Wealth International, Limited (trustprofessionals.com) : Where There's W.I.L., There's A Way

W.I.L. Finance Digest :: April 2009, Part 1

This Week’s Entries :


“Many analysts that focus primarily on the U.S. credit system and economy see only an intractable deflationary spiral. Examining the incredible global policy and monetary backdrop, I see potential ‘firepower’ that I do not want to dismiss or underestimate.”

Previous publications by PrudentBear.com’s Doug Noland have focused on the deflationary spiral the U.S. is caught in, held at bay only by massive increases in government debt and guarantees. We posted two excellent examples of such work here. The implicit overhanging question has always been: Once that strategy stops working, then what? Is there even a conceivable “next” after that?

Perhaps yes.

Last week the G20 leaders came to an agreement that has the form of a “New World Order” spearheaded by the IMF. Behind all the technicalities is a nascent usurpation of U.S. global financial hegemony by a coalition of China, Russia, India, Brazil, OPEC, and other holders of major U.S. dollar reserves accumulated during the credit bubble years. What has gone around is now coming around.

Whatever the political implications of this reconfiguration, the credit system implications are of potentially momentous significance. As Doug explains, the dollar-based world financial system has abysmally failed to discipline the U.S. credit system, but it has imposed some restraints on the “Perifery” developing economies. Mexicans and Southeast Asians, e.g., have unpleasant memories of having to rein in their credit growth when ordered to by the IMF, in effect paying for the monetary sins of the “Core” developed world. The “Perifery” has long been fed up with that, and now they finally are in a position to retaliate – or at least get in on the action. And the de facto mercenaries in the war against deflation are ready to give orders to the emperor.

The bottom line is that the a powerful new source of fuel for a global reflationary effort may now have been created. This would be as good a “fundamental” explanation as any for the recovery in global stock markets over the last month. The market is sniffing out that the deflationary contraction may actually be halted short of total collapse, for another round, and once more those betting that the world is going to end will have been proven wrong, for another couple of years.

The Shanghai Composite, China’s leading equities index, has posted a 33% year-to-date gain. Taiwan’s Taiex index has gained 20.4% so far in 2009, with major indexes in South Korea up 14.2%, Indonesia 10.7%, Philippines 8.3%, Hong Kong 8.7%, and India 7.3%. Russia’s RTS index has posted an 18.1% y-t-d gain, with fellow “BRIC” nation Brazil up 18.0%. Benchmark Brazilian dollar bond yields are down 60 bps over the past month to 6.40%, and Mexico’s dollar bond yields have declined 100 bps to 5.91%.

This week, G20 leaders lent extraordinary support to global reflation efforts. Anthony Failoa and Mary Jordan captured the essence of the G20’s accomplishment in their article featured in today’s (April 3) Washington Post:
“The $1.1 trillion pledged by world leaders to combat the worst economic crisis since World War II effectively amounts to a rescue package for both poor and rich countries, potentially including the United States. The bulk of that money will be channeled through the Washington-based International Monetary Fund, which emerges from the summit with a vastly redefined and enhanced mission. The IMF has long focused almost exclusively on helping developing nations in crisis. As part of Thursday’s agreement, it will take the extraordinary step of effectively extending a $250 billion line of credit to boost liquidity in nations hobbled by the credit crunch, with the bulk of the funds going to the industrialized nations of Europe, United States and Japan. The fact that the United States, for instance, could draw as much as $42.5 billion of those funds to help jump-start domestic lending underscores the breadth of the global plan, which has both short-and long-term fixes for a crisis that has hit nations small and large, wealthy and not.”
In our age of really big numbers, the G20’s pledge of $1.0 trillion of loans and guarantees for new IMF (bailout) programs and another $100 billion for World Bank lending did not raise eyebrows. It is nonetheless an incredible case of institutions virtually given up for dead coming back to adrenaline-induced vivacity – and likely sporting greater influence than ever before. “Developing” economies – having feared they had nowhere to turn for help in stabilizing their financial systems and economies – suddenly know precisely where they will be greeted with open arms. IMF director Dominique Strauss-Kahn celebrated the organization’s newfound “firepower” and exclaimed, “The IMF is back”! The International Monetary Fund’s new resources and mandate must have the “Periphery” pinching themselves with giddiness. Markets are giddy.

If pledges and commitments are indeed fulfilled, the IMF will possess a formidable $750 billion war chest to do battle with. In addition, the IMF will expand (“print”) its own currency of account – “Special Drawing Rights” (SDRs) by $250 billion – to be distributed to member countries large and small. This is a nice win for Chinese and Russian policymakers that have been calling for SDRs to play an expanding role as a world reserve “currency.”

A New World Order

Today, from Bloomberg’s Rich Miller and Simon Kennedy:
“Global leaders took their biggest steps yet toward a new world order that is less U.S.-centric with a more heavily regulated financial industry and a greater role for international institutions and emerging markets ... ‘It’s the passing of an era,’ said Robert Hormats, vice chairman of Goldman Sachs International, who helped prepare summits for presidents Gerald R. Ford, Jimmy Carter and Ronald Reagan. ‘The U.S. is becoming less dominant while other nations are gaining influence.’”
The days of the U.S. dictating the workings of the Group of Five (the U.S., France, Germany, Japan, the UK), later the G-6 (Italy was included), the G-7 (Canada was added in 1976), the G-8 (when Russia was included) or even the G8+5 have given way to altogether different power dynamics with the relatively nascent G20 (Group of Twenty Finance Ministers and Central Bank Governors).

Having accumulated trillions of (chiefly dollar) reserves during the bubble years, China, Russia, India, Brazil, OPEC and others today wield unprecedented power and influence when it comes to the course of international policymaking. U.S. influence has waned remarkably. And the days of the Washington-based IMF responding to global crisis by imposing monetary tightness, fiscal discipline and economic overhaul (e.g., Southeast Asia 1997) are over. From an analytical perspective, the (U.S.) “Core” and the (“developing”) “Periphery” of the world system are these days atypically like-minded when it comes to supporting the cause of unbridled global bailouts, stimulus, and reflationary measures more generally. It all provides ample fodder to fuel the ongoing inflation versus deflation debate. Yet when pondering the prospective global monetary structure perhaps the strongest case is to be made for Ongoing Monetary Disorder.

One could reasonably argue that the “Core” has made such a mess of domestic and global finance that a shift of power out to the “Periphery” could not make things any worse. From a credit perspective, however, there are important nuances. For decades, the U.S.-dominated “dollar reserve” system at least at the margin constrained “Periphery” credit systems. Regrettably, this dollar-based “system” failed to discipline the U.S. credit system, and this failing has led to the failure of this monetary structure.

The dysfunctional global “system’s” recurring boom and bust cycles saw the “Periphery” hopelessly flooded with hot “money,” only to then have these credit systems crushed by the inevitable reversal of speculative flows. The “Periphery” became absolutely fed up. More importantly, they are now finally in a position to do something about it. A new system is in the works that would seemingly ensure that even the “Periphery” becomes insulated from market discipline.

Today from the Los Angeles Times’s Don Lee:
“Could the world’s currency of choice have the face of Mao Tse-tung on it, not George Washington? Quixotic or not, the Chinese are preparing for that day. In a series of what might be called baby steps, Chinese officials recently have moved to globalize the yuan and promote its influence overseas, with Shanghai designated as command central. Since last December, China has signed deals with six countries, including South Korea, Malaysia and most recently Argentina, for currency swaps that would inject Chinese money into foreign banking systems. That would allow foreign companies to pay for goods they import from China in yuan, bypassing the dollar. ... Beijing is also taking initiatives to use the yuan ... to settle trade accounts between some Chinese provinces and neighboring states. ... ‘The central bank has set promoting the renminbi for payment settlements as the main task for this year’s work,’ said Shi Lei, an analyst ... at Bank of China. ... China is also spreading the yuan’s influence in Asia by making loans and investments in other countries. ...”
The media and Internet are abuzz with commentary contrasting the declining U.S. position to that of China Rising. For the moment, my analytical focus is not in passing judgment on disconcerting secular trends. I am instead trying to figure out the more immediate consequences of (moving-target) reflationary policymaking at home and abroad. Many analysts that focus primarily on the U.S. credit system and economy see only an intractable deflationary spiral. Examining the incredible global policy and monetary backdrop, I see potential “firepower” that I do not want to dismiss or underestimate.

When the technology bubble burst in 2000, there was an unappreciated fledgling mortgage finance bubble poised to balloon to unimaginable extremes. I have theorized that a global government finance bubble today exerts a robust inflationary bias, counterbalancing the collapse of the Wall Street bubble. The extent and duration of this ongoing “counterbalancing” is an open issue of great significance. I view the resuscitation of the IMF and World Bank as critical developments for the unfolding government finance bubble thesis. I view the heightened role of the “Periphery” in global matters as supportive of global “reflation.” And, most importantly, I view the dynamic of an increasingly assertive China as integral to global reflationary efforts.

Back in 2000, conventional thinking (including that of the Fed) was convinced the collapse of technology stocks equated to the bursting of THE U.S. bubble. Similarly, today the bursting of the U.S. bubble is thought to correspond with the bursting of bubbles across the globe. Especially when one examines the horrendous numbers coming out of its export sector, it is reasonable to presume that China is intertwined in the U.S. bust. Yet it is my view that China is in fact a historic bubble – and that it may have commenced what may prove a powerful new phase of inflationary excess.

