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AUSTRIAN ECONOMISTS CAN EXPLAIN THE BOOM AND THE BUST
Austrian Economists predicted both the 1930s bust and the current one. In both eras the conventional theorists failed to foresee the busts. In the 1930s the in-crowd huffed and puffed for more than a decade and failed to effect any kind of meaningful recovery. The jury is still out on the current one, but nothing we have seen so far is the least bit encouraging. Quite the contrary.
Arch-conventional commentator Paul Krugman sniffs that the Austrian’s “hangover theory” explaining the recession is unconvincing, notwithstanding that the Austrians fully expected the recession while he did not. As covered in a post in the previous Finance Digest, Krugman professes to fail to understand why unemployed workers do not instantly find new employment in the newly favored sectors – highlighting the failure of the conventional economics body of theory to conherently incorporate the workings of time among other things. Robert Murphy addressed the theoretical objection then. Here he shoots down an alleged empirical piece of counterevidence trotted out by Krugman, showing instead that the evidence lends support to the Austrian view.
In a recent debate, prominent Keynesian professor and blogger Brad DeLong claimed that the Austrian explanation of the business cycle “does not work as an intellectual enterprise.”
DeLong quotes Paul Krugman who, back in December, apparently dealt the Austrian diagnosis a crushing defeat on both theoretical and empirical grounds.
In the present article, I will set the record straight. Krugman’s theoretical criticism of (what he dismissively calls) the “hangover theory” of recessions is silly, and his empirical test is also a poor one. Once we set up a more appropriate test, the “hangover” theory, i.e., the Mises-Hayek explanation, passes with flying colors.
Krugman’s Two-Pronged Critique of the “Hangover Theory”
On his popular New York Times blog, back in December, Krugman lamented the idiocy of his colleagues. He cannot believe that John Cochrane would say something this (allegedly) foolish:
“We should have a recession,” Cochrane said in November, speaking to students and investors in a conference room that looks out on Lake Michigan. “People who spend their lives pounding nails in Nevada need something else to do.”
In response to such (apparent) nonsense, Krugman offers first a theoretical objection:
The basic idea is that a recession, even a depression, is somehow a necessary thing, part of the process of “adapting the structure of production.” We have to get those people who were pounding nails in Nevada into other places and occupation, which is why unemployment has to be high in the housing bubble states for a while.
The trouble with this theory, as I pointed out way back when, is two-fold:
(1) It does not explain why there is not mass unemployment when bubbles are growing as well as shrinking – why did we not need high unemployment elsewhere to get those people into the nail-pounding-in-Nevada business?
Before dealing with Krugman’s second (and empirical) objection, let us handle this theoretical objection.
You cannot understand Austrian business-cycle theory (ABCT) unless you first understand the Austrian view of the capital structure of the economy. In this article [posted here as well], I showed how Krugman was simply incapable of grasping ABCT because he lacks a rich enough model of capital. For those newcomers who are unfamiliar with ABCT, I strongly encourage you to read the fuller discussion in the hyperlinked article.
For our purposes here, a brief recapitulation of the argument: In a market economy, prices really serve a function; they are not mere appendages of exploitative power relations, but instead market prices signal real, underlying scarcity and help everyone in the economy adjust his plans in light of reality. The interest rates on various loans also mean something; they are not arbitrary.
In particular, the market interest rate coordinates the “intertemporal” (i.e., across-time) activities of investors, businesses, and consumers. If consumers become more future oriented and want to reduce consumption in the near term in order to provide more for later years, what happens in the free market is that the increased savings push down interest rates, which then signal entrepreneurs to borrow more and invest in longer projects. Thus resources (such as labor, oil, steel, and machine time) get redirected away from present goods, like TVs and sports cars, and the freed-up resources flow into capital or investment goods like tractors and cargo ships.
Now when the Federal Reserve artificially reduces interest rates below their free-market level, it sends a false message to entrepreneurs. Firms begin expanding as if consumers have increased their savings, but in fact consumers have reduced their savings (due to the lower interest rates). Businesses that churn out durable goods, such as furnaces, cargo ships, and, yes, houses will find business booming, because these sectors respond positively to low interest rates.
On the other hand, other sectors do not need to contract, because (unlike the scenario of genuine savings) nobody is cutting back on consumption. This is precisely why the Fed-induced boom is unsustainable – real resources have not been released from consumer sectors in order to fuel the expansion of the capital sectors. Because modern economies are so complex, the charade can continue for a few years, with entrepreneurs cutting corners and “consuming capital” (i.e., postponing necessary replacement and maintenance on equipment) while both investment and consumer goods keep flowing out of the pipeline at increased rates. But the music eventually stops, since (after all) the Fed’s printing of green pieces of paper does not really make a country wealthier. When the Fed “cuts interest rates” it is not really creating more capital for businesses to borrow. It is instead distorting the signal that the market interest rate was trying to convey.
So, in this context, Krugman the Nobel laureate is confused. When the Fed starts dumping wads of newly printed cash into particular sectors of the economy, why does this foster a period of prosperity – however illusory and fleeting it may be? Why instead does the money drop not cause millions of people to get laid off?
I admit I feel sheepish even phrasing the question that way, but go reread Krugman’s blog post; that is what he is asking. The answer, of course, is that businesses armed with newly printed Fed dollars must bid away workers from their original niches in the structure of production. Obviously, this process does not lead to mass unemployment. The workers voluntarily quit their original jobs because the inflated money supply has allowed a few firms to offer them higher salaries. The Fed’s injection of new money has not yet distorted the whole economy, and so there is no reason for other businesses to suddenly find themselves in trouble and lay off workers at the beginning of the artificial boom.
In contrast, once the bubble has popped, many firms realize they are embarked on unsustainable projects. They need to lay off their workers. Unemployment goes up, and only as workers reluctantly accept lower wages can they be reintegrated into the economy. On average, workers are earning less during the bust period than at the height of the boom. This is because the salaries and wages of the boom period were exaggerations of the true “fundamentals” of worker productivity, and also because the fundamentals themselves have been hurt due to the waste of capital during the boom period.
In short, workers on average are not as economically productive during the recession because the whole structure of production has been thrown out of whack by the Fed’s injections of funny money. It is much harder for workers to switch jobs and take a pay cut versus quitting a job in order to take a better one that pays more.
That is the simple explanation for why the Fed-induced boom sees low unemployment, while the necessary bust experiences high unemployment.
The Housing Bubble Has Nothing to Do With Job Losses?!
After his theoretical objection, Krugman turns to the data to raise a second objection to the “hangover theory”:
(2) It does not explain why recessions reduce [employment] across the board, not just in industries that were bloated by a bubble.
One striking fact, which I have already written about, is that the current slump is affecting some non-housing-bubble states as or more severely as the epicenters of the bubble. Here is a convenient table from the BLS, ranking states by the rise in unemployment over the past year. Unemployment is up everywhere. And while the centers of the bubble, Florida and California, are high in the rankings, so are Georgia, Alabama, and the Carolinas.
This is rather surprising, is it not? Forget the Austrian theory; Krugman is here saying that the bursting of the housing bubble does not help explain the onset of the recession! But do not worry, Krugman’s analysis is flawed. You are not going crazy.
First, note that the BLS table Krugman links to looks at the over-the-year change in unemployment (by state) from December 2007 to December 2008. Now, is that really a good measure of whether the bursting of the housing bubble has anything to do with the recession? After all, the bubble had well burst by December 2007. So if the “hangover theorists” are right, you would expect the connection between unemployment jumps and housing-price collapses to be weaker the farther along you get from the bursting of the bubble.
In response to an email from a grad-school friend, I decided to check on the relation during a time frame that more tightly captures the bursting of the housing bubble. The OFHEO has quarterly data on home prices by state; I picked the top of the bubble as the second quarter in 2006.
Then I picked the other variable to be the change in unemployment (in terms of absolute point changes, not percentages of percentages) from June 2006 to December 2008, which is available (though not in a very convenient form) from the BLS.
Armed with this data, I ranked the states according to these two criteria, and looked at the worst 10 in both rankings. In other words, I looked at the list of the 10 states that had seen the biggest percentage decline in home prices since the 2nd quarter of 2006, and I also looked at the list of the 10 states that had seen the biggest jump in the unemployment rate from June 2006 to December 2008. The 7th through 10th slots on the two lists did not match up, but check out the worst 6 slots in both lists:
Ranking of States By Point Increase in Unemployment Rate, June 2006 to December 2008
Ranking of States By Percentage Drop in OFHEO Housing Price Index, 2Q 2006 to 4Q 2008
- Rhode Island (+4.9)
- Florida (+4.8)
- Nevada (+4.8)
- California (+4.4)
- North Carolina (+3.9)
- Michigan (+3.8)
Note that North Carolina and Arizona are the only ones that do not match. That seems like a very strong correlation. (Depending on how we frame the problem, the chances of this matching occurring randomly are anywhere from 1 in 8,400 to about 1 in 350,000.)
- California, –27%
- Nevada, –26%
- Florida, –22%
- Arizona, –16%
- Rhode Island, –11%
- Michigan, –11%
Brad DeLong and Paul Krugman continue to mock the Austrian explanation for the business cycle, but their ridicule is based on their own deficient model of the economy’s capital structure. Moreover, Krugman’s quick empirical points turn out, upon closer inspection, to support the Austrian position. Unfortunately, because DeLong and Krugman have so fundamentally misdiagnosed the problem, their “solutions” are a recipe for further disaster.
REVISITING THE (MORONIC) GLOBAL SAVINGS GLUT THESIS
A superior analytical framework examines the underlying credit excesses that fuel asset inflation and myriad other distortions.
Alan Greenspan is resorting to extraordinary measures to save his reputation from the consequences of his policies. He always was a maestro of obfuscation and double-talk, taking the art of making a lot of nothing sound like something to new highs. To our minds, his chef-d’oeuvre of preposterousness was the “savings glut” hypothesis – an ad hoc theory used to explain why developing countries were apparently lending money to U.S. consumers and governments so they could buy geegaws, McMansions, bridges to nowhere, and depleted uranium shells, all the while funding the financial bubble to boot.
