’s “decade of lost growth,” focuses on the need to avoid deflation and intensifying deflation expectations. With the threat of a deflationary spiral and double-digit unemployment looming on the horizon, central banks throughout the world are now engaged in a race to the bottom on interest rates.
Furthermore, central banks are turning to the weapon of last resort, the so-called Nuclear Option – or “Quantitative Easing,” (QE) in order to keep credit flowing to the private sector. Central banks are pegging overnight interest rates near zero percent, and pumping huge amounts of cash into the money markets, by buying commercial paper, corporate and government bonds, alongside mortgages.
If done on a massive scale, QE is as a powerful stimulus, and ultimately can stabilize an economy, and buy time for the financial system to recover. Among the Group of Seven industrial nations, the European Central Bank is the most hawkish, targeting its overnight loan rate, at a paltry 1.50%, but its reluctant to cross the Rubicon, by pegging interest rates near 0%, and purchasing huge blocks of government bonds, in order to force long-term interest rates lower.
In a flash of déjà vu, Japan’s Nikkei 225 index fell to the 7,000 level this month, its lowest since 1982, after the Dow Jones Industrials briefly slumped to a 12-year low. Tokyo’s financial warlords, the world’s most brazen interventionists, are threatening to set-up a government body that will buy as much as $200 billion of exchange-traded funds and shares directly on the Tokyo stock market, to artificially prop-up prices, Finance chief Kaoru Yosano warned on February 24th.
Bank of England Experiments with QE
A prolonged climate of deflation is a central banker’s worst nightmare – it tends to deter consumers from spending until prices become even cheaper, and there is a risk that deflation could become so deeply embedded in consumer psychology, that it can lead to a prolonged period of falling prices and chronically weak company profits. Deflation, or falling prices over a long period of time, increases the cost of servicing debt as cash inflows are squeezed. Matters are made worse by falling wages and job losses, which can led to widespread defaults on auto and credit card loans.
Although the UK economy has been spared the trials of deflation since 1947, the Bank of England is worried that British households with high debts could fall prey to the “debt-deflation” trap this year. Britain is a nation of borrowers rather than savers, and it was a combination of falling prices and soaring debt burdens that plagued the U.S. economy in the 1930s. Britons’ total personal debt – the amount owed on mortgages, loans and credit cards, stands at £1.46 trillion, up 165% since 1997, and each household now owes an average of about £60,000.
Thus, the BoE’s monetary policy going forward is expected to be geared towards combating the scourge of deflation. Alongside a half-point rate-cut to 0.50% on March 5th, the BoE unveiled its nuclear weaponry, aiming to purchase £100 billion of British gilts, and £50 billion earmarked to buy corporate bonds and commercial paper. Some £75 billion will be disbursed over the next 3 months. BoE chief Mervyn King commented, “Nothing in life is ever certain. These measures, we think, will work in the long run. I cannot be sure how long it will take.”
“We are now towards the end of what is pretty clearly going to be a first quarter in which national output falls very sharply,” said BoE member Kate Barker on March 13th, “I strongly support the move to quantitative easing, and once it became necessary, it was important to act in a decisive manner. To gauge the effect of the purchases, I will be looking for a flatter gilt yield curve, narrower corporate bond spreads, and other positive effects on a range of assets. The bank may need to reverse these gilt purchases quickly, once they have their effect,” she said.
The BoE’s shift to QE jolted the British gilt market, driving benchmark 10-year yields below the December lows of 3%, and into closer alignment with the slumping Dow Jones Commodity Index, which is hovering -30% lower than a year ago, measured in local currency terms. Although the UK government’s official inflation rate is elevated in positive territory, it is widely expected to turn negative in the months ahead, mirroring the sharp slide in the global commodities markets.
The lessons learned from the Great Depression, and Japan’s post-bubble economy in the 1990s, has moved several central bankers into shocking the system with QE, trying to arrest deflationary expectations and reduce the real burden of debt. The Bank of England has moved boldly, aiming to resurrect the devil of inflation. Whereas the Japanese spent around 5% of their GDP on QE, or printing money to buy JGB’s, the BoE on the other hand, has committed to spending just over 10% of GDP.
