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MOONWALKING WITH FABER
The markets may be moving backwards while giving the appearance of moving forwards. Marc Faber shares his outlook.
Marc Faber’s take on the stock market is that it is doing an imitation of late Michael Jackson’s amazing “moonwalk”: It is moving forward in nominal terms but backward in real terms. The U.S. Fed and world’s central banks have succeeded is stemming “the terror on the screens” at the expense of longer term price stability.
What investments avoid achieving the pyrrhic victory of gains that are really losses? Typical Faber answers: Asian healthcare, banks in countries like Thailand, tourism, and the usual gold. He recommends avoiding condos in financial centers and buying farmland.
The markets are reviving, and by the analysis of investor and commentator Marc Faber, speaking in Korea at the AsianInvestor Institutional Investment Conference this week, we saw the bottom when the S&P 500 index hit 666.
The terror on the screens may be over, but it comes at a price, and that price is paid in the debasement of the currency.
Markets may continue to soar, says Faber, but if the dollar in your pocket is going to depreciate, it is a scant consolation. In real terms, investment values may move backwards.
Faber feels our central bankers are moonlighting as money printers, and any man in the Fed who tries to halt the presses, and put up interest rates to mop up the voluminous liquidity, is going to find himself jobless.
“The Fed’s monetary policy has made things more volatile,” he observes. “Had they not cut rates, financial institutions would have started deleveraging earlier, instead of continuing to build their balance sheets, prompted by the cheaper rates.”
U.S. debt to GDP is now at 37% and that does not include all its future promises and obligations, which could see it balloon to 600%. With $8 trillion in government debt, Faber believes it is an impossibility that monetary policy will be relaxed [i.e., tightened].
The private sector is in no shape to take up the slack, so the government money printing has to continue and he predicts that interest rates will be kept below inflation and GDP growth for a very long time.
However, the dollar has performed well in the last year, just as Faber predicted back in autumn 2008, The dollar may have once been weak when there was excess liquidity and rising asset prices, but recently, whenever confidence has fallen in general, people have returned to the dollar.
As people fluctuate between fear and relief, Faber expects that we will witness large sentiment-driven volatility, as markets rise and fall sharply according to the prevailing mood.
“Stocks will do better in the next decade, especially in Asia, given dividend yields, but not in real terms against currencies,” he says. “If you borrow, then do it in U.S. dollars.”
And where should that money be invested, assuming that you do not want to see the cash in your piggy bank being inflated away to oblivion?
Marc Faber thinks there are opportunities in Asian healthcare, in banks in countries like Thailand (where the Lehman structured note salesmen found the people too unsophisticated to buy their product), tourism, and naturally gold. On the property side, he recommends avoiding condos in financial centers and buying farmland.
“HOW LONG CAN THE U.S. DOLLAR DEFY GRAVITY?”
If foreign lenders were to significantly reduce their purchases of U.S. Treasury notes, without even dumping their current holdings, U.S. long-term interest rates could zoom higher, and the U.S. dollar could crumble. This nightmare scenario has been relegated to the den of doomsayers and fear mongrels, yet is starting to become an increasingly realistic proposition.
Massive intervention by the European Central Bank, the People’s Bank of China, the Bank of Japan, and other major creditor nations have kept the U.S. dollar from collapsing. The U.S.’s creditors are seemingly on a treadmill they cannot get off of – U.S. dollar holders face a “prisoner’s dilemma” says an Indian economic adviser. Any one major holder would be better off dumping their dollar holdings, but then everyone else would join them and torpedo the value of everyone’s holdings. So they all uneasily sit tight, instead easing off on their additions to U.S. dollar-denominated assets at the margin.
Global Money Trends editor Gary Dorsh notes that even that could lead to a “nightmare scenario” if everyone is not careful. It is kind of a miracle some version of that scenario has not already unfolded. Meanwhile, the printing presses run nonstop.
In the midst of the longest and deepest, post World-War II recession, America’s financial position with the rest of the world has deteriorated sharply. Three decades of massive trade deficits have turned the United States from the world’s top lender to the world’s largest debtor – and dependent upon the whims of the so-called emerging nations, laden with huge foreign currency reserves, to finance the bailout of Wall Street Oligarchs, and President Barack Obama’s social programs.
Foreigners own roughly half of the U.S. government’s publicly traded debt, or $3.47 trillion, representing nearly 25% of the size of the U.S. economy, the highest level in history. If foreign lenders were to significantly reduce their purchases of U.S. Treasury notes, without even dumping their current holdings, U.S. long-term interest rates could zoom higher, and the U.S. dollar could crumble.
That would deal a double whammy to the U.S. economy. Higher yields on Treasury debt could translate into higher mortgage borrowing rates for homebuyers – weighing on the housing market, while a weaker U.S. dollar could lift the price of crude oil to above $70 per barrel, inducing an “Oil Shock” to the world economy. This nightmare scenario has been relegated to the den of doomsayers and fear mongrels, yet is starting to become an increasingly realistic proposition.