It would of course have been a conundrum, to coin a term, had capital-short/labor-surplus developing countries been using their savings to fund an American consumption spree. But it was not real savings. It was foreigners reinvesting U.S. Fed funny-money credit into financial instruments rather than real goods, thereby fueling asset rather than goods and services price inflation. Someone had to fund the U.S. borrow-and-spend binge, and it was the Federal Reserve, cannily disguised as foreign lenders.
As Doug Noland phrases it below: “The issue was never some glut of ‘savings’ but a historic glut of credit and the resulting ‘global pool of speculative finance.’ ... [I believe] it unequivocal that U.S. credit excess and resulting over-consumption, trade deficits, and massive current account deficits were the underlying source of so-called global ‘savings.’”
It never seemed to occur to Greenspan and his minions that the system was totally dysfunctional, thanks to the credit bubble. And they still do not get it, or they pretend not to. Greenspan again referenced “excess of global savings” just a couple of weeks ago ... no doubt to the consternation of the U.S. creditors such as China, who must wonder what set of lunatics is the counterparty to their financial claims.
“The extraordinary risk-management discipline that developed out of the writings of the University of Chicago’s Harry Markowitz in the 1950s produced insights that won several Nobel prizes in economics. It was widely embraced not only by academia but also by a large majority of financial professionals and global regulators. But in August 2007, the risk-management structure cracked. All the sophisticated mathematics and computer wizardry essentially rested on one central premise: That the enlightened self-interest of owners and managers of financial institutions would lead them to maintain a sufficient buffer against insolvency by actively monitoring their firms’ capital and risk positions.” ~~ Alan Greenspan, March 27, 2009, Financial Times
Alan Greenspan remains the master of cleverly obfuscating key facets of some of the most critical analysis of our time. The fact of the matter is that “the sophisticated mathematics and computer wizardry” fundamental to contemporary derivatives and risk management essentially rested on one central premise: That the Federal Reserve (and, more generally speaking, global policymakers) was there to backstop marketplace liquidity in the event of market tumult. More specific to the mushrooming derivatives marketplace, participants came to believe that the Fed had essentially guaranteed liquid and continuous markets. And the bigger the credit bubble inflated the greater the belief that it was too big for the Fed to ever let fail. It was clearly in the “enlightened self-interest” of operators of “Wall Street finance” and throughout the system to fully exploit this market perversion. With unimaginable wealth there for the taking, along with the perception of a Federal Reserve “backstop,” why would anyone have kidded themselves that there was incentive to ensure individual institutions “maintained a sufficient buffer against insolvency”? By the end of boom cycle, market incentives had been completely debauched.
The Greenspan Fed pegged the cost of short-term finance (fixing an artificially low cost for speculative borrowings), while repeatedly intervening to avert financial crisis (“coins in the fusebox”). There is absolutely no way that total system credit would have doubled this decade to almost $53 trillion had the Activist Federal Reserve not so aggressively and repeatedly intervened in the markets. To be sure, the explosion of derivatives and attendant speculative leveraging was central to the historic dimensions of the credit bubble.
Mr. Greenspan today made it through yet another article without using the word “credit.” “Free-market capitalism has emerged from the battle of ideas as the most effective means to maximize material wellbeing, but it has also been periodically derailed by asset-price bubbles ... Financial crises are defined by a sharp discontinuity of asset prices. But that requires that the crisis be largely unanticipated by market participants. ... Once a bubble emerges out of an exceptionally positive economic environment, an inbred propensity of human nature fosters speculative fever that builds on itself. ...” He might cannily dodge the topic, but Mr. Greenspan recognizes all too well that credit has and always will be central to the functioning – and misfunctions – of free-market capitalistic systems.
With respect to the past, present and future analysis, I believe the spotlight should be taken off asset prices. Such focus is misplaced and greatly muddies key issues. Much superior is an analytical framework that examines the underlying credit excesses that fuel asset inflation and myriad other distortions. Ensure us a stable credit system and the risk of runaway asset booms and busts disappears. Today’s financial crisis – and financial crises generally – are defined by a sharp discontinuity of the flow of credit. Major fluctuations in asset markets – on the upside and downside – are typically driven by changes in the quantity and directional flow of credit. Central bankers should focus on stable finance and resist the powerful temptation to monkey with asset prices and markets. As common sense as this is, today’s flawed conventional thinking leaves most oblivious and poised for mistakes to beget greater mistakes.
When it comes to flawed conventional thinking, few things get my blood pressure rising more than the “global savings glut” thesis. Two weeks ago from Alan Greenspan, via The Wall Street Journal:
“... The presumptive cause of the world-wide decline in long-term rates was the tectonic shift in the early 1990s by much of the developing world from heavy emphasis on central planning to increasingly dynamic, export-led market competition. The result was a surge in growth in China and a large number of other emerging market economies that led to an excess of global intended savings relative to intended capital investment. That ex ante excess of savings propelled global long-term interest rates progressively lower between early 2000 and 2005. That decline in long-term interest rates across a wide spectrum of countries statistically explains, and is the most likely major cause of, real-estate capitalization rates that declined and converged across the globe, resulting in the global housing price bubble. By 2006, long-term interest rates and the home mortgage rates driven by them, for all developed and the main developing economies, had declined to single digits – I believe for the first time ever. I would have thought that the weight of such evidence would lead to wide support for this as a global explanation of the current crisis.”
It is difficult these days for me to accept that Greenspan, Bernanke and others are sticking to this misplaced view that a glut of global saving was predominantly responsible for the proliferation of U.S. and global bubbles. The failure of our policymakers to understand and accept responsibility for the bubble must not sit well internationally. Long-time readers might recall that I pilloried this analysis from day one. The issue was never some glut of “savings” but a historic glut of credit and the resulting “global pool of speculative finance.” In today’s post-bubble period, it should be indisputable that the acute financial and economic fragility exposed around the globe has been the result of egregious lending, financial leveraging, and speculation. True savings would have worked to lessen fragility – instead of being the root cause of it.
Unfortunately, there is somewhat of a chicken or the egg issue that bedevils the debate. Greenspan and Bernanke have posited that China and others saved too much. This dynamic is said to have stoked excess demand for U.S. financial assets, pushing U.S. and global interest rates to artificially low levels. This, they expound, was the root cause of asset bubbles at home and abroad. I take a quite opposing view, believing it unequivocal that U.S. credit excess and resulting over-consumption, trade deficits, and massive current account deficits were the underlying source of so-called global “savings.” Again, if it had been “savings” driving the process, underlying system dynamics would not have been so highly unstable and the end result would not have been unprecedented systemic fragility. Instead, the seemingly endless liquidity – so distorting of markets and economies round the world – was in large part created through the process of unfettered speculative leveraging of securities and real estate.
As is so often the case, we can look directly to the Fed’s Z.1 “flow of funds” report for credit bubble clarification. Total (non-financial and financial) system credit expanded $1.735 trillion in 2000. As one would expect from aggressive monetary easing, total credit growth accelerated to $2.016 trillion in 2001, then to $2.385 trillion in 2002, $2.786 trillion in 2003, $3.126 trillion in 2004, $3.553 trillion in 2005, $4.025 trillion in 2006 and finally to $4.395 trillion during 2007. Recall that the Greenspan Fed had cut rates to an unprecedented 1.0% by mid-2003 (in the face of double-digit mortgage credit growth and the rapid expansion of securitizations, hedge funds, and derivatives), where they remained until mid-2004. Fed funds did not rise above 2% until December of 2004. Mr. Greenspan refers to Fed “tightening” in 2004, but credit and financial conditions remained incredibly loose until the 2007 eruption of the credit crisis.
It is worth noting that our current account deficit averaged about $120 billion annually during the 1990s. By 2003, it had surged more than 4-fold to an unprecedented $523 billion. Following the path of underlying credit growth (and attendant home price inflation and consumption!), the current account deficit inflated to $625 billion in 2004, $729 billion in 2005, $788 billion in 2006, and $731 billion in 2007. And examining the “Rest of World” (RoW) page from the Z.1 report, we see that RoW expanded U.S. financial asset holdings by $1.4 trillion in 2004, $1.076 trillion in 2005, $1.831 trillion in 2006 and $1.686 trillion in 2007. It is worth noting that RoW “net acquisition of financial assets” averaged $370 billion during the 1990s, or less than a quarter the level from the fateful years 2006 and 2007.
See this posting for more extensive analysis of the Fed “flow of funds” report by Doug Noland.
The Z.1 details, on the one hand, the unprecedented underlying U.S. credit growth behind our massive current account deficits. RoW data, in particular, diagnoses the flooding of dollar balances to the rest of the world – and the “recycling” of these flows back to dollar instruments. This unmatched flow of finance devalued our currency, and in the process inflated commodities, foreign debt, equity and assets markets, and global credit systems more generally. In somewhat simplistic terms, ultra-loose monetary conditions fed U.S. credit excess, excessive financial leveraging and speculating, asset inflation, over-consumption, and enormous current account deficits. And this unrelenting flow of dollar balances to the world inflated the value of many things priced in devalued dollars, thus exacerbating both global credit and speculative excess. The path from the U.S. credit bubble to the global credit bubble is even more evident in hindsight.
Back in November of 2007, Mr. Greenspan made a particularly outrageous statement. “So long as the dollar weakness does not create inflation, which is a major concern around the globe for everyone who watches the exchange rate, then I think it is a market phenomenon, which aside from those who travel the world, has no real fundamental economic consequences.”
Similar to more recent comments on the “global savings glut,” I can imagine such remarks really rankle our largest creditor, the Chinese. As we know, the Chinese were the major accumulator of U.S. financial assets during recent bubble years. They are these days sitting on an unfathomable $2.0 trillion of foreign currency reserves and are increasingly outspoken when it comes to their concerns for the safety of their dollar holdings. There is obvious reason for the Chinese to question the reasonableness of continuing to trade goods for ever greater quantities of U.S. financial claims.