It is commonly appreciated that China has about $2 trillion in reserves to go with its population of 1.3 billion. This alone provides China unprecedented reflationary capabilities. China also maintains a tight relationship between its banking system and government policymakers, and it is worth noting that recent reports have Chinese bank lending posting another eye-opening month of expansion ($234 billion!). China is also now aggressively using currency swaps and other financing mechanisms to drive exports and trade, especially in Asia. There is also increased talk of the Chinese government providing global vendor financing for its major industries, a potentially huge development from both China and global perspectives. Clearly, if Chinese industrial policy seeks to elevate the status of key domestic industries, current global tumult provides quite a rare opportunity to press decidedly ahead. Moreover, if China moves to develop its northern region as it has developed the south, there is really no bounds to the amount of “money” that could be spent.

On a short-term basis, the Chinese are (as always) fixated on maintaining social stability. As an analyst, I have to presume this is constructive to reflationary policymaking – especially considering the extraordinary nature of today’s global financial and economic risks. To what extent longer-term ambitions of global power and influence also work to spur near-term Chinese stimulus is more difficult to gauge. But until I see something to convince me otherwise, I will assume that today’s global backdrop provides China an opportunity to focus on – and move forward with – its long-term objectives. In the age of synchronized global stimulus, I do not see why China would not “compete” fiercely in such endeavors as well. And I believe this dynamic could very well prove a powerful force in spurring global reflation. History may look back at this week’s G20 meeting in London as a key inflection point. The “Core” is in shambles, yet the surprising development may turn out to be the Periphery Rising (inflating).


A governor of the People’s Bank of China said that the International Monetary Fund’s Special Drawing Rights (SDR) should replace the dollar as the world’s main currency. Martin Hutchinson explains why the idea is preposterous, notwithstanding the sound basis of the governor’s anti-dollar bias. Hutchinson suggests China go ahead and link the renminbi to gold. That would provide a long-term benefit to the world economy and its own citizens’ wealth.

Zhou Xiaochuan, governor of the People’s Bank of China, said last week that the International Monetary Fund’s Special Drawing Rights (SDR) should replace the dollar as the world’s main currency. The political reasons for his proposal are clear, its merits rather less so. Could the world economy work better with a global central bank, whether in the form of the IMF or some other body, and with a global currency as its main reserve unit?

There is certainly a good argument for the world ditching the dollar. It’s estimated that the U.S. budget deficit for the current fiscal year that runs through September will be 12% of Gross Domestic Product (GDP). Broad money supply, whether measured by M2 or the St. Louis Fed’s MZM, has risen at annual rate of 17% in the six through March 16, before the start this week of the Fed’s potentially hyper-inflationary purchase of $300 billion of Treasury bonds over the next six months.

There is thus no reason to believe that the dollar represents a sound store of value, the principal function of a reserve currency. While liquidity in U.S. dollar debt instruments is enormous and ever-increasing as their supply skyrockets, there must be a danger of disruptions in the Treasury bond market similar to that caused by the “failed auction” last week in the U.K. gilts market, potentially causing price discontinuities and liquidity outages. In criticizing U.S. economic management, therefore, Zhou is on solid ground, reflecting many of the criticisms this column has made of U.S. monetary policy since 1995 and fiscal policy since 2002.

Other major world currencies do not look any more solid than the dollar. The pound is equally affected by the financial services disaster, and the U.K. has a budget deficit that is as large as the United States in terms of GDP, has been much worse managed over the last several years, and is based on an economy with very little raison d’etre outside the shrunken financial services sector. The yen has been strong recently, but that strength has caused a collapse in Japanese exports, down in February by almost half from the previous year. Domestically, the Japanese economy had been quite well run until September 2008, but the current prime minister Taro Aso, represents a reversion to the worst tendencies of the 1990s, with four wasteful public spending “stimulus” plans announced, a budget deficit as large as the United States’, and a government debt three times larger.

If the euro bloc holds together, the euro will provide a satisfactory store of value, since the European Central Bank’s policy has been far less inflationary than that of the United States and its members’ budget deficits are much smaller.

Only the euro represents a haven of stability, particularly if the German and French reluctance to indulge in excessive public spending spreads to the remainder of the currency’s members. While the Mediterranean group of countries have structural weaknesses, their membership in the euro will force discipline on them, and so the chances are that the euro bloc will hold together. If it does, the euro will provide a satisfactory store of value, since the European Central Bank’s policy has been far less inflationary than that of the United States and its members’ budget deficits are much smaller. The danger is that of the unit’s relative novelty; in a deep and prolonged recession, it is possible that Italian, Greek and Irish profligacy will overwhelm German and French good management, either debauching the unit or splitting it apart.

Zhou no doubt regards China’s monetary management as a model of solidity. That is nonsense. For one thing, in spite of its $2 trillion in reserves and massive balance of payments surpluses, China has still not allowed its ordinary residents to invest abroad on a free basis. Doubtless that policy results from a desire to maintain the apparatus of a police state rather than from balance of payments paranoia. Still, it is highly immoral, blocking one of the most fundamental and important economic freedoms and protections against arbitrary government. No currency that is subject to an exchange control regime has any claim to be included in the international monetary system, the essence of which is the free movement of capital.

There are also, incidentally, remaining questions about the Chinese banking system: The $911 billion of bad loans in the system estimated by Ernst & Young in the boom year of 2006 will certainly not have diminished, and may well have increased further in the current downturn, which appears to be more severe than the Chinese authorities are admitting.

Nevertheless, whether or not his own currency is in a fit state to travel, with $2 trillion of international reserves, Zhou has a perfectly reasonable desire that the value of those reserves should not disappear in an orgy of inflationary monetary policy and “Yes, We Can” deficit spending. U.S. authorities may object to this desire, since a withdrawal of any significant portion of China’s reserves would irretrievably doom the Treasury bond market, but their right to object is vitiated by their responsibility for the spendthrift policies that led to the dollar’s vulnerability.

As the proprietor of a non-convertible currency, Zhou doubtless has only a limited grasp of the purpose of a reserve currency. This is 3-fold. First, it must provide immediate liquidity for the world’s pools of international reserves. Second, it should provide a store of value, preventing those reserves from being artificially devalued. Third, it should be as far possible “politician-proof” gaining its value through some automatic mechanism that is not dependant on the whims of central bankers and politicians. As the current unpleasantness has demonstrated, central bankers and politicians are only too likely to panic in crises and engage in value-destroying currency debasement.

The Gold Standard, in place with a few interludes for more than 200 years from its establishment by Isaac Newton as Master of the Mint in 1717 until its final collapse in 1931, fulfilled all three purposes admirably. Since gold could be melted down and re-minted in the form of any of the world’s currencies, it was admirably liquid. It provided a superb store of value, although that value fluctuated by as much as 20% to 25% with periods of new gold discoveries (California and Victoria for a decade from 1849-51, South Africa and the Klondike in the 1890s) when prices rose, and periods of economic expansion faster than the rate of gold discovery (1870-93) when prices declined. Most important, it was automatic and independent of political and central banker control. Under it, bubbles were throttled fairly early by shortages of specie and downturns were ended by natural means rather than by dissolute floods of money creation.

In an ideal world, we would satisfy Zhou’s requirements by a simple return to the Gold Standard, at a parity of perhaps $1,000 per ounce that was high enough not to be excessively deflationary. There would doubtless be a few years of disruption, as there were in 1815-19 when Britain was forced into deflation to return to the Gold Standard at its pre-1797 parity. However, in the long term, the world’s monetary system would settle down on the basis of the major currencies being linked to gold. Central banks and politicians would be deprived of much though not all of their power over money creation. Damaging bubbles such as those of 1995-2007 would be cut short by a drain of gold from the banking system, forcing higher interest rates before prices of stocks, housing and commodities got too far out of line.

In the world we live in, that option is not politically available. In any case, with global population growth running at around 1% annually, it is doubtful whether gold can be discovered fast enough to prevent an excessively deflationary price regime under a Gold Standard. Contrary to the absurdly overblown view of Fed Chairman Ben Bernanke, deflation of 1% to 2% per annum is harmless, even beneficial, but in extreme cases such as that of 1930-33, when U.S. prices fell 25% in terms of gold dollars, it stifles productive investment because holding cash becomes highly profitable in real terms.

2008’s gold mine production of 2,407 tons, higher than in recent years because of high gold prices, was only 1.4% of the gold stock of 170,000 tons. If velocity were constant, that would not be sufficient to accommodate 1% population growth and desired global economic growth of 3% without an unpleasant average annual deflation of 2.6%. (In the 19th century, gold mine output was higher in terms of the existing gold stock while population increase averaged only about 0.5% annually. The faster population growth and relatively slower gold stock increase after 1900 made the 1920s’ Gold Standard unpleasantly deflationary.) Thus a global return to the Gold Standard is currently impossible, though it would certainly be feasible and possibly attractive for an individual country.

Zhou’s proposal for increasing SDR issuance passes none of the above tests for a reserve currency. Before 1971, the SDR was linked nominally to gold, but it is currently a basket made up of 63 U.S. cents, 41 euro cents and smaller amounts of yen and sterling. The total of SDR quotas is currently SDR 21.4 billion; a proposal has been outstanding since 1997 (effectively blocked by the United States), which would increase that total to SDR 64.2 billion (about $100 billion.) Smaller than the money supply of Malaysia, that is a laughably inadequate amount of money to provide adequate liquidity for the world’s reserves.