Increasingly, some of the biggest foreign lenders to the U.S. Treasury, such as Brazil, China, India, Russia, and Qatar, are grumbling aloud, about the endless string of trillion dollar U.S. budget deficits projected in the years ahead. Lenders are crying foul over the Federal Reserve’s radical experiment with “Quantitative Easing” (QE) – the printing vast quantities of U.S. dollars, and monetizing the U.S. government’s debt.
“America, through this financial crisis, is accumulating a huge amount of debt. It is a heavy burden on the U.S. dollar,” warned Jassem al-Mannai, chief of the Abu Dhabi-based Arab Monetary Fund on June 28th. “You have China and Russia proposing an international reserve currency other than the U.S. dollar. These developments could affect negatively the dollar, and you cannot just ignore them,” he warned.
“We have lent a massive amount of capital to the United States, and of course we are concerned about the security of our assets,” warned Chinese PM Wen Jiaboa on March 13th. To speak truthfully, I do indeed have some worries. So I call on the United States to maintain its creditworthiness, and abide by its commitments and insure the security of China’s assets. We have already adopted a management policy of diversifying our ($2 trillion) foreign exchange reserves,” Wen warned. [See chart.]
The Congressional Budget Office has recently forecast the U.S. budget deficit for fiscal 2009, to reach a mind-boggling $1.825 trillion, or approximately 13% of GDP. Next year, the budget deficit is expected to total $1.43 trillion under Obama’s budget plan. Furthermore, the CBO sees the U.S. deficits between 2010 and 2019 totaling $9.1 trillion, thereby raising doubts about America’s ability to finance its debt at low interest rates, and whether it can maintain its top-tier AAA credit rating.
The exploding U.S. budget deficit and the Fed’s policy of flooding the financial markets with U.S. dollars, knocked the value of the greenback 7% lower in the second quarter, and heightened fears on global bond markets about a surge in inflation. This had the effect of eroding the value of China’s holdings of U.S. Treasury notes, estimated at roughly $1.45 trillion, putting Beijing on the offensive with Washington.
Since the Fed shocked the global markets on March 18th, by unleashing the “nuclear option” for monetary policy – “QE,” or printing an extra $1.1 trillion U.S. dollars, in order to buy U.S. T-Notes and mortgage backed bonds, there has been a new dynamic influencing the psychology of the U.S. credit markets, namely – latent paranoia over foreign flight from the U.S. dollar and Treasury Notes.
On March 24th, the People’s Bank of China’s (PBoC) chief Zhou Xiaochuan, emphasized his worry over the inflationary risks from the Fed’s money printing scheme, by proposing to replacing the U.S. dollar with the SDR currency, that is controlled by the IMF, as the new global reserve currency. Suresh Tendulkar, an adviser to Indian Prime Minister Manmohan Singh, is urging New Delhi to diversify its $265 billion foreign-exchange reserves and hold fewer U.S. dollars.
China’s holdings of U.S. Treasury debt have soared by $257 billion from a year ago, to $763 billion today, exceeding Japan’s holdings of $686 billion. Increasingly, the functioning of the massively indebted American economy is dependent upon China’s willingness to recycle much of its export earnings, (largely dependent on sales to the U.S. consumer), to provide loans to the U.S. government.
U.S. dollar holders face a “prisoner’s dilemma” in terms of managing their bond holdings.
Yet, any precipitous move by Beijing to become a net seller of U.S. Treasury debt, runs the risk of igniting a U.S. dollar selling panic, triggering massive losses in China’s own portfolio of Treasuries, and the collapse of its main export market, the United States. India’s economic adviser Tendulkar says U.S. dollar holders face a “prisoner’s dilemma” in terms of managing their bond holdings.
Recent saber-rattling by Beijing over Washington’s mismanagement of its fiscal and monetary affairs, began to conjure up fears in the global bond market, that Beijing was discreetly selling off some of its U.S. bond holdings. The benchmark Treasury’s 10-year yield, which influences the direction of home mortgage rates, zoomed higher in the second quarter, briefly penetrating the psychological 4.00% area, up from 2.50% when the Fed began its mad experiment with “nuclear QE.” The surge in yields caught the Fed and the U.S. Treasury by complete surprise.
“The Chinese government grilled me about a hundred times, on whether we are going to monetize the actions of our legislature.”
Selling hysteria in the Treasury bond market reached a fever pitch on May 27th, when Dallas Fed chief Richard Fisher, told the Wall Street Journal, “senior officials of the Chinese government grilled me about a hundred times, on whether we are going to monetize the actions of our legislature. I was asked at every single meeting about our purchases of Treasuries. That seemed to be the principal preoccupation of those that invested their surpluses in the United States,” he said.