Interestingly, Chinese policymakers are today comfortable making pointed comments. Policymakers around the world are likely in agreement on a key point but only the Chinese are willing to state it publicly: The chiefly dollar-based global monetary “system” is dysfunctional and unsustainable. Mr. Greenspan may have actually convinced himself that dollar weakness has little relevance outside of inflation. And the inflationists may somehow believe that a massive inflation of government finance provides the solution to today’s “deflationary” backdrop. Yet to much of the rest of the world – especially our legions of creditors – this must appear too close to lunacy. How can the dollar remain a respected store of value? Expect increasingly vocal calls for global monetary reform.
“The desirable goal of reforming the international monetary system, therefore, is to create an international reserve currency that is disconnected from individual nations and is able to remain stable in the long run, thus removing the inherent deficiencies caused by using credit-based national currencies.” ~~ Zhou Xiaochuan, head of the People’s Bank of China, March 23, 2009
STOCK MARKET HAS ITS BEST RUN SINCE THE CRASH
The U.S. and other stock markets have had a nice run since their early March bottom. Believers and skeptics abound. We predict that the stock market will fluctuate.
Stocks rallied a 3rd straight week, their best streak in 7 months, and ran up more than 23% in just 13 days. The better news: Investors are deeply skeptical. The bounce of more than 20% off the 12 1/2-year low reached on March 9 meets Wall Street’s technical (if widely scorned) definition of a new bull market.
So why did it bring more circumspection than celebration? Many traders see short-covering as the culprit, as heavily-shorted stocks racked up the biggest gains. Financial stocks left for dead have bounced the hardest, and are up 26% this month. Chatter at happy hour, now just called cocktail hour, attributes the buying to “reverse window dressing,” where money managers reluctant to hoard cash during that rare winning month begin buying the high-fliers.
Such qualms are warranted, as U.S. households lost $11.2 trillion last year, and a lengthening rally in a still-weakening economy also increases odds of a pullback such as Friday’s. But lingering mistrust also suggests there are ample cash reserves that could drive stocks higher, should more investors become convinced the rally is for real.
Whether that conviction blooms or wilts will depend on a handful of looming catalysts. Come April 7, Alcoa leads the parade of U.S. companies reporting 1st-quarter earnings. As 2009 began, analysts were girding for a 12% decline in 1st-quarter profits. But now they are bracing for a 35.5% plunge (or a 19.8% slide after stripping out financials), says Thomson Reuters. Can companies clear this lowered bar?
The coming weeks also conclude government “stress test” of banks. Last week, the government outlined a plan to entice private investors to buy problem loans and securities, which Treasury Secretary Timothy Geithner calls “legacy assets,” as though they are family heirlooms. Already, the betting is intensifying on survivors and failures. Goldman Sachs’s bank analysts, for example, have identified eight firms they think can swiftly repay bailout money over the next year: Morgan Stanley, Comerica, US Bancorp, JPMorgan, Bank of New York Mellon, First Horizon National, Northern Trust, and City National.
Consumer spending ticked up for a second straight month in February, even as incomes fell and layoffs mounted. Best Buy also improved the mood, after its sales-drop narrowed to 2.5% early this year, from 6.8% in December. As the government program to spur consumer lending kicks in, traders will scour data to see if clinging to skepticism will be rewarded.
The Dow Jones Industrial Average ended the week up 498, or 6.8%, to 7776. The Standard & Poor’s 500 gained 47, or 6.2%, to 816, and despite Friday’s retreat, it is 20.6% above its March 9 low and on track for its month since 1991. The Nasdaq Composite Index jumped 88, or 6%, to 1545 and could see its best month since October 2002, while the Russell 2000 added 29, or 7.2%, to 429.
Just how elusive is the 2nd-half recovery? The U.S. economy shriveled 6.3% in 4th-quarter 2008, but some economists are penciling in some expansion by late summer. If they are right, it is not inconceivable for stocks to turn higher four months before the economy does.
Recent signs suggest the economic rot has slowed – but they do not yet validate a lasting recovery. Deferred purchases helped lift orders for big-ticket items 3.4% in February off a 5-year low. Mortgage applications jumped as rates fell. But the prevailing stance remains one of doubt. A March survey of fund managers conducted by Merrill Lynch showed bond-weighting pushing new highs, while allocation to stocks shrank to a record low near 41%. And improving stocks have not relaxed the VIX volatility index below a key threshold near 40.
Having favored bonds almost exclusively since October, Richard Hughes, co-president of Portfolio Management Consultants, is not yet ready to switch allegiance to stocks. “The market still lacks confidence, and the U.S. and global economies are still on life support,” Hughes says. First, he would want to see fewer weekly jobless claims and the glut of unsold homes shrink from more than 10 months’ supply to seven or eight. Banks also must lend and consumers must borrow to assure him that baby boomers, who have led recent economic revivals, have not defected permanently from spending to saving.
Rare Feat: The Dow rallied for a third straight week, its best streak since May 2008, as hopes increased that fiscal stimuli will halt the economic rot.
In contrast, Michael Darda, chief economist at MKM Partners, thinks leading indicators of profit growth, such as a steep yield curve, have begun to improve. Imploding profits late last year sets up easier comparisons later this year; and skepticism about this rally “makes us more confident that it is for real,” he says. Darda thinks the recent March lows “will not be seen again,” and the S&P 500 might even double from its March depth by late 2010. Yet he does not think this bull can push to a record high “before the next bear market develops, potentially in 2011 or 2012, when a rise in marginal tax rates collides with potential Fed tightening.”
ACTIVELY MISMANAGED FUNDS
Mutual fund managers are paid lavishly in good markets and bad. In the current bad one, a lot of them are not earning their keep.
The average stock mutual fund charges a 1% or so management fee to underperform the market. So why do investors get suckered in, time and again? Partly because these funds, as the saying goes, are sold, not bought. And partly out irrational optimism that next time it will be different. No need for you to repeat the mistakes of others.
For years William Miller’s name appeared atop lists of the world’s most successful stock pickers. His Legg Mason Value Trust outperformed the S&P 500 every single year for a decade and a half through 2005, an astonishing streak regularly cited as evidence that a smart fund manager can consistently beat the market. Customers flocked to this hot hand. Assets in the fund climbed to $12 billion, representing $200 million a year in management fees for Legg Mason.
That is when the gravy train came screeching to a halt. Value Trust’s 6% gain in 2006 was only half as good as the market’s. The fund has lost money ever since, including a 6.7% decline in 2007, 55% in 2008 and 20% through February of 2009. Each of those numbers was worse than the broader market’s return. [The cummulative loss 2007-Feb. 2009 is about 2/3 – for those who stuck around.]
Behind the drubbing are ill-timed bets on Bear Stearns, Countrywide Financial and other bombshells. Miller’s recent stewardship has proved so bad that it has more than wiped out the above-market returns of Value Trust’s good years. Annual returns since its birth in 1983 now average 11.1%, barely ahead of the S&P 500’s 10.9% return.
Adjust for the fact that investors dumped most of their money into Miller’s fund as his hot hand was cooling and the picture is uglier. If they had made identical bets on an S&P 500 Index fund over the past 26 years, their return would have averaged 5.8% versus Value Trust’s 5.4%.
Another way to look at Value Trust: Investors paid Miller and his underlings $2 billion in management fees to destroy wealth. Legg Mason says it is not fair to blame investors’ bad timing on Miller, who for his part remains doggedly optimistic, telling shareholders in his latest newsletter that better times are ahead: “The long-term opportunities for the fund have never been better.”
Value Trust is an exceptional case of outsize gains followed by outsize losses, but the phenomenon of active managers creating wealth only for themselves is no fluke. What makes this especially searing to investors these days is the implication by many active funds that they are worth a premium because they will rescue you from nasty bear markets while “dumb” index funds abandon you to a mauling.
The facts indicate otherwise. Last year, during the worst stock market drubbing since 1931, the average active stock fund lost 40.5%, versus a 37% loss for the market-tracking Vanguard S&P 500 Index, according to Morningstar. Stretch out the time frame and active management looks no better. According to Standard & Poor’s, 69% of actively run large-company funds, 76% of funds buying midsize companies and 79% of funds buying small companies underperformed their indexes in the five years through last June.
“Investors have been willing to subordinate their own economic interests to the fund managers,’” sighs Vanguard founder John Bogle, who has devoted his life to popularizing passive funds. He hopes the declines will force investors to hold their fund managers to account: “At some point there is going to be a comeuppance.”
Especially humiliating lately is the performance of the largest funds, including Fidelity Magellan, in Peter Lynch’s day the grand master of actively managed vehicles. The fund lost 52% in the past year.
While Magellan has been a disappointment to investors, it has done very well for its manager, Fidelity Investments (in which the family of billionaire Edward Johnson owns a large stake). The fund’s 0.73% annual expense ratio on $41 billion in average assets added up to $295 million in fees last year. Investors could have stuck their money in Fidelity’s Spartan 500 Index at 1/7 the cost and earned more over the past 1-, 3-, 5- and 10-year periods.
What were Magellan investors thinking? Economists have long struggled to square the view of investors as rational actors with the fact that they entrust 79% of their money to active funds, despite prodigious evidence that it is a losing game. This is where behavioral economics comes in. Humans, the discipline notes, are hardwired optimists. To our detriment as investors, we tend to overestimate our ability to pick winning stocks and stock pickers, like Bill Miller.
The other problem is that funds are often sold rather than bought. The sellers are in it for commissions. Those are easiest to skim off actively managed funds that charge fat fees in exchange for the prospect (but not the probability) of knocking out the lights or the protection offered by “professional management” in troubled times.
Franklin Templeton’s ads boast that its flagship Growth Target Fund has “weathered the ups and downs of the market for over 50 years.” That included some rough sailing in 2008, when Growth Target, a supposedly conservative mix of stocks and bonds, lost 31% of its value and lagged its index by six percentage points, according to Morningstar.
American Century enlisted pedaler Lance Armstrong to evoke his successful battle against cancer as a template to “provide for a secure financial future.” Ultra, American Century’s largest fund, lost 41.7% last year, lagging the S&P 500.