Zhou would propose – and senior IMF officials breathlessly endorse – that new SDRs be created to raise the SDR money supply to an adequate value comparable to the broad U.S. money supply of $9.6 trillion. Needless to say, this would be extraordinarily inflationary. Spurred by the grossly over-expansionary U.S. monetary policy, and later by similar follies elsewhere, international reserves more than quadrupled in the decade from 1998, rising at an average annual rate of over 16%. Since September, most monetary authorities have pursued even laxer monetary policies, so an epidemic of high global inflation is inevitable once the recession bottoms out. A large expansion of SDRs would greatly worsen that problem, preventing the SDRs themselves or any other currency from representing an adequate store of value, for international reserves or any other purpose.

The most serious reason why the SDR should not be used as a reserve currency is its control by the unaccountable bureaucrats of the IMF.

However, the most serious reason why the SDR should not be used as a reserve currency is its control by the unaccountable bureaucrats of the IMF. Far from being immune to political control, SDRs would be managed by international bureaucrats subject to no outside control by electorates or the market. Such bureaucrats would be at least as prone to damaging panic as domestic monetary authorities. Even more dangerous, they would be free to manage the world’s money by whatever cockamamie left-wing economic theories they chose, and to siphon off resources from the world’s money supply to every corrupt Third World Marxist regime they wanted to support.

Allowing the SDR to become the world’s reserve currency, even on a non-exclusive basis, would place global monetary policy entirely on a non-market basis, without individual countries having any recourse but to purge their international reserves of SDR assets and refuse to accept SDRs in payment – which would defeat the point of the exercise. It is a proposal worthy of the impoverished and genocidal China of Mao Zedong, not the hopeful market-oriented China of today.

If China is really worried about the value of its reserves and wishes to provide a long-term benefit to the world economy and its own citizens’ wealth, it has an alternative to the SDR, which would weaken rather than strengthen the trans-national bureaucrat class. The IMF, typically enough, forbids its members from linking their currencies to gold. Governor Zhou should break that prohibition and put the renminbi on the Gold Standard. With $2 trillion in reserves and a structural balance of payments surplus, China can well afford it.


In a recession, a recovery in personal consumption, incomes, and retail sales signals the start of recovery. The virtuous cycle of credit growth – and its corollary, debt growth – combine with rising incomes as the rate of unemployment growth slows. Credit expansion leads the economy out of the cycle, followed by incomes. That is what many stock market participants think they are seeing now, as previous experience has trained them to see. But they are wrong.

A good theoretical framework can be extraordinarily helpful for putting the oft chaotic data one receives from life and the world into context. A bad theory is usually worse than no theory at all. Our proclivity for the Austrian Economists’ fundamental theory about what fueled the credit bubble and what is ailing today’s economy is obvious from our history of posts, e.g., see recent instances here and here. Austrian theory informs us that there are major structural imbalances behind today’s economic troubles, and for a healthy recovery to occur these balances have to be addressed. Nothing close to that has happened so far, nor have such measures been seriously discussed. The people with their hands on the monetary and fiscal policy levers (assuming they are sincere) are operating with a bad theory. The Austrians then predict that any upswings in economic activity are likely to be halting and short-lived.

We also frequently feature Doug Noland from PrudentBear.com in these pages, e.g., see immediately above. His framework is not some “explain the universe” grand set of ideas. It is consistent with the Austrian theory with a complementary focus. His orientation is towards the almost mechanical idea that as long as system credit is expanding sufficiently fast things will not implode, but when it expands too fast things go crazy. His forté is tracking all the information which would help tell us what is going on now vis a vis these possible outcomes. Illuminating and useful.

iTupip.com’s Eric Janszen, who we have featured only once before, offers a further useful perspective, consistent with and complementary to the Austrians and Noland. One can start to drink in Janszen’s ideas on debt/finance-driven economies and central banking, e.g., in “The FIRE Economy Rules” [“FIRE” = Finance, Insurance and Real Estate] and “Saving, Asset-Price Inflation, and Debt-Induced Deflation.” This recent pithy summary gives the short of it: “Basically, he thinks the government started selling everybody out to big creditors decades ago, and the massive debt burden that resulted has paralyzed the economy.” Clearly a man after our own heart.

Helping Janszen’s case is that we has apparently made some good calls on major secular turning points in the economy and financial markets, such as the bottom of the gold bear market in 2001, and the tops of the housing and stock markets (see here). The Austrians we are aware of and Noland are good at informing one just how messed up things are, but we would not look to them for help with investment timing.

Janszen believes that all the outstanding debt will ultimately be repaid “with itty, bitty little dollars,” i.e., things will resolve in hyperinflation. Right now he observes that the government trying to reinvigorate the economy using the old tools which have worked to stop all previous post-War recessions. But it will not work this time, he says, because the debt burden has become too large.

Concomitantly, market investors are bidding up stocks in the expectation that the government will successfully reinflate the economy. But: “The stock market rally is a disconnect between investor expectations and the economy.” However, Janszen warns that he has “no special debt deflation bear market rally timing skills.”

In an economy where household expenditure accounts for 71% of GDP as in the U.S. in 2008, if household cash flows from wage income declines, retail spending falls. Government through interest rate cuts and tax cuts stimulates the economy by increasing credit cash flows. This approach worked effectively to end every recession in the U.S. since the end of World War II. Keep in mind that each recession was created by monetary policy, by the tightening of credit in order to reduce inflation expectations, real or imagined.

Think of a consumer-dependent economy as a waterwheel [see diagram], with household cash flow from wages and credit driving the wheel, and the wheel driving the creation of new jobs, income, and credit, pumping money into the economy. If either the credit flows or the income flows dry up, the wheel slows. If they both dry up, one after the other, the wheel slows a lot. In a recession, the government tries to get the wheel moving again by making up for private credit flows and private income flows with government credit and government jobs.

A depression, on the other hand, happens when debt levels are so high that there is not enough cash flow from incomes or new credit creation in the economy to service the interest on the debt. The result is debt deflation and economic depression. Debt deflation started in 2006 for households when the price of their homes began to fall.

A depression, unlike a recession, is not induced by government raising interest rates to combat inflation. On the contrary, a depression occurs in spite of all efforts by government to expand credit. Interest rates are cut to zero yet the debt deflation goes on.

Debt deflation cannot be stopped by government credit expansion because that effort only increases debt levels that are already excessive.

Debt deflation cannot be stopped by government credit expansion because that effort only increases debt levels that are already excessive as a result of decades of previous interventions to re-start the already over-indebted economy. As the economy shrinks, there is even less income available to repay debt, and a vicious cycle sets in. The wheel not only stops, it begins to run backwards and pumps money out of the economy.

Debt deflation at first withdraws household purchasing power from credit. Later households experience a purchasing power decline from loss of wage income as layoffs increase and savings are consumed in debt repayment. Government, by pouring vast sums of government money into the economy in an attempt to restart the virtuous credit cycle can produce a small “bounce” in the decline in aggregate demand that shows up as consumer spending [this diagram indicates such a bounce is happening now], but cannot restart the wheel as it can during a recession. Debt levels continue to fall, and soon consumer expenditures as well.

Stock market participants are not wired to comprehend the wholly different dynamics of a debt deflation.

Stock market participants are trained by previous recessions since WWII to expect a recovery after consumption expenditures turn around in response to fiscal and monetary stimulus. They are not wired to comprehend the wholly different dynamics of a debt deflation as we identified it in December 27, 2007 and forecast a 40% decline in the DJIA in line with the first year decline that the Japanese stock market experienced in the first year of Japan’s debt deflation (see “Time, at last, to short the market” $ubscription).

U.S. re-inflation policy has been far more aggressive than Japan’s, and the recent announcement by the Fed to begin buying Treasury bonds farther out the yield curve is motivating investors to move out of government bonds, and some of that money moved into stocks.

This rally does not reflect an improvement in the underlying economy but the response of market participants to short term government policy in the context of a widespread misperception of the current depression as a recession. The stock market rally is a disconnect between investor expectations and the economy.

How disconnected?

Japan’s experience with managing debt deflation via fiscal stimulus has been similar to that of the U.S. in the 1930s. Whenever government spending was cut, the economy slumped back into depression. The U.S. finally escaped debt deflation with WWII. There is no evidence to support the belief that fiscal stimulus can end a debt deflation, but that is the belief that governments are following worldwide.

We claim no special debt deflation bear market rally timing skills. Even after the DJIA approaches our target of 5000, we have no idea how long it will remain trading in a low range. The duration of the downturn depends on the political response to global economic contraction. The flawed philosophy and ideology of curing the debt deflation illness with further exposure to the debt disease, as the U.S. attempted in the 1930s and Japan has tried since the early 1990s, do not encourage optimism but point to a prolonged and painful period of global economic contraction.


“It” is happening, fleet of virtual heliocopters notwithstanding.

In his famous/notorious “helicopter drop” speech, Ben Bernanke explained that he would do what ever it took to prevent “it” – deflation – from happening. If he were a real politician he would have stopped there, but being an academic he went into specifics and outlined how he would stop deflation in its tracks.

Mike Shedlock went through Bernanke’s enumerated list of anti-deflation weapons and found ... that they have all been used. The bullet chamber is now empty. And deflation is still here.

In case no one is keeping track, Bernanke has now fired every bullet from his 2002 “helicopter drop” speech Deflation: Making Sure “It” Doesn’t Happen Here.