With the Treasury’s 10-year yield bumping against the 4.00% level, the U.S. Treasury chief Timothy Geithner began a 2-day visit to Beijing, amid speculation that China might scale back its purchases of U.S. Treasury notes. Geithner’s main objective was reassure top-Chinese officials that the Obama team will safeguard Beijing’s holdings of U.S. debt by bringing down the federal budget deficit and phasing out the Fed’s policy of flooding the financial markets with U.S. dollars.
The next-day, on June 2nd, Fed chief Benjamin Bernanke, boxed into a tight corner by Beijing’s saber rattling, warned the U.S. Congress that there is a limit to how many U.S. dollars the central bank can print. “Unless we demonstrate a strong commitment to fiscal sustainability in the longer term, we will have neither financial stability nor healthy economic growth,” Bernanke warned U.S. lawmakers.
“Maintaining the confidence of the financial markets requires that we begin planning now for the restoration of fiscal balance. Either cuts in spending or increases in taxes will be necessary to stabilize the fiscal situation. The Fed will not monetize the debt!” Bernanke’s pledge to stop the printing presses after August was a grand omission of Washington’s subservience to its paymasters in Beijing.
After Bernanke signaled the outer limits of the Fed’s experimentation with “nuclear QE”, the Treasury bond vigilantes loosened their vice-grip, and yields on the 10-year note tumbled by 50 basis points over the next four-weeks to 3.50%. On June 16th, Fed governor Kevin Warsh backed-up the Fed chief, declaring, “we will not compromise price stability buy monetizing large U.S. budget deficits,” explaining that “financial markets may extract penalty pricing, if fiscal authorities are unable to demonstrate a credible return to sustainable budgets.”
Sure enough, on June 24th, the Fed held to its pledge to limit its purchases to $1.45 trillion in mortgage-related debt by year-end, and $300 billion in Treasury notes by the end of August. Beijing taught the Fed learned a valuable lesson – trying to peg long-term interest rates at artificially low levels, through massive money printing, can backfire, by igniting inflation fears and sending yields sharply higher.
ECB Rescues of US$ vs. Euro, Deflation Weighs on Gold
The Fed’s promise to put nuclear “QE” on ice after August, helped to block the Euro’s advance at $1.4200. But trying to push the Euro lower was like pushing a helium balloon under water, after the Fed had already injected $1.5 trillion into the world money markets. The Fed was caught in a desperate position, and needed outside support to prevent the greenback from plummeting. Luckily, the European Central Bank (ECB) came to the rescue on June 26th, by pouring €442 billion ($613 billion) into one-year deposits, to encourage banks to start lending again.
Surprisingly, the ECB’s injection of €442 billion barely moved the gold market, which stayed locked within a tight trading range between €645 and €690/ounce. In fact, gold stayed flat in the second quarter, lagging behind the broader commodities markets, when crude oil gained +45%, London copper added 27%, and wheat rose almost 30%. Overall, the Reuters/Jefferies CRB index of 17 exchange traded commodities posted a 15% gain in the second quarter.
There is a tug-of-war underway in the European gold market. On the one hand, the ECB’s ultra-low interest rates, and massive money injections are buoying the yellow metal. However, on the other side of the coin, Eurozone bank lending and money supply growth are plummeting, into what can best be characterized as a deflationary spiral that is crippling the Eurozone economy, and weighing on gold.
Eurozone bank loans to businesses and households grew at a paltry +1.8% pace in May, the slowest on record. Eurozone banks are hoarding the cash from the ECB, to plug up the holes in their balance sheets, from losses on bad loans, which expected to reach €265 billion in the year ahead. Likewise, the Euro M3 money supply slowed to a +3.7% annual growth rate in May, down from +10.5% in April 2008. Consumer prices turned negative last month, also keeping a lid on gold.
China Inflates Money Supply, Buoying Gold
Gold is foremost an international currency, and traders from wide-ranging parts of the world, view the yellow metal from different perspectives. And while Chinese leaders are scolding the Fed over its penchant for printing vast quantities of U.S. dollars, the PBoC is expanding the Chinese M2 money supply at a blistering +25.5% annual clip, sparking fears of faster inflation, and buoying Shanghai gold. Monetary conditions in China appear to be the exact opposite of Europe and Japan.
New lending by Chinese banks is likely to hit 7 trillion yuan ($1.1 trillion) in the first 6 months of this year, easily topping Beijing’s full-year target of 5 trillion yuan. Banking regulators are now warning that credit is being channeled into the property sector and the stock market, creating asset bubbles instead of supporting small businesses and the broader economy. New lending by Chinese banks is likely to exceed 10 trillion yuan ($1.46 trillion) this year, or roughly equal to 1/3 of the size of China’s economy, the Shanghai Securities News reported on July 3rd.
The surge in Chinese bank lending has resulted in a large increase in real estate transactions of a speculative nature, and into projects that are wasteful, making it hard for investors to repay bank loans in the future, China’s central bank chief warned on July 4th. The Shanghai Composite Index has risen by over 50% this year, reflecting not so much the strength of the underlying economy, but rather, the large amounts of speculative capital flowing into equity markets.