At 79, long retired from his executive role at Vanguard but as voluble as ever on the subject of investment costs, John Bogle is getting some vindication. The crash is making investors rethink their faith in funds that try to beat the market. Last year they yanked out $222 billion while adding $18 billion to their index holdings, according to Lipper. That left $3.2 trillion with active managers at year’s end, compared with $672 billion in passive mutual funds and exchange-traded funds.
If you still think rationality rules investment decisions, consider State Farm S&P 500 Index A. It charges a 3% upfront load and 0.78% a year in fees to do what Fidelity’s index fund does for no load and 0.1% a year. How do you explain the $310 million in the State Farm index fund?
SAFE HARBOR IN DEEP WATER
Deepwater drillers Transocean, Diamond and Noble will be key beneficiaries as oil supplies get tighter and prices trend higher.
The dramatic decline in oil prices from $150 a barrel to $50 has taken its toll on the oil services industry. The drilling rig count, e.g., is way off from a year ago. But such is not the case for specialized rigs that drill in ultra-deep (6,000 feet or deeper) ocean water. So all drilling companies are not equal. Here is an introduction to the major drillers with heavy concentration in the favorable deep-water submarket.
Shares of deepwater drillers caught fire this month, bouncing 20% to 25% from early-March lows, putting them smack in the vanguard of the market’s powerful rally. Those eye-popping gains, of course, came from severely depressed levels. And, even after the move, shares of the big offshore names are far below last year’s highs. Transocean [RIG], for example, fetches $61, down from $163. Diamond Offshore Drilling [DO] goes for $66, down from $148. And Noble [NE] closed Friday (March 27) at $25, down from $69.
In other words, the stocks are still 55% to 65% off their peaks. Are they bargains?
That depends on the price of oil. Crude breaking above $54 a barrel to a 2009 high gave a mighty jolt to the sector – sending short sellers scurrying for cover and bearish analysts to ratchet up estimates. To be sure, oil had been edging up for weeks, but the Fed’s plan to load up on Treasuries ignited fears of inflation, caused the dollar to plummet and helped crude spike a cool 50%-plus from its February low.
In the next few months, oil prices seem primed to rise even further. OPEC has a far better grip on supply than expected. Demand for gasoline, which fell precipitously in the latter half of 2008, jumped 2% year-over-year last month, the strongest reading since early 2007. And while investors have focused on demand, the prospect of dwindling supplies has gone largely unnoticed.
Indeed, even before prices cratered, oil production was declining in the North Sea and Mexico and starting to contract in Russia, observes Peter Vig, who runs the Dallas-based energy hedge fund RoundRock Capital and is a seasoned veteran of both Wall Street and the oil patch. The political shift in Russia, he argues, has chilled Western investors’ enthusiasm, and production there will continue to fall – in stark contrast to 2000 through 2007, when the former Soviet Union chipped in 2/3 of the increase in the global oil supply.
Cautious on world economies, Vig nonetheless sees oil exiting 2009 at $60 to $65 a barrel and averaging at least $65 to $70 in 2010.
That would be a big plus for offshore drillers. But even if prices backtrack, these companies are well-equipped to weather a prolonged storm, owing to backlogs that amount to some three years of boom-time revenues.
Sometime in the next 12 to 18 months, shares of companies such as Transocean, Diamond and Noble have the potential to appreciate 25% to 100% more.
Savvy investors looking for an energy play are likely to be attracted to those last frontiers of exploration, the enormous deepwater deposits. The breathtaking size of the discoveries offers potentially spectacular returns. And only a handful of companies boast the ultra-deep rigs, which can cost upward of $600 million apiece, and the expertise to drill safely in ocean waters up to two miles deep.
The biggest deepwater find so far is the Tupi field, discovered in 2007 off the coast of Brazil and estimated to contain 5 to 8 billion barrels of oil. By way of comparison, all the remaining oil reserves in the U.K. North Sea are perhaps 5 billion barrels, energy experts reckon. Other oil strikes off Brazil, moreover, have sparked speculation, Vig relates, that future fields may encompass reserves “some multiple of Tupi’s.”
Eventually, production from Tupi may top 1 million barrels a day, but not until at least 2014, or seven years after its discovery, Vig stresses. Which is why oil giants like Petroleo Brasileiro, or Petrobras (which discovered Tupi), and deepwater super-majors like ExxonMobil, which fattened its exploration budget 11% this year, set long-range drilling agendas that are rarely disturbed by short-term gyrations in oil.
All drilling rigs, however, are not created equal. Demand for land rigs and offshore rigs that drill in less than 400 feet of water – jack-ups, as they are known – has been hard hit in places like the shallow-water Gulf of Mexico because of slumping natural-gas prices, now well under $4 per thousand cubic feet. The U.S. rig count is down 45% since September, data from Baker Hughes show. Moreover, jack-ups are also being idled in places like offshore West Africa and the Mideast, even as a worrisome supply of new-builds – an estimated 75 to 85 in the next three years – threatens to swell to a worldwide glut.
Faring far better are deeper-water rigs, collectively known as “floaters,” especially drill ships and semisubmersibles capable of working in depths of 6,000 to 12,000 feet. Demand for ultradeep rigs remains buoyant, with rates running at $500,000 to $650,000 a day. All told, the number of rigs at work in international waters is down only 11% from the June 2008 peak and less than 3% since September, according to Baker Hughes.
While each of the big three has superb niches in deep water, all have some exposure to the softening market in midwater and jack-up rigs.
Transocean lays claim to roughly 1/3 of the deepest drilling rigs in the world. The crown jewels of its 136-rig fleet are 34 deep and ultradeep rigs. Rolling off the assembly line are 10 more ultradeep rigs, slated to work under long-term contracts as early as this year.
Unlike its two large competitors, Transocean is shouldering a pile of debt, the legacy of its November 2007 merger with rival GlobalSantaFe. That merger catapulted Transocean to the top of the heap. Revenue last year topped $12.6 billion, and the company’s stock-market value is now $19.5 billion. Long-term debt, though, stands at 45% of total capital.
While management estimates free cash flow from the backlog will handily exceed maturing debt, including some $4 billion coming due next year, investors worry debt could become a problem in a severe downturn.
Transocean’s backlog has shrunk $1 billion in the past two months, to $38.7 billion, reflecting the troubles of a small unit drilling fixed-priced wells in the shallow gulf, a softening in the North Sea market for midwater semisubmersibles and a global fall-off in demand for jack-ups. Of Transocean’s 65 jack-ups, 31 roll off contract this year.
Deepwater rigs, happily, are a whole different story – an “encouraging” one, says Chief Executive Bob Long. Nearly all Transocean’s deepwater rigs are booked for this year, 90% for next year and 70% for 2011. These contracts account for 75% of the company’s $38.7 billion backlog. Moreover, with some smaller rivals strapped for cash and shelving plans for super-expensive new-builds, Long expects the deepwater market in 2011 and 2012 to be “even stronger than we expected a year ago.”
Transocean’s margins are lush. On every $1 of sales in 2008, it posted a flashy 33-cent net, thanks in part to a light 15% tax rate (something the company, by its recent move from the Cayman Islands to Switzerland, hopes to preserve).
Vig expects net of $13 to $13.25 a share for 2009 and about $13 for 2010. That compares with $13.09 a share last year, including charges (or $14.33 without.) At $61, shares are going for 4.7 times estimates for this year and next.
In 12 months, he figures Transocean will climb to $80.
Diamond Offshore was born back in 1989, when the Tisches, who run Manhattan-based Loews [L], bought a few secondhand drilling rigs from a distressed seller. Today, Houston-based Diamond – still 50.5%-owned by Loews – boasts revenue of $3.5 billion, a market value of $9.2 billion and a fleet of 45 drilling rigs, including 12 deep and ultradeep rigs, 19 midwater floaters and 14 jack-ups.
Most of Diamond’s deep and ultradeep rigs are drilling in the Gulf of Mexico for such customers as Murphy, Devon Energy and Anadarko. Two are working for Petrobras off the coast of Brazil.
Like Transocean, Diamond has a few idle rigs. Nonetheless, its $10.3 billion backlog looks pretty solid. Deep and midwater floaters, which last year chipped in an outsized 85% of operating profit, are virtually all under contract this year and more than 70% booked through 2010.
Comforting, too, is Diamond’s super balance sheet, with cash and securities outweighing long-term debt, and no big outlays on tap for new builds. The company’s deepwater strategy has centered on “economically” upgrading its fleet by taking a semisubmersible capable of drilling in, say, 2,000 feet of water and substantially refurbishing it, increasing its drilling depth to 6,000, 8,000 and even 10,000 feet of water.
Cash-rich Diamond, in any protracted downturn, has the wherewithal to snap up first-rate equipment on the cheap. The fat balance sheet, combined with generous cash flows, also allows the company to pay out handsome special dividends, which, together with the regular ones, totaled $6.75 in the past 12 months. At the stock’s current price of 66, that means Diamond stockholders (including Loews) are getting a yield of 10.2% on their investment. Not bad when 10-year Treasuries yield 2.8%. As Peter Vig puts it, “I like getting paid up front.”
Earnings will come in at $10.25 a share this year, Vig believes, and about $10.15 next, up from $9.43 last year. If he is right, shares are fetching about 6.4 times this year’s expected net and 6.5 times the projection for 2010.
Within a year, he sees the stock selling at 80-plus.
For a decade now, Noble has been quietly transforming itself from an operator of jack-ups into a deep-drilling heavyweight. At $6.6 billion, however, its market value is still dwarfed by Diamond’s $9.2 billion and Transocean’s $19.5 billion. And the number of floaters in its 63-rig fleet – 13 (with four more under construction) – does not match Diamond’s 31 and Transocean’s 67.
Moreover, because jack-ups still make up nearly 70% of Noble’s fleet, the company is awarded a lower price/earnings ratio and a sharply lower multiple of tangible book than its two larger rivals.
Noble’s international jack-ups have hit choppy waters off the shore of West Africa, where 3 of 5 jack-ups are idle, and in the Mideast, where one rig is stacked. And another half-dozen roll off contract this year.