Here is Bernanke’s roadmap, and a “point-by-point” list from that speech.
  1. Reduce nominal interest rate to zero. Check. That did not work. ...
  2. Increase the number of dollars in circulation, or credibly threaten to do so. Check. That did not work. ...
  3. Expand the scale of asset purchases or, possibly, expand the menu of assets it buys. Check & check. That did not work ...
  4. Make low-interest-rate loans to banks. Check. That did not work. ...
  5. Cooperate with fiscal authorities to inject more money. Check. That did not work. ...
  6. Lower rates further out along the Treasury term structure. Check. That did not work. ...
  7. Commit to holding the overnight rate at zero for some specified period. Check. That did not work. ...
  8. Begin announcing explicit ceilings for yields on longer-maturity Treasury debt (bonds maturing within the next two years); enforce interest-rate ceilings by committing to make unlimited purchases of securities at prices consistent with the targeted yields. Check, and check. That did not work. ...
  9. If that proves insufficient, cap yields of Treasury securities at still longer maturities, say 3 to 6 years. Check (they are buying out to 7 years right now.) That did not work. ...
  10. Use its existing authority to operate in the markets for agency debt. Check (in fact, they “own” the agency debt market!) That did not work. ...
  11. Influence yields on privately issued securities. (Note: the Fed used to be restricted in doing that, but not anymore.) Check. That did not work. ...
  12. Offer fixed-term loans to banks at low or zero interest, with a wide range of private assets deemed eligible as collateral (... Well, I am still waiting for them to accept bellybutton lint and Beanie Babies, but I am sure my patience will be rewarded. Besides their “mark-to-maturity” offers will be more than enticing!) Anyway ... Check. That did not work ...
  13. Buy foreign government debt (and although Ben did not specifically mention it, let us not forget those dollar swaps with foreign nations.) Check. That did not work. ...
Bernanke has failed. “It” has happened. The proof is irrefutable as detailed in Humpty Dumpty On Inflation and Fiat World Mathematical Model.

What now Ben? More of the same stuff that failed miserably before, only on a grander scale?


Asia’s stock markets rallied significantly in March, essentially overcoming the losses of January and February. The recovery has perhaps been so quick that we should be alert to a setback, argue several veterans of the arena.

Asia’s markets staged a tremendous rally in March after a horrific January and February, staunching losses in Asian mutual funds and equities. For the quarter, the average Asia ex-Japan mutual fund tracked by Lipper Reuters was down 1.2%, and the average Japan fund was down 18.2%. (For the 12 months ended March, the losses are 42.6% for Pacific ex-Japan funds, 41% for Japan portfolios.)

During the March quarter, the Dow Jones Wilshire Pacific index fell 10.8%, while the Dow Jones Asia Titans index fell 9.8%. In local currency, the standout market was China, with the Dow Jones CBN China 600 index up 39%. Taiwan jumped 13.5%; South Korea, 7.3%; and India was 0.6% higher. Asia’s worst markets included Japan, down 8.5%, and Hong Kong, down 5.6%.

The accompanying surge in inflows suggests investors be alert. Emerging-market inflows totaled $3.5 billion in the past two weeks, according to Bank of America Merrill Lynch strategist Michael Hartnett, making for “the strongest two-week period since May 2008.” (Global emerging markets funds had inflows in the past week of $900 million, while Asia funds saw inflows of $400 million; EMEA and Latin funds saw small redemptions.) Inflows in the past four weeks totaled 1.7% of total assets under management. “The trading rule says: Inflows in excess of 1.5% of total AUM in a 4-week period [means] sell,” writes Hartnett. He adds: “The four big sell signals in April 2006, July 2007, September 2007 and April 2008 all worked with a 2- to 4-week lag,” so the sell signal “could be early.”

So what happens next? We checked in with the best-known Asia fund complex this side of the Pacific, Matthews Asia. The group launched a dedicated Asia Small Companies fund [ticker: MSMLX] the week Lehman Brothers went bankrupt last fall. It was a rocky period, but so far this year, the fund is up 8.1%. The group’s Asian Technology Fund is up 5.95%. Meanwhile, the flagship Matthews Asian Growth & Income fund is up 1.84% so far this year.

Andrew Foster, acting chief investment officer at the San Francisco-based fund family, recommends caution going into the rally: Hedge funds could still dump shares once they allow investors to start withdrawing again. However, in a much longer view (with the emphasis on much – Foster thinks three to five years), “this is a pretty attractive time to be thinking of these markets.” Valuations are cheap, and stock and bond buybacks mean “more of a floor is starting to form.”

Foster is especially sanguine about China, which could “credibly double” the size of its own $590-billion stimulus package to revive its economy, given the government’s strong fiscal position. China’s economy, and most significantly its property market, is starting to stabilize. Real estate accounts for 5% of China’s economy, a significant proportion of domestic employment (77 million jobs), and 18% of fixed-asset investment, according to Riedel Research. Many provinces get 1/5 of their income from real estate, and real-estate investment in China has grown 20-30% a year in the past few years, a major engine of growth. The uptick is lifting consumer sentiment, particularly in smaller cities, says Jing Ulrich, JPMorgan China’s chairman. Prices and mortgage costs are down, boosting affordability “and driving what looks like a sustainable volume recovery,” says Ulrich.

Despite China’s rejection of Coca-Cola’s bid for Huiyan Juice Group, Foster believes it is committed to reform, including the listing of smaller growth companies, as well as big ones like troubled Agricultural Bank of China. Rumors about a listing of the latter have recently revived, and China Life Insurance [LFC] has said it is interested in taking a stake, though Agricultural Bank says it has no plans to go public.

Foster likes Chinese domestic plays, including Hang Lung Properties (0101.HongKong), which “expanded into China much more aggressively in 2005 and 2006” and is “especially good” at developing properties in large cities.

What about other markets? Japan remains vulnerable to weak exports, says Foster, though its real-estate investment trusts will start to benefit from consolidation and growth. He also likes software company Trend Micro (4704.Japan) for its “substantial yield and nice balance sheet.”

India too will have a rougher time. “People have deferred capital spending and major-ticket purchases, which is causing a drag on Indian growth at the same time foreign capital flows dried up,” says Foster. It also faces a general election this month, adding to the uncertainty. Foster adds that, though “the India growth outlook is decent, and valuations are more attractive now, the China story is much more resilient.”


Stocks always outperform bonds “in the long run,” right? It depends on what you mean by “long.”

The standard line of pap is that as compensation for taking on the extra risk of stocks versus bonds, investors are rewarded with extra returns, e.g., 3% to 5% annually. At worst, we are told, you may have to wait through some sketchy periods to reap those benefits.

If you look at the really long run, going back to the early 1800s, this turns out to be true – to the tune of 2.5% annually, which adds up over 200-odd years. How about over periods more relevant to a normal human lifetime? It depends, and the starting point matters a lot.

In particular, when stocks are expensive – e.g., 1929, 1969, 1972, 1980, 1987, 1999, and 2007 – it has been the case that going into bonds for at least a couple of years has consistently paid off. Research from Rob Arnott, a well-respected financial analyst, specifically compares total returns available from buying the S&P 500 with those available from buying 20-year Treasury bonds, in each case rolling the respective investment over annually.

From the 1929 stock market bubble peak it would have taken 20 years before the cummulative returns from the S&P caught up to Treasuries. From the 1969 post-War bull market peak you would have done just as well for the next 10 years going with “certificates of guaranteed confiscation,” brutal 1970s bond market performance notwithstanding. Extraordinarily, with the recent stock market wipeout 20-year Treasuries have actually slightly outperformed the S&P over the last 40 years! Long-term indeed.

Of course the story is quite the reverse if the starting point is when stocks are cheap, e.g., 1932, 1937, 1942, 1949, 1974, 1978, 1982, 1988, etc. (and, arguably, now). Critical, however, is that you then get out of stocks when valuations wander into Lala Land.

To us the most important point is that timing does make a difference if it is based on valuation. If stocks are expensive then you cannot depend on time to bail you out of the decision to buy too dearly, unless you have the better part of a lifetime to wait. Cannot find any cheap stokcs to invest in? That is a signal. Ignore all the pitches from financial planners and fund managers to the contrary.

If stocks outperform bonds by as much as 5% over the long run then, for our truly long-term money, why should we bother with bonds? Why not just ignore the volatility and collect the increased risk premium from stocks? That is the message of those who believe in “Stocks for the Long Run” and also from those who want you to invest in their long-only mutual fund or managed account program. Indeed, it is always a good day to buy their fund.

One of my favorite analysts is my really good friend Rob Arnott. Rob is Chairman of Research Affiliates, out of Newport Beach, California, a research house which is responsible for the Fundamental Indexes which are breaking out everywhere (and which I have written about in past letters), as well as the only outside manager that PIMCO uses, for his asset allocation abilities. He has won so many industry awards and honors that I will not take the time to mention them. In short, Rob is brilliant.

He recently sent me a research paper that will be published next month in the Journal of Indexes, entitled “Bonds: Why Bother?” The publisher of the journal, Jim Wiandt, has graciously allowed me to review it for you prior to it actually being sent out. The entire article will be available when the Journal of Indexes goes to print in late April ... Qualified financial professionals can also get a free subscription there to pick up the print copy. There is some very interesting research at the website. But let us look at a small portion of the essay. I am reducing 17 pages down to a few, so there is a lot more meat than I can cover here, but I will try and hit a few things that really struck me.

It is written into our investment truisms that investors expect their stock investments to outpace their bond investments over really long periods of time. Rob notes, and I confirm, that there are many places where investors are told that stocks have about a 5% risk premium over bonds.

By “risk premium,” we mean the forward-looking expected returns of stocks over bonds. As noted above, if you do not think stocks will outperform bonds by some reasonable margin, then you should invest in bonds. That “reasonable margin” is called the risk premium, about which there is some considerable and heated debate.