Chinese leaders are essentially following the playbook of Fed chief Ben “Bubbles” Bernanke and “Easy” Al Greenspan.
About 1.16 trillion yuan ($170 billion) of Chinese bank loans are estimated to have been funneled into the Shanghai stock market in the first 5 months of 2009, China Business News reported. That is 20% of the 5.8 trillion yuan loans banks made in that time period. Thus, Chinese leaders are essentially following the playbook of Fed chief Ben “Bubbles” Bernanke, and “Easy” Al Greenspan, which calls for flooding the banking system with paper currency, in order to forestall a normal economic recession, which in turn, creates new bubbles.
China is the world’s 2nd largest exporter, and suffered a record year-on-year fall in exports of 26.4% in May, following similar trends in other export-led Asian economies including Japan, South Korea and Taiwan, indicating weak global demand. The collapse in Chinese exports also follows a 21% devaluation of the U.S. dollar against the yuan, which Chinese leaders partly blame for the slump.
Beijing has ramped-up the growth of its money supply, to prevent the U.S. dollar from falling below 6.80 yuan, in a bid to remain competitive with other central bankers around the world, who seek advantages in global trade through weaker currency exchange rates. Beijing aims to reduce its exposure to the U.S. dollar through the use of currency swaps with key trading partners, such as Argentina, Malaysia, Indonesia, Brazil, and Russia. The PBoC signed an agreement with Hong Kong to allow the settlement of cross-border trade in yuan.
Japan fights Deflation by Defending U.S. Dollar
Japan does not disclose the currency breakdown of its $1 trillion of foreign reserves but most of its FX stash is parked in U.S. dollars. Tokyo does not favor a change in the dollar’s status as the key currency, since it is comfortable with a gentleman’s arrangement with the U.S. Treasury that allows it to manipulate the yen’s value. The Bank of Japan (BoJ) still commands a lot of respect as a tough currency manipulator, when its economic interests are threatened by speculators.
The BoJ’s reputation for hard nosed intervention was etched in stone during the 15 months ending March 31, 2004, when it sold ¥35 trillion ($327 billion) in the currency market to support Nikkei 225 multinationals and exporters, and prevent the dollar from falling below ¥100. As a result, Japan’s FX-stash ballooned to a record $826 billion, with the U.S. dollars acquired, recycled into U.S. Treasuries.
Japan is now facing the threat that deflation will become deeply entrenched in its economy, preventing a rebound from its worst postwar recession. Japanese wholesale prices were -5.4% lower in May from a year earlier, the sharpest decrease since 1971, reflecting the collapse of key commodities, in the second half of 2008. Deflation is a vicious cycle, where companies start cutting prices to attract customers, as falling wages and the worsening job outlook dampen spending.
The primary tool that Tokyo has at its disposal to fight deflation, is pressure on the BoJ to print more yen, in order to prevent the dollar from moving lower, and exerting more downward pressure on commodity prices, in yen terms. On March 18th, the BoJ increased its monthly purchases of government bonds (JGB’s) by a third to ¥1.8 trillion ($18.3 billion) from ¥1.4 trillion, in order to inflate the supply of its currency. The BoJ pegs interest rates at 0.1%.
Japan’s export slump deepened in May, casting doubt on its ability to emerge from its worst postwar recession. Overall, shipments abroad dropped 41% from a year earlier, while exports to the U.S. and Europe fell by 45%, from a year ago. Tackling two threats with one stone, the BoJ is trying to fend of deflation and weaker exports, by aiming to establish an artificial floor under the U.S. dollar at ¥94, through covert intervention, mainly through money printing operations.
Ironically, the yen has become a so-called safe haven currency, during times of strife in the global banking sector. While European and U.S. banks are writing down more than $1 trillion in subprime losses, Japanese banks have been surprisingly stable. Japanese banks, hammered by the collapse of a real estate bubble in the early 1990’s, have not reported gigantic losses related to the collapse of the American real estate bubble since its peak in August 2006.
Instead, Japan’s megabanks – Mitsubishi UFJ Financial, Mizuho Financial, and Sumitomo Mitsui Financial, have admitted to only $5 billion of subprime losses so far. “The maximum losses of Japanese financial institutions are ¥1 trillion ($9.4 billion), not big enough for the government to act,” said Kaoru Yosano, former chairman of the ruling Liberal Democratic Party’s fiscal reform panel.
Tokyo has laid out plans to sell a record ¥44 trillion ($460 billion) of new debt in the fiscal year thru March 2010, to finance regular and stimulus spending to ease the pain of recession. Yet despite the record issuance, Japanese 10-year bond yields still remain depressed near historic lows. The Tokyo bond market is the world’s second largest, with $8.5 trillion outstanding, yet 10-year JGB yields have been locked in a super-tight range between 1.15% and 2.00% for the past eight years.