The consensus pegs Noble’s net at $6.33 a share this year and $5.70 in 2010; low-ball estimates are more like $5.50 this year and $4 next. Even on worst-case numbers, shares at $25 are trading at 4.5 times this year’s estimate and about 6 times next year’s projection.
With its impressive balance sheet – long-term debt (net of cash) amounts to less than 5% of equity – Noble is ready, should things “get ugly,” as Chief Executive David Williams puts it, to do what it has always done in a downturn: buy rigs at bargain prices, this time including, perhaps, ultra-deep new-builds.
He does not sound perturbed by the global recession. “We punch holes in the ground for money,” he explains. “There is nothing we can do about the oil price. There is nothing we can do about the credit markets.” What Noble can do is what it has always done: “We run this company for margins, and we are pretty good at it.”
Last year, on every dollar of sales, Noble posted a stunning 45 cents in profit. (Like Transocean, Noble’s tax bill was light, at 18%, and the company also is relocating from the Cayman Islands to Switzerland.)
Some 80% of Noble’s rigs are booked this year, and 40% through 2010. Though relatively small in number, Noble’s deepwater fleet – including four rigs yet to be delivered, three of them already under contract – accounts for 80% of a $10.9 billion backlog, equal to 3.3 years of revenue.
Sunken Stocks, Soaring Prospects Transocean Diamond Noble Ticker RIG DO NE Market Value ($bil) 20.1 9.4 6.6 3/26/2009 price 64 67 25 % Decline From High 61 55 64 2009 P/E 4.9 6.5 3.9 Price / Tangible Book 2.3 2.8 1.2 Net Earned / Sales (%) 33 37 45 Tax Rate 15 29 18 Return on Equity 29 42 33 Net Long-Term Debt / Equity (%) 74 0 5 Sources: RoundRock Capital; Thomson Reuters;
Noble has made judicious use of its extra cash flow by repurchasing its own stock. In the 4th quarter, for example, it bought two million shares at 21 and change. In the low-to-mid-20s, Noble’s shares are going for roughly half what it would cost to replace its fleet.
Noble’s stock sells at only 1.2 times tangible book.
Eric Ende, a portfolio manager at Los Angeles-based First Pacific Advisors, likes companies in niche industries with nice balance sheets and stellar margins. He is bullish on deepwater drilling and finds Noble’s shares “ridiculously depressed.” In 12 to 18 months, he thinks the stock could double.
VENI, VIDI, VISA
Often misunderstood, the world’s largest payments network could get a powerful lift from the growing use of debit and credit cards.
Visa has one heck of a nice business franchise, collecting a small fee every time a Visa debit or credit card is used. With a 75% share of the U.S. debit card transactions market its position is well nigh impregnable. Notably, Visa itself takes no credit risk. That is taken by its card issuers.
The market served by Visa and little brother MasterCard International is still growing, as 57% of transactions in the U.S. are still in cash while that share is still higher almost everywhere else in the world. In all it is hard to think of an established company more deserving of a P/E of 20.
It is uncommon when the chief executive of a company with a $50 billion market value and a globally ubiquitous brand feels compelled to explain to investors the rudiments of its business. Yet this is the position Joe Saunders, CEO of Visa, sometimes finds himself in. The first slide of an investor presentation given by the company last month states “What we are,” which is the “largest payments-network company in the world.” As for “what we are not,” that includes “credit-card issuer, lender, exposed to consumer-credit risk.”
Persistent misapprehensions about Visa’s [V] business, a year after the company completed the largest-ever initial stock offering in the U.S., have created an opportunity for investors seeking a financially stable mega-cap growth stock as a core holding.
Visa brands debit and credit cards issued by banks, and earns fees on payments that move over its proprietary network. As such, it stands in the vanguard of a burgeoning secular trend: the use of plastic for everyday and big-ticket transactions.
U.S. payments via debit card, in which the money is drawn directly from a purchaser’s bank account, grew at an 18% annual rate between 2002 and 2007, according to McKinsey. Even though that pace is expected to slow to about 9% through 2012, the public’s increasing reliance on cards of both sorts could provide a powerful lift to Visa’s earnings and shares, which trade around $55.50. Some fans think the stock could trade up to the $70s, even in a difficult economy.
Visa has about 75% of the U.S. debit-card market, compared with 25% for MasterCard International [MA], its principal global competitor. While the rivalry between them is spirited, they jointly compete against a bigger foe: cash and checks. In the U.S., cash is used in 57% of transactions, and most countries are even more cash-centered.
Plastic’s long-running encroachment on cash and check usage could create an attractive tailwind for years to come.
Plastic’s long-running encroachment on cash and check usage could create an attractive tailwind for Visa and MasterCard for years to come. With pretax profit margins exceeding 40%, steady top-line growth easily translates for both into earnings-growth rates exceeding 15%.
Much excitement greeted the Visa IPO, which priced in March 2008 at $44 a share. The stock immediately traded into the mid-$60s, where it fetched more than 30 times forecast earnings, a rich multiple. By last May it had raced into the high-$80s, before losing nearly half its value as the market for almost everything consumer-tinged was hammered.
Visa has some sensitivity to consumer-spending activity, but even after the September 11, 2001, terrorist attacks, when the consumer largely froze, revenue grew at a high-single-digit rate. In 2008’s 4th quarter, when U.S. consumers snapped their wallets shut, San Francisco-based Visa posted double-digit top-line growth. A planned price increase will help boost revenue this year, while lapping last year’s results, hurt by high gasoline prices, will lead to better comparisons.
Visa trades at 20 times 2009 forecasts of $2.70 a share for the fiscal year ending in September. The company posted a profit of $1.7 billion, or $2.25 a share, in fiscal 2008, on total revenue of $6.26 billion. The stock’s multiple may appear rich relative to the Standard & Poor’s 500, which trades at less than 14 times future earnings. Yet Visa’s profit, based on its guidance and analysts’ forecasts, will rise by almost 20%, a rare distinction in a growth-starved market.
MasterCard is more modestly valued at 16 times calendar 2009 forecasts, and is attractive as an investment as well. The valuation discount is due to Visa’s greater exposure to debit, and the continued overhang of some merchant-pricing litigation involving MasterCard. Visa has cut a deal that shifts this liability to the issuing banks.
Also, MasterCard has been public since 2006, and is further along than Visa in transitioning to a profit-maximizing company from a member-bank-owned cooperative.
One potential model for Visa’s shift is the path taken by futures exchanges such as CME [CME], which have transitioned from ownership by their largest customers to independence as trading networks, and have profited from volume growth. They also enjoy pricing power, good free cash flow and defensible margins. For Visa, margin expansion and conservative revenue expectations could produce $5 to $6 of earnings per share in five years, some money managers estimate.
Bill Sheedy, Visa’s president for North America, notes the business “is not very capital intensive. The main costs are marketing the brand and running the network.”
Visa has the flexibility to modulate spending to protect or increase its margins. That means it has room to meet or outdo current earnings forecasts, and that its shares are not as expensive as they appear. If the stock beats a path back toward $70, as expected, it would reinforce Visa’s emerging status as a core blue-chip-like holding.
CHEAP? YES. A BARGAIN? PROBABLY NOT
It can be tough for companies to claw their way back once they have slipped into “penny stock” territory, or even below $5 a share.
It is tempting when a stock you know plunges in price to try to jump in and catch a rebound. The warning here is that if the price goes down through certain critical levels, namely $5 per share and $1, then the likelihood of a bounceback is diminished. Those price levels have a black hole-like gravity pull that makes escape more difficult. Explanations for this empirical regularity include loss of institutional sponsorship and the threat of stock exchange delisting.
Having said that, recall that John Templeton got his start in 1939 by buying $100 worth of every stock on the NYSE that was selling for under $1. Four years later he had quadrupled his investment. Of course that was back when a dollar was a dollar. The Fed had not yet perfected its something-from-nothing legerdemain and exercised it wantonly. One 1939 dollar was equivalent to $15 in 2009, perhaps supporting this article’s contention after all.
It is a basic rule of physics: the further an object falls, the faster it plummets. The same principle applies to stocks these days.
A Thomson Reuters study prepared for Barron’s shows that the average price decline last year of the 637 New York Stock Exchange- and Nasdaq-listed stocks that broke below $5 (but stayed above $1) was 61%. For the 176 stocks that traded below $1 anytime during 2008, the average drop was a stunning 84%. In comparison, the larger-cap (and higher-priced) stocks in the Standard & Poor’s 500 index slid by 38.5%, on average.
What is striking about 2008 is that so many of the stocks that showed up in the penny-stock category were household names, or at least well-known on Wall Street. They include retailers Rite Aid (ticker: RAD), Pier 1 Imports (PIR), and Eddie Bauer (EBHI); radio broadcasters Westwood One (WON) and Sirius XM Radio (SIRI); auto-parts giants Dana Holding (DAN) and Noble International (NOBL); and financials Friedman Billings Ramsey Group (FBR) and Thornburg Mortgage (THMR). As a category, penny stocks have attracted even more attention as AIG (AIG) entered their realm and Citigroup (C) hovered near it.
The data suggest that risks rise as a stock heading lower breaks through certain price points. Institutions may not be permitted to own stocks trading below a set level, like $5. And very low-priced stocks may be subject to greater volatility owing to less liquidity, decreased visibility and research coverage, and the potential for delisting from a major exchange and exile to an over-the-counter venue. Also, margin-buying opportunities become more restricted.
Among the stocks that have dropped below $5: General Motors (GM), CB Richard Ellis Group (CBG), CIT Group (CIT), Office Depot (ODP), and Sprint Nextel (S).
Glenn W. Tyranski, head of financial compliance at NYSE Regulation, says that an average of $1 is the minimum value that the exchange requires a stock to maintain over any 30-day trading period.
Former Fidelity Magellan manager Peter Lynch is skeptical of single-digit stocks. “The notion that if it gets back to $10, I will sell [virtually assures a] whole painful process [that] may take a decade, and all the while you are tolerating an investment you do not even like,” he says. Unless an investor is confident enough to buy more shares, Lynch thinks he ought to sell immediately.