This comes at a time when the UK’s M-4 money supply is already expanding at a record +18.8% annualized clip, and could soon rival the growth rates seen in Third World countries. But with a record 2 million Britons signing on for unemployment benefit last month, the BoE has no interest in defending the principles of sound money. “Most of us come from the generation that grew up believing that mass unemployment and world recession were things of the past, relevant to the history books but not the textbooks,” declared BoE chief Mervyn King on March 17th. “That assumption is under threat,” he warned.
Federal Reserve Begins Monetization of Government Debt
Over the course of the past decade, the BoE and the Fed have usually steered their monetary policies in the same direction. But in a strange twist, the two Anglo central banks appeared to be moving in opposite directions since January. Bond traders noticed that the Fed’s balance sheet had shrunk by 17% from a record $2.3-trillion in December, signaling a subtle tightening of monetary policy.
Traders blamed a recent 1% up-tick in U.S. Treasury 10-year yields on a massive supply of debt that is swamping the market. During the first 5 months of fiscal 2009 (Oct. 2008-Feb ‘09), the U.S. federal budget deficit had tripled compared to the same period a year ago, growing from $265 billion to a whopping $765 billion, the largest ever. The 5-month deficit is already 70% bigger than the full-year deficit of $459 billion for fiscal 2008, weighing heavily on T-Note prices.
Treasury yields were rising in January and February, even as the Dow Jones Commodity Index was skidding to a -52% loss in March from a year ago, telegraphing a severe bout of deflation in the months ahead. Rising interest rates and falling prices is a dangerous cocktail for any economy. Corporate bond yield spreads compared with Treasuries widened in a vicious cycle, with bond investors demanding higher yields as compensation for the risk of company defaults.
However, on March 7th, Fed chief Ben “Helicopter” Bernanke, speaking at a ceremony naming Exit 190 of Interstate Highway 95 in his honor, vowed to use all of the Fed’s weapons to stabilize financial markets and pull the economy out of recession. “At the Fed, we will continue to forcefully deploy all the tools at our disposal as long as necessary to restore financial stability and the resumption of healthy economic growth,” he said, a clear hint at a future shift to “nuclear-QE.”
On the morning of March 18th, global bond investors were anxiously waiting to hear if the Fed would follow in the footsteps of the BoE and the Bank of Japan – and begin monetizing a huge chunk of the Treasury’s debt, in order to put a lid on longer-term yields. For the past six-weeks, U.S. Treasury 10-year yields had found stiff resistance at the psychological 3% level, where traders speculated the Fed would prevent yields from rising any further. The BoE’s ability to manhandle the gilt market, driving British yields sharply lower, was also a supporting factor for U.S. T-Note prices.
At the end of its 2-day policy meeting on March 18th, the Bernanke Fed unleashed its most powerful weapons, saying it would monetize $300 billion of the Treasury’s debt over the next 6 months, with maturities ranging from 3 to 10 years. At the same time, the Fed said it will buy an additional $750 billion of mortgage-backed securities guaranteed by Fannie Mae and Freddie Mac, bringing its total purchases of these securities to $1.25 trillion. The Fed’s decision caught many traders off guard.
Treasuries rallied furiously, with the yield on the 10-year T-note plunging 54-basis points, to as low as 2.48%, a record single-day decline. While the Fed is prepared to grow its balance sheet further if needed, “We have to be very careful in deploying our arsenal,” said Dallas Fed chief Richard Fisher on February 23rd. “The Fed must avoid appearing to monetize the exploding fiscal deficits, as this could undermine confidence in the central bank’s commitment to price stability. We must be very careful not to inflate unsustainable and disruptive distortions (i.e., bubbles) in the Treasury market, through any extraordinary efforts beyond our normal balancing operations,” Fisher warned.