The BoJ will monetize roughly half of the supply of new debt to hit the market this year. Yet massive yen printing and record debt sales have not translated into sharply higher JGB yields. Instead, Japanese 10-year yields are trending lower, weighed down by the specter of deflation. The Fed has not been able to duplicate the BoJ’s mastery over the Tokyo bond market, because the U.S. has the distinction of being the world’s largest debtor nation, and dependent upon the whims of other lender nations, while Japan is the opposite – the largest creditor.
Japan became a creditor nation about 30 years ago, when Japanese investors held $11.5 billion more in foreign assets than foreigners held in Japan. By 2007 however, Japan’s overseas assets rose to a record ¥610 trillion ($5.9 trillion), making it the world’s largest creditor nation for the 17th year running.
Short sellers get lots of abuse for an investment strategy that frequesntly makes sense. Five names to bet against now.
North Carolina company Short Alert has been producing reports recommending stocks to sell short since 1998. Using a somewhat artificial methodology which assumed no use of stop-losses, Barron’s calculates that the firm’s recommendations produced annual returns averaging 18.3% from 1999 through 2008. Not shabby at all. However, the calculation for 2004 was a loss of 37%, and that was followed by three years in a row of 13% losses. It is hard to say whether an intelligent stop-loss strategy would have ameliorated any of these losses, but clearly short selling involves some risks – especially during a bull mania. Then again, as we have all seen lately a long-only strategy is not without risks either.
Short Alert currently has five outstanding short recommendations. This Barron’s article includes thumbnails on the recommendations, and some background on the general strategy of short selling.
Short-sellers are the perennial un-Americans, vampires intent on driving down the prices of shares, destroying companies and greedily sucking the blood out of innocent investors.
That is the mistaken image that many people have of shorts. In reality, there is nothing unfair or devious about betting against a stock that you think will decline, just as there is nothing wrong about betting against the NFL team that you believe will lose the Super Bowl. And over the past decade, investors who shorted some stocks probably would have done much better than the vast majority of individuals, who go only long – buying shares in the hope of eventually selling them at a higher price. Shorts reverse the process. They borrow stocks and then sell them, hoping that their prices tumble, which would let them replace the borrowed shares for less than what they paid for them.
Why do more individuals not short stocks? Short sellers’ unwarranted slimy image repulses some of them. In addition, many people consider bull markets to be the long-term norm – a belief that recent events have sorely tested. Lastly, shorting is considered to be very risky, even though it need not be more volatile than using a long strategy. There is, however, one big danger. Whereas the most a long can lose is the price he paid for a stock, the price of a shorted stock theoretically can rise infinitely, making it immensely expensive to buy shares to cover a short position and creating losses far in excess of the original investment.
But, done intelligently, shorting can be enormously lucrative. Just consider the trading record of Short Alert, a small North Carolina-based research firm that has been producing reports recommending stocks to short since 1998. In the 10 1/2 years ended June 30 of this year, about 75% of the 86 recommendations it made would have turned a profit, even if they were judged based on the conservative criteria used by Barron’s in examining Short Alert’s record. In other words, the firm offers an excellent window on how to pick stocks to sell short.
Barron’s found that the firm, led by managing partners Nat Guild and the ironically named Michael Long, produced annual returns averaging 18.3% from 1999 through 2008. If the period studied is stretched through the end of June, the annual returns jump to 20.3%. But beware: Short selling is not always a route to easy money: 2004 would have produced a terrible loss of 37%, followed by three years in a row of 13% losses.
In judging Short Alert, Barron’s tracked the short positions for a year after they were implemented. Thus, the most recent of the 86 reports we reviewed is dated June 19, 2008.
Currently, Short Alert has five short recommendations. Two of them – j12 Global Communications (ticker: JCOM) and Middleby (MIDD) – are companies that it successfully recommended shorting last year but that it contends still have room to fall. The others are Compass Minerals (CMP), K12 (LRN), and Pactiv (PTV).
Specifics on these stocks are given later, but obviously, these are not household names. In fact, the companies targeted by Short Alert tend to be small, with stock-market values around $1 billion. Small stocks are especially prone to becoming overpriced, says Baruch Lev, a New York University finance professor. “There is a great deal of information on large companies,” he observes, “which makes it very difficult to hide protracted overvaluation. In comparison, very few people watch the prices of the billion-dollar companies, so most of the earnings manipulation takes place on that level.”
Short sellers can make a positive contribution by trading against earnings manipulation subterfuges.
The “manipulation” he refers to can simply mean taking unwise steps to boost earnings to justify a lofty stock price. Adds Lev: “The main reason for firing managers is bad stock-market performance, so the greater the overpricing, the greater the risk to managers. The managers know this, but unfortunately their typical response is to try desperate things to justify the price – ultimately a self-defeating strategy. The short sellers can make a positive contribution by trading against these subterfuges.”