And that seems the key point to many investors – if you have done your homework on the shares and still like them, you can hang on – but if not, sell.
This is not to say that low-priced stocks have no fans.
Preston Athey, manager of the $3.6 billion T. Rowe Price Small-Cap Value Fund (PRSVX), looks at these new penny stocks as long-dated options. They could rebound, but run a well-above-average chance of expiring in bankruptcy.
Athey has 14 diverse stocks in his portfolio trading for under a buck. While acknowledging that a handful will likely go belly up, he expects these shares to collectively outperform his portfolio and the market over the next 5 years.
"Where cash flow and operational earnings are still positive and where there is more cash than debt on the books, stocks that are stuck trading below $1 could be there in part out of benign neglect,” says the T. Rowe manager.
Monterey Gourmet Foods (PSTA) is a pasta maker whose shares he has held since 2001, buying them at an average five bucks each. Although the stock is trading at 1.01, Athey is not panicked: “The company has the lead position at large retailers including Costco and Sam’s Club.” He notes that Monterey also has a book value of $1.71 a share, 12 cents of cash per share, positive operating earnings and net cash flow, and no debt.
Bradford Evans, co-manager of Heartland Value Fund (HRTVX), cites Digirad (DRAD), which specializes in cardiovascular- and nuclear-imaging systems. It projects 2009 sales of $80 million, and has $28 million in cash and equivalents and a book value of $2.47. Yet its market cap is $18 million and its shares are just 95 cents. In 2008, the stock traded down from its peak of $3.50 in early February, to a bottom of 48 cents on December 4. Evans, who owns Digirad stock, believes it is poised for a turnaround this year, thanks to a strong balance sheet, good technology, significant partnerships with leading medical schools and a restructuring plan that will better manage growth while controlling costs.
One should also bear in mind that listed companies can wipe out investors, too. Remember Nortel Networks and Lehman Brothers? Still, the inability of a stock to sustain listing requirements, such as a minimum average price and market cap, can get it booted off the Big Board and Nasdaq, and by then, there is often little to salvage. Consider Thornburg Mortgage. It ended 2007 with a stock-market value of $1.2 billion and a price of 92.40. By the end of November 2008, it had been booted from the NYSE onto the pink sheets; its stock closed the month at 52 cents. By the end of the year, it was trading at 16 cents, and as of March 25, it was at five cents.
The NYSE’s Tyranski says that 47 companies were delisted last year for compliance violations, which included trading for an extended period below $1, and a market cap below $25 million – recently temporarily lowered to $15 million because of the market’s dive. The 47 were 2.5 times the number of stocks delisted in 2007.
While the relaxation of listing standards will slow the pace at which stocks are tossed off exchanges, that means more listed stocks will be trading for less than a buck. They may be cheap, but they are not necessarily bargains.
THE WEIGHING MACHINE
Patience is a value-investing virtue and, like Graham, I tend to pay attention to the scale more than the ballot box.
Value money manager John Rogers weighs in, so to speak, with some current recommendations. For all the stocks in discount territory that are lying around one might think he could have found some deeper discounts than those covered here. The ideas have merit nevertheless.
We can thank the late Ken Lay and Bernie Ebbers for some of the mess our financial system is in now. I am talking about mark-to-market accounting, a reform attempt brought in by the Sarbanes-Oxley law in an effort to prevent accounting frauds like the ones perpetrated by Enron and Worldcom. Before Sarbox, companies based valuations of many assets on expected cash flows, and this sometimes meant marking to a financial model. In the wake of those frauds, marking financial assets to market prices seemed to be the fair thing to do on a balance sheet. Market prices seem less susceptible to manipulation than prices coming out of a financial model. It seemed fair, that is, until last summer, when credit markets seized up, and no one was willing to buy derivatives, mortgage-backed securities or even commercial paper. Asset values plummeted, companies collapsed and so did confidence in our financial markets.
To illustrate what is going on, here is what mark-to-market would mean to your home mortgage. Let us say a few years ago you bought a house and put down a healthy down payment. You like your house and have no intention of selling, and you are paying your mortgage every month. But let us say houses in your neighborhood have been selling for much lower than they did when you purchased your home. Suddenly your home’s value is less than the amount you owe on your mortgage. Now, as long as you keep paying the mortgage, the bank should be fine, right? Not so, under mark-to-market rules. In this scenario the bank would have to assess what that underwater mortgage might fetch in a distressed sale and ask you to make up the difference.
Mark-to-market accounting was intended to promote transparency, but its unintended consequence is unnecessary forced trading. Value investor and Sears Holdings [SHLD] Chief Executive Edward Lampert rails against it in Sears’s current annual report. He quotes Benjamin Graham: “In the short run the market is a voting machine. In the long run it is a weighing machine.” Our financial system now rests on the shoulders of a voting machine, says Lampert
That is one reason I like to remind readers of the name of this column. Patience is a virtue in value investing and, like Graham, I tend to pay attention to the scale more than the ballot box.
There are lots of “toxic” assets on balance sheets today. In all likelihood they will be worth plenty in the future, but right now they are not. Mark-to-market accounting means a company’s value rests upon last-trade prices rather than the value that it stands to create over the coming years. I believe, like Steve Forbes and Warren Buffett, that this system needs fixing.
In the meantime, however, there are ways to capitalize on the resulting volatility. The way to beat the market is to ignore the voters and look further into the future to the weighing machines.
I recently added computer maker Dell [10, DELL] to my portfolio. Michael Dell resumed his role as chief executive in January 2007, but the market takes a skeptical view of his ability to reestablish industry leadership. Quarterly earnings reports have been disappointing, but I am taking a longer-term view. The market values the company at $19 billion, but it holds $8.4 billion in cash and generated $1.9 billion in operating cash in the past 12 months.
I warned you last year about the commodity bubble. It has popped, and oil has fallen from $150 to $50. That has given me a chance to buy shares of Hess [63, HES] on the cheap. The recession is bad, but it is temporary, and over the long term demand for oil from emerging countries will rise from here. Hess is well positioned with substantial deepwater reserves off the coasts of Brazil, Africa and Australia and in the Gulf of Mexico. The stock trades at a 14% discount to my estimate of its intrinsic value.
I also own shares of money manager Janus Capital [5.7, JNS], which I first acquired in 2002, when its stock bottomed that year. As its assets under management have shrunk from $208 billion at the end of 2007 to $123 billion at the end of last year, its stock has also declined. But like recessions, bear markets end. The company’s enterprise value (debt plus market value of common, less cash) is $1.6 billion, or 1.3% of assets under management. Both the asset total and the value/assets ratio are temporarily depressed. Buy before they rebound.
WHY WINNING FUND MANAGER JIM MELCHER IS SITTING ON DRY POWDER
“We are always focused first on how much we can lose.”
The performance of hedge fund Balestra Capital, 33% annually since its 1999 inception vs. -1.4% for the S&P 500, obviously commands notice. Last year the fund was up 47.6%! Suffice it to say that one does not produce such returns by doing what everyone else is doing, or by extensive diversification. The fund’s “global macro” investment approach eschews individual securities selection in favor of big picture bets.
Balestra chief investment officer Jim Melcher is also not afraid to sit on a big cash position. In fact he is doing that right now, with over half of his assets being in cash. He also holds some puts on U.S. and foreign stock market indexes. “Capital preservation trumps our other concerns,” says Melcher. Capital preservation evidently means not joining the bullish crowd just yet.
“Everything about fencing is unnatural,” explains Jim Melcher, chief investment officer and head of global macro hedge fund Balestra Capital. “You have to retrain your instincts to respond counterintuitively, very much like managing money.”
The discipline has helped him succeed at both. Melcher, 69, was a two-time national épée fencing champion and a member of the U.S. Olympic team in the terror-scarred 1972 games in Munich. (An épée is a type of sword.) Betting against the crowd, he has also carved out gold-medal returns: His $850 million fund soared nearly 46% last year, topping the average global macro hedge fund by a whopping 47.6 percentage points and the Standard & Poor’s 500 by nearly 83 percentage points. Returns like those earned Balestra a 4th-place finish in Barron’s Hedge Fund 75 leading performers of 2007.
More importantly, this was not just a single lucky thrust. Since the fund’s inception in 1999, Melcher has posted annualized returns of 33% from long and short investments in commodities, currencies, equity and debt indexes, interest rates, and credit-default swaps (CDS). In contrast, the stock market over the past decade was off an average of 1.38% a year. And so far this year, the New York-based fund is still delivering strong returns, up 6.64% through February, thrashing the S&P 500 by 24.82 percentage points.
Here is how he does it.
"The one thing that probably distinguishes our approach to investing,” says Melcher, “is that we are always open to change when informed by regular, objective reviews of data and trends affecting markets.” He does not get bogged down by any strategic biases. Instead, he primarily invests in highly liquid securities that can be sold within hours. The result is a fluid investment approach that enables the fund to turn on a dime.
Another big difference: Whereas many global macro managers are trend-followers, Melcher relies on his discretion, without any buy or sell triggers. He pays lots of attention to risk, using options to minimize it. “Options play a key role in our portfolio, to gain exposure with limited downside and to hedge overall positions,” he explains.
The investment manager does everything possible to understand the overall direction of markets, restricting exposure to a particular investment theme to no more than 15% of the portfolio and liquidating positions if they are causing losses to exceed 3% to 5%. Further, management stress-tests all holdings weekly to see how they would fare under extreme scenarios.
But you could not discern Melcher’s strong focus on risk through traditional metrics. Balestra’s historic annualized standard deviation, a measure of volatility of the fund’s average annualized return over a given period, is nearly 40%. In contrast, the S&P 500’s annualized deviation over the past 10 years is just 6.76%. Balestra’s staggering figure is a result of the fund’s consistent upward trajectory. The fund’s Sortino ratio, which corrects for this bias in calculating risk-adjusted returns, is 3.47%. Since 2000, the S&P 500’s ratio has been minus 0.47%.
One of the fund’s worst experiences came in 2006’s third quarter, when it shorted high-yield bonds. “At the time, risk was barely being priced into the market, with spreads for junk having collapsed to 300 basis points,” recalls Matt Luckett, a general partner in the fund. “So we shorted the CDX Index, which tracks the spreads of 100 high-yield bonds.