The Fed’s version of “shock and awe,” triggered an immediate and broad sell-off in the U.S. dollar’s value, its biggest 1-day loss against a basket of currencies since at least 1985, after traders learned the Fed intends flood the world markets with greenbacks. The dollar’s appeal as a “risk aversion” currency melted away, as global markets zoomed higher. In a Twilight Zone episode, Russia’s central bank grabbed the opportunity to intervene in the forex market, buying dollars at 38.90 roubles.
The March 13th edition of Global Money Trends and other recent issues, informed its subscribers that the Fed was aiming to enforce a ceiling for the 10-year Treasury yield in the 3% to 3.25% range, and warned of a downturn in the US$ Index, after the U.S. “Plunge Protection Team” unleashed another potent weapon on March 10th, with greater manipulative power than QE, that squeezed short sellers in the stock market. The upcoming March 20th edition will focus on ways to maneuver in the markets in an environment of global QE in the months ahead.
Chinese Central Bank Engages in Money Printing to Revive Economy
Beijing is already several steps ahead of the G-7 central bankers, in jumping on the QE bandwagon. The People’s Bank of China (PBoC) has been very busy inflating its M2 money supply, from a +14.8% annualized clip in November, to as high as +20.5% in February. Under the command and control of Beijing’s Politburo, China’s state owned banks have already extended 4.9 trillion yuan of new loans in the first 2 months of this years, up 35% from the same period a year ago.
Beijing is expanding the Chinese M2 money supply to achieve three key goals – to prevent an appreciation of the yuan against the dollar and other key currencies, to combat deflation which is already seeping into China’s economy, and a determined attempt to re-inflate the Shanghai stock market, by artificial means. “Confidence is more important than gold or money,” Wen declared.
“We face unprecedented difficulties and challenges,” Wen told delegates to China’s parliament in Beijing on March 5th. “The nation needs to reverse the economic slide as soon as possible,” he warned. China’s export reliant economy has slowed to a 6.8% growth rate, compared with 13% for all of 2007, and has already cost the jobs of 20 million migrant workers, adding to the risk of widespread social unrest. Beijing will increase its spending by 22% this year to 7.62 trillion yuan ($1.1 trillion), on new infrastructure and social programs, to cushion the economy.
On a February visit to Beijing, U.S. Secretary of State Hillary Clinton tried to convince Chinese premier Wen to keep investing in U.S. Treasuries in order to help finance the bailout of failing U.S. banks and pay for a $787 billion U.S. stimulus package. Clinton warned that if the U.S. economy collapsed China would pay a steep price as well. “It would not be in China’s interest, if we were unable to get our economy moving. Our economies are so intertwined. The Chinese know that in order to start exporting again to its biggest market, the United States has to take some drastic measures with the stimulus package. We have to incur more debt,” Clinton said.
“We are truly going to rise or fall together. By continuing to support American treasury instruments, the Chinese are recognizing our interconnection,” she said. But China’s foreign minister, Yang Jiechi, dodged a question as to whether Beijing would continue buying the U.S. notes. Chinese critics argue that Beijing’s exposure is too great and too dangerous. Global investors are keeping a close eye on the mounting risks, but few expect the Treasury bond bubble to explode soon.
Beijing now owns an estimated $1.7 trillion in U.S. dollar assets, $900 billion of Treasury bonds and short-term bills, $550 billion in agency bonds, $150 billion in corporate bonds, $40 billion in U.S. equities, and $40 billion in short-term deposits. The State Administration of Foreign Exchange (SAFE), part of the People’s Bank of China, manages the bulk of Beijing’s $2 trillion FX reserves, while, China’s state banks and sovereign wealth fund, oversee $250 billion.
Spelling out China’s dilemma, any effort by Beijing to unload a significant part of its massive Treasury and agency holdings could flood the market and trigger a selling panic, with devastating impact on the value of its foreign currency reserves. If China stops buying them, it needs to worry about the Fed monetizing the debt, which could lead to hyper-inflation and a bond market rout, once the U.S. economy stabilizes.