An unpublished study co-authored by Southern Methodist University business professor Hemang Desai argues that Short Alert does make such a contribution. Desai and two collaborators examined the research firm’s recommendations from 1998 through 2005, to discover traits common to them. One was unsustainable financials, produced by, say, increasingly booking sales that have not yet been paid in cash, or by taking lower depreciation to pad reported earnings. Others include huge growth in overhead, low book-to-market ratios and big price increases over 12 months.
Applying these measures, the researchers sifted through the stock-market histories of a broad list of companies from 1990 through 1996. Their key finding: The traits drawn from Short Alert’s picks reliably identify underperformers. But that is only a start. While such stocks generally will fall during bear or sideways markets, that is not necessarily true in a bull market, which tends to push up even unworthy companies. What Short Alert brings to the party is an ability to find those with a particularly “leaky business model,” as managing partner Guild puts it, and the leakier the better.
Indeed, Short Alert’s returns were quite healthy in the bull market of the late 1990s. For positions initiated in 1998, returns in 1999 averaged 58%; for those initiated in 1999, returns in 2000 averaged 43%. And its 46% return in the bear year of 2008 meant that its picks fell by more than the overall market.
The four losing years from 2004 through 2007 were due partly to the fact that, under Barron’s assumptions, losses and gains were allowed to run without being capped by stop orders. (Such orders mandate that a position be covered at a certain price.) Instead, we imposed a trading protocol based strictly on time. For each short-sale recommendation, a profit was allowed after one year if one existed. If it did not, the position was held another year before being covered at a profit or loss. (A full explanation of our methodology is available here.)
The lack of stop orders might be unrealistic. A professional short seller would probably use them, or options, to stem losses. But because Short Alert leaves it up to its readers to determine if, and at what levels, any stops should be put in, we felt it would be misleading and arbitrary for us to assume that they had been used. This removes the possibility of using 20-20 hindsight to improve results.
In any case, the absence of stop orders occasionally resulted in a short seller’s worst nightmare – open positions held, and at times closed out, at more than a 100% loss. What made all the difference was diversification, with other positions often showing a profit. And patience at times proved to be a valuable virtue. For example, Terayon Communications Systems, a short recommendation initiated on August 3, 1999, had more than tripled in price a year later, which would have resulted in more than a 200% loss. The method dictated by Barron’s required that the stock be held another year – by which point it was 63% below the initial sale price.
The truth is that it is much easier to determine that a stock is overpriced than to accurately predict when it will fall. That can lead to stomach-churning uncertainty that can last for weeks, or even months. The shorting game is clearly not for everyone.
The Five to Short
The five stocks that Short Alert currently identifies as ripe for shorting are a varied lot.
Compass Minerals, says Guild (pronounced “guyld”) is a “one-off [success] that Wall Street treats as a continuing story.” The company is North America’s largest producer of de-icing salt, which accounts for 55% of its operating profit. The rest comes from potash, used in fertilizers.
While the price of every other fertilizer component has collapsed by 70%, potash remains at bubble levels, Guild says, even through demand has collapsed and North American inventories are at record levels. Farmers do not need to apply potash every year for a healthy crop and, even if they did, buying much now would be a problem, since credit is tough to obtain.
As for the salt business, long-term demand grows if new roads are built, and road-miles have been rising only 0.2% a year in the U.S. In the short run, demand is driven by winters, which were among the worst on record in the Midwest and parts of New England over the past two years. But unless the coming winter is especially severe, high prices and state and local budget woes could crimp demand.
A Compass spokesperson notes that, of the six analysts that cover the stock, one rates it a Strong Buy, another as a Buy and three as Hold. Only one of the six agrees with Short Alert that it is a Sell. But Guild contends that, based on normal prices and sales volume for salt and potash, the stock is worth 12, far below its current level in the mid 50s.
J2 Global Communications, the subject of a June 19, 2008, report by Short Alert, was down 14% a year later, but Guild sees far more downside.
About 80% of the company’s sales come from transmitting electronic faxes, a business that is in decline. Its growth in subscribers has come from acquiring other companies, he says. And 50% of its paid subscriber list turns over every year. Its stock is now hovering above 20 but could easily plunge below 10, asserts Guild, if it were hit with the one-two punch of no significant acquisitions and fewer paid subscribers. J2 President Scott Turicchi counters that “our short position has fallen to 1.7 million shares, less than 4% of outstanding shares of j2 Global and near an all-time low.”
K12 is viewed by Guild as a “limited-market” story. “When Wall Street gets excited by a new product,” he remarks, “it overestimates the size of the market.” K12’s product is an online educational package for home-based students from kindergarten through high school. The company can also provide live teachers for students who really need help.
Guild cites research showing that on-line learning has clear benefits for a very limited number of students, and he adds that state and local budget cuts threaten to reduce per-student support. K12 Chief Financial Officer John Baule notes that the company’s market is now quite small and has lots of room to grow. The key question, however, is whether the stock deserves a price/earnings multiple of 50. If its earning growth slows and its P/E shrinks to, say, 25, the stock, recently in the low 20s, could fall sharply.