Most people would consider 40 years to be the “long run.” So, it is rather disconcerting, or shocking as Rob puts it, to find that not only have stocks not outperformed bonds for the last 40 plus years, but there has actually been a small negative risk premium.

In a footnote, Rob gets off a great shot, pointing out that the 5% risk premium seen in a lot of sales pitches is at best unreliable and is probably little more than an urban legend of the finance community.

How bad is it? Starting at any time from 1980 up to 2008, an investor in 20-year Treasuries, rolling them over every year, beats the S&P 500 through January 2009! Even worse, going back 40 years to 1969, the 20-year bond investors still win, although by a marginal amount. And that is with a very bad bond market in the ‘70s.

Let us go back to the really long run. Starting in 1802, we find that stocks have beat bonds by about 2.5%, which, compounding over two centuries, is a huge differential. But there were some periods just like the recent past where stocks did in fact not beat bonds.

Look at the following chart. It shows the cumulative relative performance of stocks over bonds for the last 207 years. What it shows is that early in the 19th century there was a period of 68 years where bonds outperformed stocks, another similar 20-year period corresponding with the Great Depression, and then the recent episode of 1968-2009.

In fact, note that stocks only marginally beat bonds for over 90 years in the 19th century. (Remember, this is not a graph of stock returns, but of how well stocks did or did not do against bonds. A chart of actual stock returns looks much, much better.)

Bill Bernstein notes that in the last century, from 1901-2000, stocks rose 9.89% before inflation and 6.45% after. Bonds paid an average of 4.85% but only 1.57% after inflation, giving a real yield difference of almost 5%. In the 19th century the real (inflation-adjusted) difference between stocks and bonds was only about 1.5%.

In the late 1990s, stock bulls would point out that there was no 30-year period where stocks did not beat bonds in the 20th century. The 19th century for them was meaningless, as the stock market then was small, and we were now in a modern world.

But what we had was a stock market bubble, just like in 1929, which convinced people of the superiority of stocks. And then we had the crash. Also, from 1932 to 2000 stocks beat bonds rather handily, again convincing investors that stocks were almost riskless compared to bonds. But in the aftermath of the bubble, yields on stocks dropped to 1%, compared to 6% in bonds. If you assumed that investors wanted a 5% risk premium, then that means they were expecting to get a compound 10% going forward from stocks. Instead, they have seen their long-term stock portfolios collapse anywhere from 40-70%, depending on which index you use.

So what is the actual risk premium? Rob Arnott and Peter Bernstein wrote a paper in 2002 about that very point. Their conclusion was that the risk premium seems to be 2.5%. Arnott writes:
“My point in exploring this extended stock market history is to demonstrate that the widely accepted notion of a reliable 5% equity risk premium is a myth. Over this full 207-year span, the average stock market yield and the average bond yield have been nearly identical. The 2.5 percentage point difference in returns had two sources: inflation averaging 1.5 percent trimmed the real returns available on bonds, while real earnings and dividend growth averaging 1.0 percent boosted the real returns on stocks. Today, the yields are again nearly identical. Does that mean that we should expect history’s 2.5 percentage point excess return or the five percent premium that most investors expect?

“As Peter Bernstein and I suggested in 2002, it is hard to construct a scenario which delivers a 5% risk premium for stocks, relative to Treasury bonds, except from the troughs of a deep depression, unless we make some rather aggressive assumptions. This remains true to this day.”
One other quick point from this paper. Just as capitalization-weighted indexes will tend to emphasize the larger stocks, many bond indexes have the same problem, in that they will overweight large bond issuers. At one point in 2001, Argentina was 20% of the Emerging Market Bond Index, simply because they issued too many bonds. If you bought the index, you had large losses. The same with the recent high-yield index which had 12% devoted to GM and Ford. In general, I do not like bond index funds, and this is just one more reason to eschew them.

So Then, Bonds for the Long Run?

Let me be clear here. I am not saying you should put your portfolio in 20-year bonds, or that I even expect 20-year bonds to outperform stocks over the next 20 years. Far from it! The lesson here is to be very careful of geeks bearing charts and graphs ... Very often, they are designed with biases within them that may not even be apparent to the person who created them.

Professor and Nobel Laureate Paul Samuelson in late 1998 was quoted as saying, a bit sadly, “I have students of mine – PhDs – going around the country telling people it is a sure thing to be 100% invested in equities, if only you will sit out the temporary declines. It makes me cringe.”

When someone tells you that stocks always beat bonds, or that stocks go up in the long run, they have not done their homework. At best, they are parroting bad research that makes their case, or they are simply trying to sell you something.

As I point out over and over, the long-run, 20-year returns you will get on your stock portfolios are VERY highly correlated with the valuations of the stock market at the time you invest. That is one reason why I contend that you can roughly time the stock market.

Valuations matter, as I wrote for many chapters in Bull’s Eye Investing, where I suggested in 2003 that we were in a long-term secular bear market and that stocks would be a difficult place to be in the coming decade, based on valuations. I looked foolish in 2006 and most of 2007. Pundits on TV talked about a new bull market. But valuations were at nosebleed levels. And now?

I have been doing a lot of interviews with the press, with them wanting to know if I think this is the start of a new bull market. There are a lot of pundits on TV and in the press who think so. I also notice that many of them run mutual funds or long-only investment programs. What are they going to do, go on TV and say, "Sell my fund"? And get to keep their jobs?

Am I accusing them of being insincere? Maybe a few of them, but most have a built-in bias that points them to the positive news that would make their fund (finally!) perform. And believe me, I can empathize. It is part of the human condition. But you just need to keep that in mind when you are thinking about investing in a new fund, or rethinking your own portfolio.


Six talented managers are finding value in various corners of the market.

It is natural that when capital gains are no longer a given that people will rediscover the virtues of investing for income. And when the trauma of major capital losses is still fresh it is natural for people to start worrying about principal protection, i.e., return of as well as on investment. Thus the revival of interest in bond funds.

A recent poll – before the March stock market rally to be sure – found that for the first time in 5 years a majority of money managers liked bonds better than stocks. Part of the attraction must be due to investment-grade corporate yields being higher than the long-run average returns delivered by stocks, while having greater downside protection. Treasury yields are another story, of course. Benefiting from Doug Noland’s “global government finance bubble,” their yields are absurdly low.

For the average investor, the main avenues for gaining exposure to bonds are mutual funds and ETFs. This article features six credible candidates among fund managers.

The volatility of the stock market has caused many investors to stash their cash in certificates of deposit, money-market funds – even under the mattress. There is a better alternative: bonds, some of which offer substantial value, and less agita than equity.

The word is getting out. For the first time in 5 years, a majority of money managers favor bonds over stocks, reports the quarterly Investment Manager Outlook Survey by Russell Investments. The poll was conducted between February 26 and March 6, just prior to the latest equity rally.

Taxable and tax-exempt bond funds enjoyed net inflows of $36.6 billion last year, versus U.S. equity-fund outflows of $93 billion. Mortgage, investment-grade, high-yield and municipal bonds got hammered last year – regardless of quality – as the credit markets seized up. But liquidity is improving. Bond prices appear to have stabilized. They are still cheap by historical standards. With the Federal Reserve likely to use all of its firepower to keep interest rates low, less-volatile bonds could well outperform equities this year.

Barron’s has picked a half dozen top-notch mutual-fund bond specialists that investors should consider. Their managers share three characteristics: They are conservative, savvy and experienced. Here are their thoughts on where the best values are.

The co-managers of the $2.84 billion First Pacific Advisors’ FPA New Income Fund avoided last year’s train wreck by changing tracks in 2004 and ‘05, when they began to worry about mortgage delinquencies. As a result, the managers, Robert Rodriguez and Thomas Atteberry, got rid of Alt-A and subprime-mortgage-related securities. The fund (ticker: FPNIX) also exited high-yield bonds when the possible rewards no longer seemed to merit the risks. Both moves paid off. FPA had a gain of 4.3% last year, beating the typical intermediate-bond fund by 9 percentage points. The fund loaded up on triple-A-rated Fannie Mae, Freddie Mac, Ginnie Mae and Federal Home Loan Bank collateralized mortgage obligations, or CMOs, and pass-throughs (pools of mortgages whose cash flows are the monthly payments made by homeowners).

We previously posted an interview with Robert Rodriguez here.

At the end of 2008, the fund had about 36% of its assets in cash, which it has since cut to about 25%, says Atteberry. “It is nice having cash available when someone has to sell” for redemptions. The fund, which has no sector limits or index benchmark, is up 1% year-to-date through April 1.

Right now, about 42% of his mortgages are older CMOs or pools. That is in part because loans written before 2002-03 were still subject to tougher lending standards and because a 5-year-old, 15-year mortgage with a balance of $100,000 or under has a much lower chance of being refinanced, which would leave the mortgage holder stuck with a lower yield.

Atteberry does not like Treasuries. “These are unsustainable [low] interest levels, with rates manipulated by the Fed’s buying 30-year” debt, he says, referring to the Fed’s plan to buy long-term Treasuries. Right now, outstanding Treasury bonds equal 60% of U.S. GDP. By the end of 2010, they will be 100%. That is about equal to the debt levels in such shaky economies as Italy, Greece and Sri Lanka.

The fund, which cannot have more than 25% of its assets rated below AA, does come with a couple of caveats. Although it has a low expense ratio of 0.61%, FPA has a front load of 3.50%. And Rodriguez, who has never had an annual loss since taking over the fund in 1984, will take a 1-year sabbatical next January. However, Atteberry, who has been with FPA since 1997, is a bond veteran who is expected to keep to the same strategy. The two shared Morningstar’s fixed-income manager-of-the-year award for 2008.