Ironically, the U.S. economic slump has already caused a massive drop in American purchases of Chinese goods. Chinese exports plunged 25.7% in February from a year earlier, slashing the country’s trade surplus from a record $40.2 billion in November to $4.8 billion in February. A continuation of this downtrend means Beijing would earn fewer dollars to recycle into U.S. dollar bonds. Therefore, the Fed felt compelled to fill the void, as the buyer of last resort for the Treasury’s IOUs.
Bank of Japan Raises the Nuclear Threshold
The Japanese banking crisis of the 1990s and early 2000s had roots similar to the American crisis – a stock market and real estate bubble that burst, leaving banks holding $450 billion in loans that were virtually worthless. Japan’s “lost decade,” of growth, provides powerful evidence of the danger of allowing deflation to emerge and persist – profits shrink, investment dries-up, and consumers spend less in anticipation of even further cuts in prices.
Japanese wholesale prices were -1.1% lower in February, than a year earlier, the first annualized decline in 6 years, putting Japan on course for its second bout of deflation, since the late 1990s-mid-2000s. Japan’s economic output contracted at an annualized 12.1% rate in the 4th quarter, its fastest rate of decline since the 1974 oil shock, shrinking about twice as much as the U.S. and the Euro zone, due to its heavy reliance on exports, and the sharp rise of the Japanese yen.
After a stunning 10% drop in industrial output in January, a similar GDP contraction in the January-March period is expected, as the global downturn intensifies. Fearing that a sliding stock market will erode the capital of the Japanese financial sector, the Bank of Japan has devised a dual scheme to buy ¥1 trillion of stocks directly from banks, and a separate plan to buy ¥1 trillion ($10 billion), of subordinated bank debt, in order to bolster their capital bases, and prevent a drought in lending to companies and households in need of cash.
On March 18th the Bank of Japan, the original QE pioneer, raised its nuclear threshold, signaling its plan to monetize a record ¥1.8 trillion ($18.3 billion) of government bonds (JGB’s) each month, up from ¥1.4 trillion previously. Effectively, the BoJ will monetize 2/3 of Japan budget deficit, projected at ¥33 trillion for the upcoming fiscal year, as the government prepares more spending to cushion the country’s worst recession since World War II.
Not surprisingly, the BoJ held its overnight interest rates steady at 0.1%, squarely within the Fed’s targeted range of zero to 0.25% for the fed-funds rate. Most importantly, throughout this decade, the BoJ has displayed its virtual mastery over the world’s 2nd largest bond market, with $8.7 trillion of JGB’s outstanding, by locking the 10-year Japanese yield within a very tight range between 1.20% and 2.00%, much to the dismay of Japanese fixed income investors.
One of the biggest outgrowths of the BoJ’s fixation with the hallucinogenic QE drug and ultra-low interest rates, was the spawning of a $7 trillion “yen carry” trade, which vastly inflated global stock markets worldwide, and in the end, boomeranged on the BoJ, when the carry-trade unwound – propelling the Japanese yen to 16-year highs against the dollar, and driving the Nikkei 225 index to 26-year lows.
Another unintended consequence of the BoJ’s overdosing on the QE drug, has been the multi-year bull market for Tokyo gold, which tripled in value in yen-terms. Repeating the same mistakes of the past, the BoJ has slashed its overnight loan rate back to 0.1%, and is boosting its JGB purchases by a third. Right on cue, the Tokyo gold market rebounded from ¥70,000/oz in October to as high as ¥90,000 today, compliments of the BoJ’s money printing machine.
With increasing regularity, central bankers are engaged in the most extraordinary currency devaluations ever witnessed. The results of these interventions could be heightened currency volatility and stock market instability. While the Fed can afford to open the monetary flood gates now, when the economy does recover, it puts a great deal of weight on hard-core inflationists to know when to tighten again.
They were supposed to do something similar in 2003-05, but instead, former Fed chief “Easy” Al Greenspan, kept interest rates submerged too-low for too-long. The Greenspan Fed’s decision to open the monetary spigots inspired a global commodity boom unlike any since the 1970s. A massive housing bubble also developed, feeding the sub-prime mortgage debt bubble, which ultimately burst, and led to the worst financial crisis and economic contraction since the Great Depression.