The fourth stock, Middleby, was the subject of a January 18, 2008, report by Short Alert. A year later, it was off 58%, but it has since retraced 2/3 of its loss.
Guild calls Middleby, which makes commercial-kitchen equipment, a “classic roll-up,” with acquisitions hiding the slipping growth in the core business. The Short Alert analyst says “research shows that most acquisitions reduce shareholder value,” an assertion seconded by finance professor Lev. Middleby has been buying some of its rivals. But the recession has led to a decline in new restaurants and, by extension, in orders for equipment. Middleby CFO Tim Fitzgerald readily concedes that there is “softness in the restaurant industry,” but adds that the company is “strategically well-positioned when the market returns.” But, Guild would argue, at a price much lower than the recent 44.68. The Barron’s protocol would have required that profits be taken on MIDD early this year, at 23.81 a share.
The fifth company, Pactiv, makes egg cartons, plastic cups, take-out containers and Hefty bags. The subject of a critical June 17 online feature by Barron’s Daily Stock Alert (“Pension Problems Could Put a Hefty Hurt on this Stock”), Pactiv is what Guild terms a “misleading earnings story,” stemming from certain accounting rules.
Although Pactiv has massive, unfunded pension liabilities, all of its earnings for 2008 came from a nonexistent return on pension assets. Similar legerdemain, says Guild, is bloating earnings in 2009. Pactiv CEO Richard Wambold and CFO Ed Walters counter that their handling of pension income is quite proper and merely applies generally accepted accounting standards. Guild agrees, but maintains that GAAP sometimes distorts a company’s financials. According to his calculations, Pactiv could be worth as little as $6.40 a share. It recently traded above 20.
In addition to recommending outright shorts, Short Alert also publishes a “Most Dangerous” list of stocks that rate further scrutiny. That list, available in greater detail on SquareOneAnalytics.com, now includes:
Imax (IMAX): Short Alert argues that Imax’s 3-D systems are at the end of their growth cycle and face new competition, and that the company is bleeding cash, with all of its debt due next year.
Hanesbrands (HBI): This is an apparel maker whose brands are in decline and that gets 40% of its earnings from pension “profits.”
Lancaster Colony (LANC): It sells caviar and candles – items that consumers can easily do without in a recession and that face growing competition.
Scholastic (SCHL): Short Alert views this famed outfit as a fading monopoly on elementary-school book clubs.
Pentair (PNR): This maker of pool pumps and equipment is overleveraged and faces a declining market.
Sally Beauty Holdings (SBH): This outfit, which has grown by acquiring beauty salons, could run into trouble if recession-plagued consumers cut back on buying high-priced salon grooming products.
Yes, there are dangers in shorting stocks. But there are dangers in going long, too. Vilify short sellers if you must. But remember, the smart shorts cried all the way to the bank last year and for much of 2009; other investors simply cried.
THOSE DAMNED DERIVATIVE THINGIES
The basic problem is a lot of insurance that is not insurance.
Financial Accounting professor Chris Clancy joins the line of those who have attempted to explain the who “derivative thingy.” The details, as usual, run into the MEGO (“my eyes glazeth over”) syndrome, but the bottom line is that a lot of money was bet on bad things happening to poorly underwritten mortgages. The parties making the bets had no offsetting loss that would counteract the winnings from such bets working out, i.e., they had no insurable risk. It was not that different from a hit man buying life insurance on his next contract.
Nobody knows who these “counterparty” bettors are, but the claims to be settled are on the order of a quadrillion dollars – really. Clancy reiterates a point made previously by others: This could not have happened without collusion among major players. Is some of the bailout money going to pay off the counterparties? The Fed will not say, which is why Ron Paul’s Fed-audit bill is such a threat to the whole scam.
Is there a way to unwind the whole mess without wrecking the whole financial system? Perhaps. One could posit a schema, says Clancy, where the funny-credit created out of thin air is returned to whence it came. Funds already collected on the criminal enterprise could be taken back, but good luck with that part.
This essay is a story about insurance, or rather, a story about a type of insurance policy which underwent a mutation. This mutation was not spontaneous – it was engineered. It was one of the biggest scams ever perpetrated.
Paradoxically, the problem was that it worked too well and just got too big.
I hope you stay with the story until its denouement. Maybe you will be gobsmacked. If it moves you to go out and start looking for suitable lamposts – then it is understandable.
When a business makes a loan to another party it can insure against the risk of default. This would be prudent behaviour if the lender had concerns about the borrower not repaying everything which was due.
Insurance companies, like all industries, work to a set of fundamental principles. Two of their most fundamental principles are indemnity and insurable interest.
Indemnity simply means that no-one should “profit” from making an insurance claim. Instead, the money received should be enough to restore you financially to the position you were in before the reason for making the claim occurred.