The Fidelity Government Income Fund returned an eye-popping 11% in 2008, helped by its holding of U.S. Treasuries, especially longer-dated bonds.

Bill Irving, taxable-bond-portfolio manager at Fidelity, concedes it is “very unlikely we will be able to repeat that performance” this year. He expects the Fed, which plans to buy $300 billion in Treasuries and $1.25 trillion in mortgages, to keep interest rates in a tight range for the year. The $6.92 billion no-load fund was up 0.49% in 2009 through April 1.

Irving does not plan to take big chances. He aims to keep 80% of the fund [FGOVX] in government bonds, FDIC-insured debt, government-guaranteed Ginnie Mae CMOs and pass-throughs, and other agency debt. The fund will not buy riskier assets to chase incremental yield. The Government Income fund, which sports a very low 0.45% expense ratio, is designed to provide “steady income, and is a counterweight to the equity component of a diversified portfolio,” says Irving. It certainly played that role convincingly in 2008.

Municipal bonds, generally considered safe bets that rarely default, got whacked last year as fears spread about state and local governments’ ability to repay their debts. By autumn, a AA-rated bond was yielding 6.80%, which was “insanely cheap,” says Joe Deane, manager of Legg Mason Partners Managed Municipals Fund [SHMMX].

Deane did not sidestep all the problems. His $3.9 billion fund lost 9.3% last year. He has, however, returned 3.62% a year on average over the past 10 years, and has already gained 6.97% this year. (Managed Municipals has a front load of 4.25% and an expense ratio of 0.66%.)

Prices got so low early in 2009 in part because hedge funds sold munis to raise cash for redemptions. “We were not looking for liquidity,” says Deane. “We were providing it.” Then bargain hunters jumped in, helping to push yields on double-A tax-exempts back down to 5.30% in February.

Legg Mason was able to mitigate losses by buying a lot of pre-refunded munis last year – refinanced municipal debt that uses its proceeds to buy Treasuries to be held in escrow, from which they pay interest and principal on the original issues.

After the brief rally, yields have begun to creep back up near 6%, a level Deane finds “very cheap.” The portfolio manager, who has been with the fund since 1988, recently has been buying essential services’ revenue bonds and general-obligation bonds from states and cities “that have the wherewithal and political will” to balance their budgets. Among them: New York City water bonds.

The mortgage-heavy TCW Total Return Bond Fund [TGLMX] posted a 1.1% gain last year. Tiny as it is, that is a remarkable return in light of all the problems in the mortgage-securities market. On an absolute basis, the fund’s modest return still placed it ahead of 71% of its intermediate-term rivals, according to Morningstar.

“We have a strong risk-management philosophy,” says TCW Chief Investment Officer Jeffrey Gundlach, who oversees the $2.93 billion fund (see related article, “How to Profit from Obamanomics”). The no-load, with an expense ratio of just 0.44%, has tacked on a 2.46% year-to-date return through April 1.

Gundlach has about half his fund in government-backed bonds like Ginnie Maes, Fannie Maes and Freddie Macs, yielding 4%. The other half is invested in nonguaranteed senior mortgage bonds, which carry more risk – but also an average yield of 18%. “Incrementally, we are finding entry points for triple-A” mortgages because investor fear of delinquencies is very high. A bond originally rated triple-A with 1% to 2% delinquencies, considered “money-good,” might fall from par to 90 cents on the dollar, yielding 7.5%. But a mortgage bond with 5% delinquencies drops to 60 cents on the dollar, in part because the credit agencies drop their rating at this trigger to single-B, which is noninvestment grade. Of course, one man’s junk is another man’s treasure, in Gundlach’s view.

Gundlach, with 25 years of managing mortgages for TCW, also was shrewd in targeting the A-tranches of 2-part mortgage-backed securities that pay out half of their principal to this A-portion before they start paying principal on the B-slice. The A tranches’ losses have been much lower. This is a market where experience counts.

Investors seeking a larger playground might consider the $10.4 billion Templeton Global Bond Fund. While the U.S. credit markets froze, this fund [TPINX] gained an impressive 6.3% last year, with investments in sovereign issues from France, Sweden, Korea and Russia, and with a heavy concentration on the credit ladder of single-A, triple-B and double-B-rated bonds.

“Last year is a prime example of the motivation for wanting global exposure,” says Michael Hasenstab, portfolio manager. “People have a home-country bias in fixed income,” he observes, but a well-run global fund has “lower total volatility.” His fund has a 5-year trailing-return record of a healthy 7.92%.

The fund consists of three baskets: interest-rate markets, currency markets and sovereign-credit markets – meaning sovereign bonds not issued in the country’s own currency. The fund has a front load of 4.25% and an expense ratio of 0.92%.

Right now, he is short the Singapore dollar because he believes it is vulnerable due to the local economy’s heavy reliance on exports and finance. “It will have to devalue to compete,” he says. He has also got a big position in the Mexican interest-rate market, where he expects more rate cuts.

Barron’s final bond-fund selection is only for the adventurous. It is the T. Rowe Price High-Yield Fund [PRHYX], which dropped a stomach-churning 24.5% last year as the junk-bond market collapsed.

Be aware that corporate defaults are climbing – and are expected to continue to rise as many credit-challenged companies are unable to refinance their high-yield debt when their bonds mature. This probably will not change until the economy shows signs of reviving. That said, portfolio manager Mark Vaselkiv has loaded up on cheap leveraged loans backed by assets that do not have to return to par to offer a nice return. That is reason enough to give a look.

“Rule No. 1: Don’t blow yourself up!” says Vaselkiv, who has run the fund since 1996. The big drag on the market last year was securities issued by private-equity firms for leveraged buyouts. But Vaselkiv is conservative, and has a lot of higher-quality bonds, most rated single- or double-B, in his no-load fund, which has an expense ratio of 0.76%.

In the last big recession, 1991-93, his annualized 3-year total return was 22.3%.

Nearly 50% of the fund is in five sectors: health care, energy, wireless, utilities, and food and tobacco. He has got 10% in investment-grade bonds, and a similar amount in senior bank loans. Just 7% of his fund is invested in highly risky triple-C-rated junk. He also has some convertible bonds. “There is still an opportunity to make double-digit returns the next couple of years,” says Vaselkiv. But tread carefully here.


Corporate spinoffs have been cited as couterexamples to the efficient market theory, because they appear to consistently outperform the market for long periods of time once spun off from the parent. One can posit many reasons for the pattern, but the question would still remain why an exploitable pattern persists.

Here is a good introduction to the niche investment arena.

When a company in which you own stock is spinning off one of its units to shareholders, what is the best move to make? Do you keep stocks in the parent company, the spinoff or both? That question has been asked often by investors over the years.

Between 1990-2006, there were more than 800 spinoffs in U.S. exchanges, totaling more than $800 billion in market value, according to Peter Hunt’s Structuring Mergers & Acquisitions (third edition, 2007). Read on to find out how these transactions affect the parent company, the spun off unit and, most importantly, the shareholders. ...

The Spin on Spinoffs

In a pure spinoff, a company distributes 100% of its ownership interest in a unit as a stock dividend to existing shareholders. It is a tax-free method of divestiture that usually helps both the parent and unit achieve better results as separate and more highly-valued entities. (To learn how to take advantage of spinoffs, read Cashing In On Corporate Restructuring.)

Many studies have found that spinoffs and parents do outperform the market – with the edge going to spinoffs. One of the more commonly cited studies by Patrick Cusatis, James Miles and J. Randall Woolridge was published in a 1993 issue of The Journal of Financial Economics. It determined that spinoffs and parents surpassed the S&P 500 Index by an average 30% and 18% respectively during the first three years of trading in spinoff shares.

A Lehman Brothers investigation by Chip Dickson discovered that between 2000 and 2005, spinoffs beat the market an average 45% during their first two years, while parent companies beat it by an average 40% in the same two years. JPMorgan examined spinoffs from 1985-1995 and estimated excess returns of 20% for spinoffs and 5% for parents over the first 18 months.

What Keeps Them Turning

Spinoffs outperform for a few reasons. Management teams at the spinoffs have greater incentive to produce, due to stock options and stock holdings, and greater freedom to start new ventures, rationalize operations and trim overhead. Management teams at parent companies can focus more on the core businesses. Stock valuations for both may rise because of investors’ preference for focused and pure-play companies.

Thus, shares in spinoffs and parents both appear to be worth holding. However, if one has to be sold, study findings suggest that, because of its smaller margin of outperformance, on average, the parent should get the ax. A 2004 study by John McConnell and Alexei Ovtchinnikov appearing in the Journal of Investment Management concluded that parent companies performed no better than the market after “correcting for one very large positive outlier.”

Still, spinoff stocks come with a couple of caveats. First, they are more volatile. With their smaller capitalizations and financial capacities, they tend to be higher beta stocks that underperform in weak markets and outperform in strong markets. As such, spinoff stocks are better to own during a bull market rather than they are during a bear.

Second, spinoff stocks often sell off in the months immediately following the restructuring. Giving shares in a spinoff to existing shareholders is not a particularly efficient way to distribute stock, since the shareholders are primarily interested in the parent company. Index funds will also sell the company, since the new company is not in the index. Other institutions will sell because the spinoff does not fit in with mandates (either it is too small, has no dividend or there is no research available).