Wall Street sees the Fed’s re-inflation efforts as a quick-fix to ease debt burdens and perhaps stabilize housing values. Congress and the White House see a way to issue $2 trillion of debt without having to pay the penalty of sharply higher interest rates. But gold bugs are focused on the big picture, and are steady buyers of the yellow metal. The gold-backed exchange-traded fund, the SPDR Gold Trust, symbol GLD, said its holdings rose to a record 1,084 tons, up 37% from 8 weeks ago.
Peter Munk, chief of Barrick Gold, explained on March 18th, “I happen to be very optimistic right now about gold prices. I think they are going to be significantly higher than last year. As the world becomes less and less secure in terms of normal investments, and people lose faith and confidence in bonds, stocks, secured debt instruments, people turn to gold. It automatically attracts people in direct proportion to their fear, and that is fear of losing their money,” Munk said.
INVESTING IN A DEPRESSION
Even if stocks drop another 15% to 20%, they are likely to at least double from their current levels over the next five years. Trying to catch the market bottom is a loser’s game.
David Dreman says let’s dispense with the euphemisms ... we are in a depression. But he does not think we are in a rerun of the Great Depression. He has some buy recommendations, including some participants in the financial sector – a sector which hurt Dreman’s performance badly in the past.
Let’s not sugarcoat what is going on. We are in a depression, not a recession. It continues to devastate industry after industry like a wild forest fire leaping across the clearings. First mortgages, then money market funds and commercial paper, then credit card debt came under assault. Layoffs and price collapses have spread from autos and auto parts to other industrial companies, metals and oil. GM, Ford and Chrysler have been problematic for years, but this is different. Easy credit has been the lifeblood of automakers, and today very few people can finance cars. Even Toyota, the master of kaizen (continuous improvement), posted an operating loss in 2008, its first in 70 years.
Some municipalities have been forced to stop funding construction projects and hiring policemen and teachers because they are unable to borrow. In Los Angeles thousands of schoolteachers are expected to lose their jobs. Unemployment will rise to at least 10% in the U.S. The International Labour Organization predicts that by the end of 2009 the world will have 50 million people looking for work. It is impossible to predict when economic and market conditions will turn because the reversal depends on how successful the stimulus programs are.
As bad as the economy is today, the situation is significantly different from what it was in the Great Depression. Virtually every industrial nation is introducing monetary and fiscal stimulus packages. There is, to be sure, a lot of bungling in the process, but economic handlers will become more effective over time. We also have a more stable political system than we had in the 1930s, when fears of anarchy, socialism and communism were well founded. At the time, Joseph Kennedy reportedly said that he would gladly give up half his wealth if such a sacrifice could safeguard the other half.
What do you do now? First, throw away any analysis or report that focuses on short-term performance. It will only get you into trouble. How a mutual fund will do in the next three months or how it has done in the past three years is irrelevant.
If you have owned defensive stocks or Treasurys you have fared better than most, but when the market comes back, these investments will be laggards. There are two types of investments I recommend now:
First, a diversified portfolio of large-cap value stocks will do well over time, particularly with prices at their lowest levels in decades and the likelihood of the highest rates of inflation since World War II. Governments around the world are printing money. Stocks have done well in preserving and even increasing purchasing power during inflationary times. Even if stocks drop another 15% to 20%, they are likely to at least double from their current levels over the next 5 years. Trying to catch the market bottom is a loser’s game.
Second, real estate will offer enormous opportunities over the next five years. No, I have not been smoking funny stuff. The rebound will benefit both houses and commercial properties. The crisis is not over, but Treasury and Federal Reserve programs will eventually kick in, and inflation will drive up prices.
I recommend exchange-traded funds because they give you cheap, easy access to a diversified portfolio of stocks in some down-and-out industries with good potential.