With the annual cost of carry averaging 3% – and huge confidence in this play – the partners soon amassed nominal exposure (based on the total value of derivatives contracts) that exceeded the fund’s assets. But within two months, spreads contracted to 230 basis points. Subsequent liquidation of the position contributed to 2006’s coming in as the fund’s only losing year – down 3.8%.
Being right was not enough.
The investment thesis was not wrong; it was just early. Spreads eventually did blow out to 1,600 basis points. “Being right was not enough,” says Melcher. “You cannot stay in a position very long that has a high carry cost, especially as it starts to move against you. We were able to adjust to a much lower carry, yet get bigger potential gains by shifting to the mortgage-backed bond area.”
The fund started buying credit-default swaps on double-A-rated mortgage-backed bonds of collateralized-debt obligations at an annual carry of 60 basis points in autumn 2006. “This was a cheap way to gain exposure to the impending housing crisis that we felt would be so severe, even the highest-quality tranches [particular slices of the CDOs] would get hit,” remembers Melcher. As the housing market melted down, the price of the CDS soared. Balestra made $180 million from the investment, which helped fuel the fund’s 199% gain in 2007.
The fund’s group-investment approach is a top-down process involving all four of the firm’s investment professionals – Melcher, Luckett, Norman Cerk, and Ryan Atkinson – tracking key macro and trading trends. Through most of the second half of 2008, it led the fund to a long dollar position. Besides seeing the commodity bubble continue to deflate, the team believed that global financial deleveraging would be largely done in greenbacks, therefore pushing up demand for the buck. The long dollar position generated about 1/4 of the fund’s 45.78% gain for the year.
In late 2007, Balestra shorted financials through the exchange-traded funds Financial Select SPDR ETF (XLF) and SPDR KBW Regional Banking ETF (KRE). “While regional banks did not have the same subprime-mortgage exposure as their large-cap brethren, and were far less involved with securitizations and other opaque financial engineering,” says Luckett, “they did have substantial commercial-real-estate exposure that is now getting hurt.” These two short positions were responsible for about 10% of the fund’s profits last year.
Melcher is very bearish about the U.S. and global economies.
In spite of Balestra’s strong start this year, Melcher is very bearish about the U.S. and global economies. He believes the current crisis is the worst since the Great Depression. While he supports President Barack Obama’s stimulus package, he thinks the government still does not grasp what needs to be done. “Policy makers must let the markets clear by themselves instead of trying to reignite more borrowing and spending. Excess stimulus may just create more problems later on.”
Melcher believes the problem ultimately stems from previous Federal Reserve policies that ensured plenty of liquidity instead of permitting periodic economic contractions to burn off weak entities and force companies to restructure.
While this outlook suggests there could be more “black swans” – rare, but crucial, events – on the horizon, Balestra, in business since 1979, has avoided such hits through some very prescient shifts into cash. Balestra first took that route before the credit crisis in 1981; then in 1987, just before global stock markets collapsed; and again right before Russia defaulted on its debt and Long-Term Capital Management blew up in 1998. The fund was also out of tech stocks before the sector started to tumble in 2000. And its short positions in 2007 and 2008 helped it rack up 2-year cumulative gains of 245%.
Although he is a believer in the importance of asset allocation, Melcher thinks that security selection has become close to irrelevant – that there is a greater need for broad market judgment rather than rigid portfolio modeling. Accordingly, he is convinced that global macro will remain the most meaningful investment strategy throughout this crisis and beyond.
Still, Melcher is keeping his powder dry, with less than half of his assets currently invested, and with reliance on limited-risk derivatives. He sees opportunities in certain high-grade corporate bonds. At the same time, he is still holding large positions in CDS of foreign corporate and sovereign bonds, betting risk premiums will rise, as well as some puts on U.S. and international equity indexes, anticipating that they will fall further.
The fund has no problem waiting on the sidelines. “Capital preservation trumps our other concerns,” says Melcher. “We are always focused first on how much we can lose.”
TELL ME WHEN DEFLATION WILL BE OVER ...
... and I will tell you how to get rich in the bond market.
How to prepare for a dénouement that could involve the extremes of either severe deflation or raging inflation? Rather than bet on one or the other, bet on each – with half of your portfolio. So goes the advice below. No glory perhaps, but no spilled guts either.
If you are a regular reader of our [Forbes] market columnists, you might be perplexed at the seeming contradictions. We have got economist Gary Shilling crying from the rooftops that deflation is upon us and you should stand pat with the low-yielding Treasury bonds he has been recommending. Then we have money manager Richard Lehmann saying the opposite – that inflation is around the corner and the time to prepare for it is now.
You may be asking yourself: Which oracle does this magazine believe in? And why do we not keep that columnist, whichever it is, and get rid of the other one? My answer will sound utterly schizophrenic, but I will explain it. I believe in both of these guys. Invest your money with two opposing scenarios firmly in mind. Plan for both depression and runaway inflation.
If you are given to hindsight – a common failing among investors – you may be inclined to find wisdom in an all-or-nothing portfolio. If only you had known, in the early 1980s, that the era of inflation was coming to an end, you could have made a fortune betting against it. This foreknowledge, in fact, would have been far more valuable than a bell telling you to get into stocks just before the great bull market that began in the summer of 1982. Shilling notes that since then stocks have returned 10.6% a year (dividends included). Had you bought 25-year Treasury zero coupon bonds beginning at their low in 1981 and rolled over once a year into a new crop of 25-year zeros, your return would have been 20.5% a year.
Coulda, woulda – a useless frame of mind. Here is a better one: humility. You think you know where markets are going, but what if you are wrong? You expect inflation, but what if you are wrong? What if we get a decadelong miasma of Japanese-like deflation and stagnation? Then your inflation bets (like high-yield corporate bonds and inflation-adjusted Treasurys) will do badly. The junk will default and the tips will fall far behind the usual Treasury bonds that have no CPI protection.
Turn it around. Suppose you expect deflation, but you turn out to be wrong. It is the 1970s all over again. Then your Treasury zeros will get killed. The crash would make the past year in the stock market look like a bull market in comparison.
My compromise plan: divide your bond portfolio. Half goes into junk and the sort of inflation defenses that Lehmann recommends. Ideally these go into your tax-deferred 401(k). The other half goes in mutual funds that own either straight Treasurys or municipal bonds. These go into your taxable account. You pass up the chance to make a killing, but you greatly lower the risk that you will be eating cat food during retirement.
A NEW ETF SEEKS TO MIMIC HEDGE-FUND RETURNS
An interesting new ETF entry claims it will mimic the performance of a fund of hedge funds. Whether this is something to truly be sought or not, it certainly is intriguing. We will see how well it tracks the indexes it aspires to track and how well it performs versus standard benchmarks for a while before passing judgement.
The $1.5 trillion hedge-fund industry, already reeling from massive redemptions, faces a new threat: an exchange-traded fund that replicates a hedge fund.
Last week, Rye Brook, New York-based IndexIQ launched the IQ Hedge Multi-Strategy Tracker ETF (ticker: QAI), which seeks returns that generally correspond, before fees and expenses, to the performance of the IQ Hedge Multi-Strategy Index. (IndexIQ is an indirect subsidiary of Financial Development Holdco, which develops and maintains financial indexes.)
"We hope it will do for the alternative [investment] space what Vanguard’s indexing did for the mutual-fund space” back in 1975, says Adam Patti, IndexIQ’s chief executive officer, who recently paid a visit to Barron’s. “In 1984, there were 84 hedge funds and people seeking alpha [the special sauce juicing returns] were willing to accept long lock-ups [of their money], a lack of transparency and high fees.” But there are more than 9,000 hedge funds now, so it is much harder to exploit market inefficiencies, a hedge-fund manager’s specialty. As a result, investors are paying “alpha fees for beta performance,” he says. For hedge-funds-of-funds investors, that fee comes on top of hedge funds’ 2% take and 20% of profits.
Not that there is anything inherently bad about beta or funds-of-funds per se.
IQ Hedge Multi-Strategy Tracker ETF, a fund of other ETFs, covers everything from global fixed-income to currencies to commodities, equities and real estate. It is also a composite of six main underlying hedge-fund strategies, including long/short equity, event-driven, market-neutral, fixed-income arbitrage and emerging markets.
It has some delicious ironies. If the fund’s managers see, say, the long/short strategy is underperforming over a period, they can short the strategy by investing in inverse ETFs that form the basis of that strategy. A fund-of-funds, by comparison, can only reduce its exposure to that strategy.
In addition, an investor gets “daily liquidity, transparency and a low fee” of 0.75% says Patti.
You do not, however, get a very nimble product, as it gets rebalanced only once a month.
Meanwhile, it has been a disastrous year for managed hedge funds. A record 1,471 were liquidated in 2008, reflecting record investor withdrawals of $150 billion in the 4th quarter, according to data provider Hedge Fund Research. That was an increase of 70% from the previous full-year record of 848 liquidations, set in 2005. Only 659 new hedge funds were launched last year, the lowest total since 2000, when 328 launched.
And of course, the hedge-fund-of-funds industry found itself mighty embarrassed by members Fairfield Greenwich and Tremont, both of which face shareholder lawsuits for throwing due diligence to the wind by giving money to Bernard Madoff’s $65 billion Ponzi scheme.
The IQ Hedge Multi-Strategy fund, although untested, might be worth a look.
20 REASONS TO BE OPTIMISTIC
Forbes columnist Rich Karlgaard gives us 20 reasons to be optimistic now. Some of them – the “everyone is pessimistic so we must be near a bottom” faux contrarianism – are questionable. Other signs observed by Karlgaard may legimately signal an at-least temporary upswing. We would emphasize the “temporary,” however. This is the first genuine credit contraction most mainstream media commentators have ever seen. They still mistake it for the rhinestone standard post-War credit growth slowdown variety, and do not understand that the old rules no longer apply.
On a recent Saturday evening in Prescott, Arizona i walked the town square looking for a meal. One cafe had this sign in the window: Depression Chili – $2 a Bowl.