As academic and sell-side studies reveal, the immediate dip in spinoff stock prices is typically replaced by strength over the next two to three years. So, an investor planning to keep the spinoff may have to wait out short-term price weaknesses. Similarly, an investor wishing to dump spinoff shares may want to wait and sell into relative strength later on.

Evaluating Individual Spinoffs

Even though spinoffs and parent companies tend to fare well relative to the market, this success is only in the aggregate. It is still important to assess individual spinoff situations to ensure that the law of averages is on your side.

Joel Greenblatt, a former hedge fund manager with a highly-successfully track record based in large part on spinoffs, is a guru on the topic. In his book, You Can Be a Stock Market Genius (1999), he says it is important to see where the interests of the managers lie. Managers earning big salaries without owning much stock may not enhance shareholder value as much as managers with large equity stakes or stock option grants might. (For related reading, see The Controversy Over Option Compensations.)

Separation Anxiety

William Mitchell, head of Spinoff & Reorg Profiles, says it is essential to “deduce the reason for separation,” which can be done by comparing the pro forma balance sheet and income statements of the spinoff and parent. The first thing to check is debt levels and the allocation of other liabilities and troubled assets (such as real state in 2008).

For example, a spinoff could end up overleveraged because the parent may be doing a leveraged recapitalization, whereby the spinoff is loaded up with debt and the proceeds are pocketed by the parent. An example of this, according to Mitchell, can be seen in some of the units spun-off from internet conglomerate InterActiveCorp (IAC) in 2008. (Find out more details by reading Owners Can Be Deal Killers In M&A.)

Another important factor for Mitchell to study is the return on capital employed, which involves taking the ratio of operating income to net working capital less cash. A spinoff (or parent) with a low reading on this measure may not have much of a strategic advantage in its line of business.

The Real World: Spinoff Valuation

Both Greenblatt and Mitchell would agree that valuation levels are another criterion. Greenblatt has commented in the media about some of his past investments in spinoffs, and his statements provide two case studies that illustrate the application of valuation and other yardsticks.

The first was the spinoff of Lehman Brothers from American Express in 1994. Greenblatt decided against investing in Lehman Brothers because the insiders did not own much stock. He did, however, like American Express because its remaining businesses of charge cards and investment management were Warren Buffett-type franchises and they were going for just nine times earnings, after subtracting the value of Lehman’s stock.

The second was the spinoff of NCR from AT&T in 1997. Greenblatt liked NCR because its shares were valued at $30 yet the company had $11 per share in cash, no debt and a fast-growing data-warehousing division. If the latter was valued at a very conservative one-times sales, it brought the net asset value up to the $30 share price. The rest of NCR’s business, delivering $6 billion in sales annually at the time, was therefore basically going for free.

The Bottom Line

Company spinoffs have happened at an average rate of about 50% since 1990. As such, it is important for investors to know what this action can mean for the value of their shares. In many cases, spinoffs have proved valuable for both the parent company and the spun off unit. However, it is important to examine the particulars of a company’s spinoff carefully before making a decision on whether to keep, sell of buy companies that are planning or have made this move.


A glut of silicon threatens First Solar – and other low-cost panel makers.

A year ago everyone was talking about a shortage of silicon capacity. That was during the credit/energy bubble. Today the operative word that applies to silicon refining capacity is “glut.” And silicon refiners plan to double capacity over the next 5 years from about 100,000 tons this year to 200,000 tons.

So it looks like another case of an industry with great growth prospects and a nice story (saving the environment), but profitless prosperity for the industry participants. An approach to valuing the companies that makes sense, as with many growing capital-intensive industries, is to look at the cost of incremental capacity vs. what a given company’s productive capacity is being valued for by the market.

A year ago, refined silicon for solar cells cost 450 bucks a kilo on the spot market. You can have it today for closer to 100 and if you wait a month it may be cheaper still. Thanks to the workings of international capitalism, the 90% margins available in last year’s market spurred silicon-factory expansions around the planet. But the new supply arrived just as end-market demand for solar panels got eclipsed by faltering government incentives, lower oil prices and the world financial freeze.

Cheaper solar silicon is of course a great thing for the planet’s living creatures. But solar companies and investors who planned for silicon that was scarce and high-priced must adjust their business models for a glut that looms larger than most anyone expected. New government subsidies will help in the U.S. and in China, which energized solar stocks last week with a plan to help China’s struggling photovoltaic industry. Lower prices will also stimulate sales volumes as solar panels become cost-competitive with fossil-fueled power. The question is whether solar energy’s volume producers will end up resembling the high-margined Intel or the profitless memory-chip makers. “An industry with 30 suppliers would be a nightmare,” says analyst Dan Ries of the brokerage firm Collins Stewart. The “flash-memory market managed to be a nightmare with just 2 1/2 suppliers.”

Silicon panels could become so cheap that they even take share from technologies that were lower-cost substitutes – namely, the “thin film” solar panels promoted by First Solar and Energy Conversion Devices.

The memory-chip analogy seems most apt. Barron’s duly warned readers last summer (“Forecast: Clouds With Sunshine,” July 21, 2008) that supply/demand shifts would hit silicon producers like MEMC Electronic Materials (ticker: WFR), which subsequently lost 2/3 of its value. But we supposed that some solar power firms would escape harm. Now it looks as if silicon panels could become so cheap that they even take share from technologies that were lower-cost substitutes – namely, the “thin film” solar panels promoted by First Solar (FSLR) and Energy Conversion Devices (ENER).

A key selling point of thin-film panels is their reduced use of costly materials like silicon: a 97% reduction, in most thin-film technologies. Now that silicon is cheaper, First Solar is hustling around to investor conferences explaining how it aims to fly under silicon’s descending cloud ceiling (see the bottom chart to the left). Some silicon panels have already become cheaper than the products of Energy Conversion. Sadly, First Solar’s margins and its premium stock multiple of 22 times this year’s estimates seem fated to decline. Energy Conversion will likely revert to the losses that dogged it for almost 50 years, leaving little solid value in the 15.77 stock except its net cash of $3.30 a share. Neither company responded to our repeated inquiries about cheap silicon.

From the start of the transistor era in the 1950s, the price of purified silicon mainly rose and fell with the tides of the semiconductor industry. Then in 2003, Germany jump-started a worldwide solar boom with an environmental imperative that its utilities subsidize solar-power providers. That one nation’s utility customers underwrote half the world’s solar panel sales until 2008, when even richer incentives appeared in Spain. In just August and September of last year, Spain’s solar developers hooked up over a gigawatt of solar modules – equivalent to the output of a small nuclear plant. “Spain last year was essentially Germany on steroids,” says Daniel Englander, a researcher with Greentech Media. “They were willing to pay a euro per watt more than the Germans were ... which totally messed-up pricing.”

Those guarantees sent developers scrambling for solar panels, and sent solar-panel makers like SunPower (SPWRA), Q-Cells (QCE.DE) and Suntech Power Holdings Co. (STP) scrambling for silicon. In the three years through June of last year, module maker Yingli Green Energy (YGE) reported that its contract price for silicon rose over 400%. It was a heady time to be a silicon refiner. With production costs of $30 to $40 per kilo, sales at spot- market prices of $450 could yield 90% margins for low-cost producers like Hemlock Semiconductor (a joint venture of Dow Corning and Japanese partners), Wacker-Chemie (WCH.DE) or MEMC. Cash-flow margins for Munich-based Wacker rose last year from 40% to 50%. Even a new manufacturer like China’s GCL Silicon Technology Holdings showed gross margins of more than 75% when it filed a registration to come public in the U.S.

So the solar industry sought alternatives to the ultra-pure silicon that manufacturers like Hemlock make in a demanding, capital-intensive process that forms crystalline ingots (shown above) from silicon vapor heated above 1,000 degrees Celsius. Promises of a cheaper way to refine solar silicon made Timminco (TIM.TO) the hottest stock in Canada last year, rocketing the shares from 65 cents to $35. Since suspending that development effort, the stock is back to two bucks.

One silicon alternative has been a big success. Last year, First Solar sold $1.2 billion worth of its proprietary solar modules, which use a thin film of the semiconductor cadmium telluride. The Tempe, Arizona, company’s low-cost manufacturing process helped reap gross margins of 54% and earnings of about $350 million, or $4.24 a share. That performance – plus the spike in oil prices – sent First Solar’s shares as high as $311 last year and allowed insiders to sell nearly $1 billion worth of shares.

First Solar panels convert less of the sun’s energy to electricity, roughly 11% compared with 20% with the best silicon-crystal panels from SunPower. But a developer can afford to buy more of the cheaper First Solar panels. After factoring in the higher hardware expense for its panels, First Solar claims that its panels cost about $1.20 per watt of generating capacity. Cheap silicon, however, slashes the cost of goods for First Solar’s rivals. By its own reckoning, silicon rivals get cost-competitive with First Solar as silicon feedstock drops toward $50 a kilo.

In Spain’s overheated market last year, First Solar distributors flipped the product at a 75% markup. The unrestricted program elicited more new solar generators than utility customers were willing to subsidize, so Spain slammed a cap on the program in October. Installations this year will barely top 20% of last year’s 2.4 gigawatts. A subsidy plan announced last week by China will not fill the hole left by Spain’s retrenchment.

First Solar’s survival plan is to reduce the all-in cost of its panels to the vicinity of 90 cents a watt in the next year or two. It aims to lower costs by aggressively scaling up production: doubling its annual output to more than a gigawatt’s worth of panels. Like most analysts, Englander and Ries believe that First Solar will stay ahead of silicon rivals. Ries bets First Solar shares will rebound from their current level of 147 to at least 175, if investors put a 20 multiple on the roughly $8.60 in earnings per share he predicts for 2010. But Ries may prove too optimistic if a silicon glut sends First Solar’s margins and shares lower, not higher.