The S&P Oil & Gas Exploration & Production ETF (29, XOP) is an equal-weighted index of 33 exploration and development companies. This sector is extremely depressed. A modest improvement in the economy will spark a rally in this group.
The Financial Select Sector SPDR Fund (9, XLF) is a market-weighted ETF holding the financial stocks in the S&P 500. Its top three holdings are JPMorgan Chase, Wells Fargo and Bank of America. The ETF is down 61% in the last year.
Another financial ETF I am buying is SPDR KBW Bank ETF (14, KBE), which tracks the KBW Bank Index. Everyone hates bankers these days, but no advanced economy can survive without a flourishing banking system. There is talk of nationalization. But what does that mean? In socialist nations the government manages the banks, staffing them with state experts at all levels and holding on to them permanently. The Obama Administration has made it clear that it wants to fix financial firms and then sell them. KBE owns 24 of the nation’s largest banks. It is down 79% in the past 24 months but will eventually snap back sharply.
DIVIDEND STOCKS THAT PAY
In the worst market for dividend stocks in decades Schwab Dividend Equity’s Paul Davis is scouting for companies that pay out neither too little nor too much.
As Will Rogers might have said, the way to earn a nice safe return on stocks is to buy a group with high dividend yields and hold on to them. If they are going to cut their dividends then don’t buy them.
There never was a lot of shame in a U.S. company cutting its dividend, and now there is even less because almost everyone is doing it. The S&P 500 reduced its dividend payouts by 6% in Q4 2008. Payout shavers in the last 6 months include “blue chips” like GE and Pfizer.
So the strategy of going for income is not without its risks. But with stock index yields exceeding Treasury and money market fund yields by a fair margin, and with growth and some inflation protection thrown in with the bargain, it looks like a reasonable idea to us. Just double-check, or hire someone that double-checks, that the payout is not likely to be cut.
Paul Alan Davis starts each day in his office near San Francisco’s Embarcadero by looking for dependable, high-yielding blue-chip stocks. Ha! There was a time when General Electric, JPMorgan Chase and Pfizer were all dependable. But this year they have all slashed their shareholder payouts.
“Companies used to be reluctant to cut dividends because they would stand out in a negative way,” says Davis, who comanages the $950 million Schwab Dividend Equity fund with three colleagues. “Now once one company does it, the sector follows.”
Standard & Poor’s reports that members of its 500-stock index did away with $16 billion, or 6%, of their quarterly dividend payouts in the last 3 months of 2008. That has left the index’s dividend yield at 3.1%, considerably below the 4% average since 1925. Bear in mind that the long-term real return from stocks is in the neighborhood of 6%. Dividends, then, are not just icing on the cake. They are half the meal.
Davis’s strategy for thriving in this environment: Befriend the trend. Paradoxically, Davis believes a company that cuts dividends may be a keeper. That is because he knows there are times when the long-term health of an enterprise, and its ability to pay dividends down the road, means first getting through today safely.
Case in point: JPMorgan Chase, which, at 2.6% of assets, is Schwab Dividend Equity’s top holding among 109 stocks. The bank cut its quarterly dividend in late February from 38 cents to 5 cents, giving it a yield today of 0.7%. Davis is not thrilled at having paid $40 a share for the stock but intends to keep it (at a recent price of $27). “Cutting back on the cash paid out to shareholders might be a good way to reinvest, solidify shares and give management flexibility over operations,” he says.
Davis, 41, has done relatively well by his investors since his fund was set up in 2003. With a negative 3.7% annual return since its inception, the fund is doing 1.5 percentage points better than the dividend fund average and 2.6 percentage points better than the S&P 500 index, according to Lipper.
A straitlaced northern California native, Davis studied finance and business at Cal State Sacramento. As a student, he became a fan of John Kenneth Galbraith’s A Short History of Financial Euphoria, which traces the dangers of investors’ herd mentality. There are exceptions, but big dividend payers tend not to be faddish stocks.