Such a sign constitutes a clear buy signal – of stocks, not chili. Advertising slogans are a barometer of the popular mood, so when images of soup lines are used in advertising it means Great Depression fear has saturated the culture. From an investor standpoint the fear is oversold.
Here are 20 reasons to be optimistic now.
- Banks are making money.
- The yield curve is positive.
- Money velocity is trending up.
- Housing starts have surged.
- Mark-to-market accounting might soon be changed by the Financial Accounting Standards Board so that bank assets will be measured by their cash flow, not by the last trade. Stay tuned. This could be huge, as 70% of even the worst assets still generate cash.
- Even Representative Barney Frank (D-Massachusetts) supports the above idea, along with another good one – reinstatement of the short uptick rule.
- Airline traffic is better than expected. I have been traveling like a madman lately and can vouch for full planes and busy airports.
- Hotel occupancy rates for the first two months of 2009 were at a record-low 58%. That generated headlines, but let us put this in perspective. The industry average in all years is 63%. So the current rate is hardly a meteor-strike disaster. March occupancy rates have turned up.
- Retail sales are recovering, too.
- Copper prices are up. Gary Shilling, a Forbes columnist and the bear’s bear, advises readers to look at copper prices as a measure of global industrial activity. (Shilling is still bearish.)
- New car sales cannot rise until used car prices firm up, which they are doing.
- The Obama Administration has made a 180-degree turn, talking up the economy instead of talking it down. Why? Smarter heads have figured out the obvious. Stocks and Obama’s approval ratings dropped in lockstep after the inauguration. Much as Obama would have liked to blame this on Bush, prices and polls said otherwise.
- The Federal Reserve has poured on the coals. This is likely to cause inflation in the long run, but at least we will have a long run to worry about.
- Moderate Democrats (not just Republicans) have awakened to the excesses in the Obama budget.
- The massive stealth tax on energy called “cap and trade” is not a slam dunk to pass this year.
- The bill pushing union card check might not pass, either. You know it is a bad idea when even liberal lion George McGovern opposes it. In a TV ad McGovern says passing the bill will “effectively eliminate an employee’s right to a private vote when deciding whether to join a union.” He goes on to say, “It’s hard to believe that any politician would agree to a law denying millions of employees the right to a private vote. I’ve always been a champion of labor unions, but I fear that today’s union leaders are turning their backs on democratic workplace elections. ... This proposed law cannot be justified.” You go, George!
- Real recoveries need bears, and the bears have not gone away. Check your local newspaper (if you have one) or, better yet, realclearmarkets.com and see. Bears are everywhere.
- On most up trading days the Russell 2000 has been outperforming the S&P 500, which has been beating the Dow 30. In other words, the rally is showing breadth.
- The clowns are capitulating. Here is comic writer Joe Queenan in the Los Angeles Times: “A few weeks ago, I panicked again and moved another hefty chunk out of the market. The Dow was then trading at 7,500; now it is approaching 6,500. I fully expect to panic again at 6,000, probably at 5,000, and might even get in a bit of late-in-the-day panicking at 4,000. Tentatively, I am drawing a line in the sand at the crucial watershed of Dow 3,000, because any hysterical selling beyond that point would be anti-American and counterproductive.”
- The Ides of March have passed. Spring is here.
Should S&P’s and Moody’s ratings be trusted?
It was hardly a surprise when Standard & Poor’s cut the rating on General Electric one notch to AA+. The only surprise was how long it took. GE’s troubles were obvious back in September, when the conglomerate agreed to pay a once unthinkable 10% interest rate to Berkshire Hathaway to get its hands on $3 billion in cash. The big ratings houses kept their investment-grade ratings on Enron and Lehman Brothers practically until the end as well, essentially reassuring bond investors their money was safe.
What other companies have been blessed with ratings from the big houses – S&P and Moody’s – that might be considered, well, generous? One way to tell is to look at the price of credit-default swaps, which are derivatives that pay off if a company skips its interest payments. Here are companies that financial research firm Markit calculates have significantly higher bond ratings than could be implied from the price of their credit-default swaps.
Companies listed are Wal-Mart (AA listed rating vs. A CDS implied rating), AIG, ArcelorMittal, CIT Group, Hartford Financial (A vs. B), Textron Financial, General Electric Capital (AA vs. BB) and TRW Automotive.
(Nominally) High-Grade Corporate Bonds Are Again Looking Rather Attractive by Several Measures
J.P. Morgan Chase credit analyst Eric Beinstein last week noted that the high-grade bond benchmark is pricing in “a default rate of about 45%” over the next 10 years – and 10 years is the average life of the bonds in the index. He says this means a hypothetical investor could buy the components of the index, funding the purchase at the London Interbank Offered Rate, watch 45% of the bonds go bust, then recover only 20% of face value, and still break even for the decade.
The worst 10-year default rate for high-grade debt since 1980, he says, was 5%, implying the market is building in truly cataclysmic credit losses, in part because liquidity in this market remains so scarce.
This is an extended way of illustrating that – outside the ultra-high-quality slice of the market – corporate debt now should reward prudent risk-taking.
It remains the case that the conditions that would boost the value of corporate debt should also be equity-friendly. But as we have seen repeatedly, the relationship between moves in these two markets are neither synchronous nor predictable.
More Acreage and Less Speculation May Bring Soybean Price Drops
Everyone is looking to save a buck, and farmers are no different. That is one big reason the grain industry is expecting U.S. soybean acreage to grow this season at the expense of corn. Simply put, soybeans are cheaper to plant than corn, mostly because they do not require as much fertilizer.
With the bottom having fallen out of the ethanol market, the urgency to sow corn has lessened, giving soybeans another advantage. Add concerns that South American oilseed production will be limited, and it all leads to a jump in U.S. bean acres.
A survey of analysts by Dow Jones Newswires suggests that the Department of Agriculture’s March 31 prospective-plantings report – the first peek at spring-planting ideas – will show that U.S. farmers intend to increase 2009 soybean plantings by about 3.5 million acres over 2008, taking most of that land from corn, which is down about 1.5 million acres. And 2008 soybean acreage was 75.7 million, while corn area was 86 million. “Farmers ... would like to plant corn over beans, but they are going to go with what needs less money upfront, and that is beans,” says Hussein Allidina, vice president of commodity research at Morgan Stanley in New York.
Profitability will be tough this year. The University of Illinois is projecting that cash rents for the best farmland in the land of Lincoln will outpace the average return – so only the most efficient producers will probably make money, underscoring the need to minimize risk. But other analysts say corn will not be out in left field, even if the USDA estimates a big bean number. John Kleist, broker and analyst at ... agricultural brokerage Allendale, says the recent rise in Chicago Board of Trade corn prices relative to soybeans could lure farmers back, especially if corn holds above $4 a bushel in the December contract (which represents the fall harvest). Corn prices have climbed from $3.0825 on March 2 to a high last week of $4.3475, for a 14% gain; soybeans have risen a more modest 10.5% and last week hit a high of $9.1475 a bushel. ...
Corn and beans, along with other commodities, have risen in part on concerns about eventual inflation. The massive speculative buying from last year is absent and the traditional commodity speculator is generally balanced between bullish and bearish in the two contracts, so there is some room for these prices to rise.
But do not expect a repeat of 2008. Demand, both Kleist and Allidina note, is poor, as livestock herds are smaller – victims of last year’s high grain prices and reduced meat consumption. Domestic use of soybeans is soft, and corn exports are erratic. Significant rallies this year will need fresh impetus. ...
The USDA report is useful in setting the tone for spring trading, but a lot can change between now and the actual planted acreage data, due June 30. Weather patterns ( floods last year, and now, too) are always a consideration – but how the global economy fares in the coming months will have just as much impact.
Raytheon and General Dynamics Bolster Dividend Payouts
Defense is one industry that had been deemed a haven in an economic downturn. Not this time. Investors’ fears about possible sharp cutbacks in defense spending by the Obama administration in 2010 and beyond are keeping defense stocks in a tailspin. Yet Raytheon [Rtrillion], the world’s 5th-largest military contractor, is armed for growth.
Raytheon, which had $23.2 billion in sales last year, boosted its quarterly common dividend by 10.7% Wednesday, to 31 cents a share, from 28 cents. ... Raytheon shares yield 3.14%.
"The increase in our dividend reflects our company’s strong financial position, our continued confidence in our future and our ongoing commitment to our shareholders,” declared chief executive officer William H. Swanson. Raytheon’s payouts resumed their climb in 2005, after being stuck at 20 cents a share for a decade. Dividends have been paid without interruption since 1964. Raytheon repurchased 30.7 million of its shares in 2008 for $1.7 billion. ...
Although Raytheon’s market value has already been sliced in half in the past 12 months on worries about Pentagon budget reductions, [analyst Peter] Arment believes the latter are well known and essentially priced in to the shares now. He said Raytheon’s sales mix for the DDG-1000 ships “does not fall off materially until 2011,” and that the company will then “augment the lost sales through M&A [mergers and acquisitions] and higher international sales.”
Traded on the Big Board, Raytheon was recently quoted at 39 and change. Its 52-week price range is 67.37 to 33.20. ...
General Dynamics [GD], 6th-biggest in the defense industry, hiked its quarterly 8.6%, to 38 cents a share, from 35 cents. This company, too, is expected to benefit from greater equipment sales for its combat-systems group, in line with President Barack Obama’s commitment to expand the Army and Marines. General Dynamics trades at around 43, and yields 3.52%.
As companies cut spending to preserve cash, dividends have taken a heavy hit, but not as much as that seen in stock buybacks. Standard & Poor’s reported Thursday that share repurchases by S&P 500 members tumbled 66% in the 4h quarter from a year ago, to $48.1 billion. S&P senior index analyst Howard Silverblatt said it was the first time since 2004’s 2nd quarter that companies spent more on dividends ($62.2 billion) than buybacks. For all of 2008, repurchases fell 42% from 2007’s record-setting $589.1 billion.
Of course the record buybacks occurred right when stock prices were at their peak.
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