Energy Conversion Devices is less fit than First Solar to adapt to a world of cheap silicon. After incurring cumulative losses of $300 million in one of the longest-running tech-stock promotions ever, the Troy, Michigan, company got a chance to commercialize its thin-film solar technology when Germany and Spain started solar subsidies. Its Uni-Solar product is flexible and can be laid flat on hurricane-exposed roofs. But its panels are less efficient at converting sunlight and therefore about $1 a watt more expensive than First Solar’s panels. “They were at $3 a watt when the rest of the industry was $3.50,” says Ries. “But now the rest of the industry is at $2.80 a watt.”

Energy Conversion was able to break its decades-long losing streak by earning $44 million, or $1.03 a share, on revenue of about $350 million in the 12 months ended December 2008. As its stock quintupled to a height of 83 bucks last year, company founder Stanford Ovshinsky was able to sell $130 million worth of shares and another $35 million worth was sold by then-Chairman Robert Stempel – a former General Motors chief who tried unsuccessfully to help Energy Conversion perfect electric cars.

The company startled Wall Street fans two weeks ago by withdrawing its previously upbeat guidance and suspending plans to expand production. Along with Energy Conversion’s strategy of selling to roofing contractors as well as solar specialists, investors might have taken heed of the uncommonly aggressive revenue recognition policy that the company adopted when it leapt into the solar market in 2007. It recognizes sales “ex-Works,” meaning as soon as its panels are finished at the factory and ready for its customers. Unfortunately, solar firms report that “take or pay” contracts and price agreements are being torn up across the industry.

As practiced silicon refiners like Hemlock turn on new production, supply may outstrip demand by 50% this year and 75% next year. Latecomers like LDK Solar (LDK) plan big refineries, although LDK’s project just suffered storm damage. In the next five years, producers plan to double capacity from about 100,000 tons this year to 200,000 tons. That will help make solar power as cheap as the fossil-fueled power grid, and it is impossible to overstate how wonderfully that will help stem global warming. But barring a price-fixing conspiracy like some memory chip makers periodically attempt, the solar industry’s margins may not be so hot.


A Dark Era for Payouts

The first quarter was the worst 3-month stretch for dividends since Standard & Poor’s began tracking payouts in 1956. According to senior index analyst Howard Silverblatt, S&P 500 companies reduced dividends by $42 billion in the period – a total exceeding the $40.6 billion sliced off payouts in all of 2008, then a record for a year.

Dividend decreases and suspensions totaling $15.9 billion in 2008’s 4th quarter trimmed 16% from 1st-quarter payments on S&P 500 stocks. The first quarter’s reductions will subtract 18% in payments this quarter.

Looking at Q1’s overall dividend activity, S&P, which surveys approximately 7,000 publicly owned corporations, could find only 193 dividend boosts – fewer than half the 475 increases seen in the January-March 2008 stretch and roughly 1/3 of the 621 hikes recorded in 2007’s initial quarter. The number of extra dividends slumped 33%, to 78 from 116.

Resumed payouts provided a small measure of cheer, rising to a dozen in the 1st quarter from 7 a year earlier.

The rise in negative actions, however, was horrific. By S&P’s count, 222 corporations cut their payouts in Q1. That compared with only 38 in the corresponding 2008 stretch and a mere 13 in the like 2007 span. The total number of omitted dividends surged to 145, against only 45 in Q1 2008 and six in Q1 2007.

S&P’s Silverblatt expects the current quarter to be slightly worse than the first, and the 3rd quarter to continue the dreary trend. As for the 4th quarter, “currently, we believe we have seen the majority of damage in dividends, with many companies (especially ones with a history of increases) deciding that they can ride out the recession,” says Silverblatt. But, he warns, come August and September, when those companies set their new budgets, “if they don’t see a better 2010, they will cut [dividends].”

The Bull Case: Not Proved

This 25% surge may turn out to be yet another bear-market rally.

Four weeks ago Barron’s made what looks like a prescient call, that stocks were very cheap, and worth buying. The market is up about 25% since then. What say they now? At least one of their principle columnists appears to be skeptical – for what that is worth.

Happy birthday, bull! You would think that passing the one-month mark since the stock market embarked on its 25% run would occasion some sort of celebration. While sentiment gauges have followed the averages higher, many market pros are unconvinced this bull is the real thing.

“It has given me a headache,” says Louise Yamada, the doyenne of market analysts and the eponymous head of Louise Yamada Technical Advisors.

At the minimum, the market’s surge seems due for some correction after enriching holders of U.S. stocks to the tune of $2 trillion since the March lows, based on the Wilshire 5000.

Investors Intelligence’s sentiment readings have reached positive levels that have killed every rally in the past three years, observes Paul Macrae Montgomery, who pens the Universal Economics letter. So, too, have the percentage of stocks trading above their 10-week reached overbought extremes that have led to reversals and new lows, he adds.

David Rosenberg, Bank of America-Merrill Lynch’s chief North American economist (until he departs shortly for his native Canada, where his bonus is none of the business of Barney Frank and the rest of Congress), also takes note of suddenly sunning sentiment readings. The surge in the American Association of Individual Investors’ sentiment gauge has brought it “close to levels that kyboshed the last bear market rally that ended in the first week in January.”

Looking at fundamentals, Rosenberg points out the market’s 5-week recovery has pushed the trailing price-earnings multiple based on reported earnings to a record 100 times, double where it was during the tech bubble. P/Es for consumer discretionary stocks have expanded to post-2002 highs as the group has rallied nearly 40% from their March lows. That sector’s gains have come in the face of a record $20 trillion contraction in wealth, a record 3.3 million jobs lost since November, and a 3.2% annual rate of decline in real “organic” personal income.

“As best we can tell, the market is now pricing in $70 of earnings (operating) [for the Standard & Poor’s 500], which would represent a 75% surge from where we are today. Not likely, in our view,” Rosenberg concludes.

Even notoriously optimistic Wall Street company analysts are looking for an 8% decline in S&P earnings, to $59.18, according to Thomson Reuters. (See “A Light at the End of 2009,” April 2.) Based on that forecast, the S&P is trading at 14.2 times this year’s earnings, not screamingly cheap. Top-down market strategists are looking for anywhere from $39 to $57 a share. Using the midpoint of $48 puts the market multiple at a dearer 17.5 times.

From a technical perspective, Yamada says the stock market can enjoy a very substantial “kickback” from a deeply oversold condition, as it has in the past month. Indeed, the averages have seen a substantial number of rallies in the bear market, most recently the move off the November lows into early January, which met the technical definition of a bull market with a 21% gain.

Yet, as vigorous as this latest move has been, Yamada points to various technical factors that cast doubt that it is the start of a new bull market.

The charts show that perhaps only 10% of stocks are trading above their 200-day moving average. That measure is a widely watched indicator of a medium-term trend. As long as the current price is below the 200-day moving average, it is hard to argue that a sustained uptrend has started.

Similarly, many stocks and averages still remain below their downtrend lines. Until they move above that downward sloping line traced by the progression of highs, the current move still looks like a bounce that could reverse when that downtrend line is hit. If so, that would mean the classic bear-market pattern of lower lows and lower highs remains intact.

A longer piece on the same subject may be found here.

Soyoil’s Biodiesel Blues

Even a $1 per gallon subsidy is not enough.

The Obama administration may put the last nail in the coffin of the troubled soybean-oil-based biodiesel industry by snatching away a production mandate the industry had been counting on to reverse sliding demand.

Plants that make biodiesel from soybean oil are struggling to produce a fuel that can compete with traditional petroleum-based diesel, but even with a $1-per-gallon tax credit they are failing, American Farm Bureau Federation economist Terry Francl says.

Soyoil is one of the two products created when soybeans are processed, and it is traded on the Chicago Board of Trade. May contract CBOT soyoil rose 8.95% on the week to 35.32 cents a pound, on expectations for smaller-than-expected U.S. soybean acreage this year and strength in equities.

Only about 1/3 of the production capacity in the U.S. is being used, says National Biodiesel Board spokesman Michael Frohlich, who chalked the up the idle plants to the current recession and a lack of capital.

“These people have invested money in these plants and they have been losing money from the day they opened,” Francl says. Help came in December 2007 when Congress approved a new renewable fuel standard that set production mandates, rising to one billion gallons per year by 2012 and then remaining at that level, at minimum, each year until 2022.

Soybean farmers were ecstatic. They are not anymore. The Environmental Protection Agency will implement the standard, and lawmakers, farmers and biodiesel makers strongly suspect the soy-based fuel will lose its mandate. ...

If there is no mandate, and you are producing soy diesel, McAdams says “You are in trouble” – and so is soyoil. About 14% of the 20.6 billion pounds of soyoil produced in the U.S. last year went into biodiesel production. And the decline in demand has already begun, Francl says. Only about 12% of soyoil production will go to biodiesel this year.

One reason less soyoil is used for biodiesel, says Greg Wagner, a commodities analyst for consultancy AgResource, is that grease – essentially animal fat – can be cheaply substituted for soyoil. Since December, grease prices have “traded at an average cash price of 59% discount to soyoil,” he says.

Frohlich says many biodiesel plants can now switch to animal fat. But the soybean sector and soy-based biodiesel producers still cling to the possibility they will get the production mandate. Until the Obama administration unveils the EPA plan, they still have hope.