While Davis is willing to buy into companies that are cutting dividends, his real focus is Goldilocks stocks, whose yields are neither too high nor too low. Typically that means something in the 3%-to-6% range. (The average price/earnings ratio for his holdings is likewise a middling 10 times 2009 estimates.) Companies that reward shareholders much more than that, Davis fears, may be stealing from their own futures or caught in last-gasp fights to stay alive. He is not, for example, about to go near Northstar Realty Finance [NRF] Group, which yields 54% but is mired in an industry rife with bankruptcies.
The sector he says that merits the most jaundiced eye, but that no dividend fund can ignore, is financial services. It was the biggest and among the most dependable dividend payers until 2007, when it began falling off a cliff. Now many big financial institutions are receiving federal bailout money, which carries a cost in preferred dividends that starts out at 5% and climbs to 9% if it is not repaid within 5 years.
Financials are Schwab Dividend Equity’s largest sector bet at 16% of holdings, followed by consumer goods and health care at about 14% each, Morningstar says. All three sectors have been battered by the downturn. Davis is confident all will snap back, including health care, which President Obama has singled out for deeper government involvement.
“Managed health care and pharmaceuticals are two categories that have a target on their backs,” says Davis, “but we know that health care is slow to change.”
Davis follows the same equity ratings system that guides most Schwab stock pickers. Stocks are ranked by 19 variables, including market indicators, such as price momentum, as well as fundamentals, like working capital efficiency (inventory relative to assets and sales). Davis does not pay much attention to net income, which managers can manipulate with amortization schedules, charge-offs and cookie jar accounts. Instead, he focuses on free cash flow, which he defines as cash after general and administrative expenses, debt service, capital spending and dividends.
Given how much stocks have fallen lately, is now a smart time to go after dividends? Yes, says Morningstar analyst Josh Peters. Many stocks, he notes, are paying considerably more than Treasurys and money market funds. They are risky but presumably less risky than they were a year ago, when they were trading at twice the price.
Schwab Dividend Equity is a no-load fund with a 1.04% annual expense ratio. For cheaper options, consider WisdomTree Dividend Top 100 [DTN], an exchange-traded fund that charges 0.4% a year and is trading at a 0.4% discount to net asset value, and the Vanguard Dividend Appreciation ETF [VIG], which charges 0.3% and is at a 0.2% discount.
Better Than Bonds
Dividend payments have collapsed lately, but some solid companies still offer attractive yields. Those paying the most, however, come with big credit risks.
Company Price ($) Dividend Yield (%) Payout* (%) Market Value ($billion) Bank of New York Mellon 28.13 3.4 79 32 Baxter International 51.85 2.0 33 32 Chubb 42.48 3.3 28 15 HJ Heinz 33.12 5.0 56 10 JPMorgan Chase 27.11 0.7 24 102 Microsoft 16.96 3.1 28 151 Prices as of March 18.
*Annual dividend rate divided by latest-12-months earnings per share.
Sources: FT Interactive Data, Thomson Reuters and Thomson IBES via FactSet Research Systems.
The Sage Gauge
It is not often, but contrarians occasionally come out of the closet to bash Warren Buffett for one thing or another. The most recent occasion was his insistence (last fall, with the S&P 500 at 940) that stocks are a good buy. But patient believers in Buffett have a way of being vindicated.
Buffett: A lifelong technophobe, Buffett declines to invest in the technology boom of the late 1990s, because he says he cannot tell which companies have staying power.
Critics: With Berkshire shares down 20% in 1999 versus an 86% gain for the Nasdaq, Buffett comes under fire. “What’s Wrong, Warren?” asks a Barron’s cover story.
Outcome: The tech bubble pops, taking the Nasdaq well below where it was at the beginning of 1999.
Buffett: In 2003 he says that the reckless use of derivatives has turned them into “time bombs” and that they are “financial weapons of mass destruction.”
Critics: Alan Greenspan credits derivatives for helping the economy withstand shocks. Others observe that the time bombs had yet to explode.
Outcome: They have been exploding for the past year.
Buffett: In 2006 Buffett tells an allegorical tale of the Gotrock family, whose moral is that hedge funds and private equity firms do little besides burden investors with fees.
Critics: Hedge fund managers call Buffett confused and say hedge fund superstars deserve their paychecks. Matthew Lynn, a Bloomberg columnist, says Buffett just may not understand them.
Outcome: Last year 1,471 hedge funds shuttered.
Infosys Technologies Is a Cheap Bet on India’s Bright Future
Wall Street’s love affair with India’s information-technology shops may be over for now, but that does not mean investors should steer clear.
Infosys Technologies (ticker: INFY), the second-largest Indian IT outfit by revenue, behind conglomerate Tata Consultancy Services (TCS.India), is holding up well in the global downturn and is positioning itself nicely for a recovery. What is more, the shares look attractively priced.
Business has dropped substantially for all IT-service outfits, but not for Infosys, which should post earnings of $2.18 per share for the fiscal year ending March 2010, down just 2% from this year’s expected profit. In contrast, companies in the Standard & Poor’s 500 index are expected to post earnings declines of at least 12% and perhaps closer to 32%.
Yet, Infosys’s stock, at a recent $26.26, is trading at just 12 times expected earnings for this year, lower than the S&P’s multiple of 13.9.
With $2 billion in cash and no long-term debt, plus free cash flow that has averaged $200 million per quarter for the past four quarters, Infosys is not likely to have a problem keeping the lights on.
Nor is it apt to eliminate its dividend, which now yields 1.3%. “We have always paid a dividend, and there is no intention for that to change,” the company’s chairman, Nandan M. Nilekani, told Barrons.com last week at the firm’s New York offices in Rockefeller Center.
In a sign of Nilekani’s optimism, Infosys is still hiring and plans to honor 20,000 job offers that it made to new recruits in 2008. Those employees will work on something, insists Nilekani, even if it means paying them a salary to do some coding for nongovernmental organizations.
None of which has eased Wall Street’s two big worries: Will the Street itself be sending much less business Infosys’s way, given the sharp contraction in financial services, and will a more protectionist, populist attitude in Washington hurt India Inc.?
Nilekani, for his part, dismisses the notion that deals with Wall Street have collapsed. The decline in revenue from financial-services firms, which historically have accounted for about a third of the company’s business, is in “the low single digits” on a percentage basis, he says.
And despite the collapse of lending and the slowdown in trading, Infosys is finding that it can still snag big contracts with wealth-management companies, transaction banking, post-merger integration work and fraud recovery, says Nilekani.
As for the shifting winds in Washington, the chairman is confident that the U.S. will not want to jeopardize its brisk trade with India. “It works both ways,” says Nilekani. “India runs a current-account deficit, because India has never been a big exporter. India consumes eight million mobile phones a month, and the country just put in an order for planes from the U.S.”
Looking beyond the current malaise, the time to invest in quality companies is when all seems darkest for their prospects. With cash, no debt and a business that still offers opportunities, Infosys represents a cheap investment in a bright future for the firm and for India Inc.
When Nancy Pelosi Is in Town, Sell
“No man’s life, liberty or property is safe while Congress is in session,” Mark Twain informed us. You can now make a bet on that thesis.
Eric Singer, a 56-year-old fund manager with past stints at Smith Barney and PaineWebber, has something he calls the Congressional Effect Fund. The $2 million mutual fund invests in Treasury bills when Congress is in session and in the S&P 500 the rest of the time. He runs the fund out of a small office in Manhattan. So far, so good: In the ten months the fund has been in existence it has returned -6%, versus -44% for the S&P 500. But this may reflect not so much the power of the Twain effect as the fact that we are in a bear market.
How does this theory work over the longer term? Singer whips out a study he did of stock performance in the 44 years ended last December. Over the course of the 7,244 days that Congress was in session the S&P was up an average annual 0.3%, dividends excluded. Over the 3,821 days that legislators were home, stocks averaged 16.1% in annual returns.
“It just kind of started as a lark and, frankly, as a joke,” says Singer, a fan of small government. Given its stiff price (expenses run 2.2% a year), that is the way to treat it.
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