Insurable interest means that you cannot insure something unless you have a legitimate interest in protecting yourself against something bad happening to that thing. So, for example, you can insure your car or the life of your spouse. You cannot, however, insure the car or the spouse of a complete stranger since your only incentive would be the hope that something bad happens to either or both. In fact, you would have a very strong motive for making sure that something bad actually does happen to either or both!
What has the above got to do with the present mess?
Understanding the gravity of the situation we are now in means getting to grips with the dreaded “D” word – and I don’t mean “Depression” – I mean “DERIVATIVES”! Few understand them. The following quote refers to Gordon Brown:
“He ... made the extraordinary confession that as Chancellor he ‘did not know a lot about’ sub-prime mortgages – a key banking practice that sparked the economic collapse.”
Mention of the “D” word is usually enough to turn most people off instantly – therefore in what follows I have attempted to keep it as brief and clear as I can and to avoid mentioning this heinous word. Instead I will refer to them as Gherkins, Sprouts and Bananas.
The current crisis was started by cheap money being kept cheap for too long. It found its way into the housing market where things escalated as a result of government encouragement for lenders to make bad loans. The lenders who made the bad loans did not care since they could sell them on to someone else.
The buyers of these loans did not care either since they knew the government would bail them out if they got into trouble. These loans were then securitized. In other words, they were divided up into securities (financial instruments) called “Gherkins” and then sold on to the financial industry.
The financial industry then employed very clever people to mix these securities up in all sorts of permutations and combinations. By the time they had finished splicing and dicing, mixing and matching a new generation of financial instrument had emerged – these were called “Sprouts.”
Why did they do this?
It was done to hide the fact that many of these securities were based on bad loans. As such they could only attract a “junk” credit rating which made them more difficult to sell on. By combining them with good loans in incredibly complicated mathematical models, using all sorts of weird and wonderful statistical techniques, this new generation of financial instruments could all attract a triple-A credit rating. Obviously this made these things highly marketable.
Sprouts were sold in vast quantities all over the world. The buyers simply looked at the credit rating. They did not know how these things were constructed. They did not realize that the models were flawed – Austrian economics tells us again and again that predictions involving human action cannot be reduced to mathematical formulae. (If you are into self-abuse and really want to put yourself through it go here for a simplified example of how to create a Sprout – and more).
Let’s return to the world of insurance.
Organizations which had purchased Sprouts in huge quantities wanted to reduce their risk. Companies like AIG, for example, offered them insurance policies. In return for regular monthly premiums they could insure against their Sprouts going bad. This was quite legitimate since they had an insurable interest – they owned what they were insuring – and would be rightly indemnified in the event of default.
What happened next was that the insurance policies themselves were then securitized and another generation of financial instruments emerged called “Bananas.”
These things have been loosely described as “insurance policies.” Nothing could be further from the truth! These things had nothing whatever to do with indemnity and insurable interest. The buyers of Bananas were given the mysterious title of “counterparties.” Nobody actually knows who they are.
What was their incentive in purchasing Bananas?
Put simply, Bananas were a bet in which the die was loaded in favor of the gambler, or counterparty. They were betting on the failure of bad loans which were purchased and then repackaged into Sprouts and then sold on! For those in on the scam there was simply no reason to buy Bananas unless they were confident that the sub-prime market would collapse – which it did. They then claimed on their “insurance” policies.
No. Do not reach for the bottle just yet. You will need a clear head for what comes next. Because it actually gets worse.
Just to recap. The housing food chain spawned three types of financial life form – Gherkins (Mortgage Backed Securities), Sprouts (Collateralised Debt Obligations) and Bananas (Credit Default Swaps).
In this must-read article by James Lieber (which I hope you pass on to as many people as possible) he argues that it was Bananas which turned what should have been a recession into a depression – that the failure of the sub-prime market and its concomitant Gherkins and Sprouts by themselves would not have landed us where we are now.
Because the amount of money which is still out there waiting to be claimed on Bananas is mind-boggling!
How did it become so large?
The answer is the word “replication.” One Sprout could be “insured” time and time again. This is why the thing became so large.
Lieber, writing in January 2009, estimated that the Banana liability was in the region of $600 trillion. In fact, Ellen Brown, writing in September 2008, put total trade in Gherkins, Sprouts and Bananas in excess of $1,000 trillion. The latter is called a quadzillion. If so then we have made it – not billions or trillions any more – now we are into quadzillions!
And just where has all this bailout money paid to financial institutions gone? There is no way of telling because the Fed is not saying. How much has gone straight into the pockets of the counterparties, whoever or whatever they are?
I pray HR 1207 makes it all the way. Maybe it will yield up the truth about what has been going on – the fact that it did not just happen – it was quite deliberate. And let us be clear, as Lieber points out in his article, it simply could not have been done without collusion between major players.
Is there a way out of this nightmare? Well, call me an optimist, but there must be. If people can devise a system whereby a tiny elite run the world on money created out of thin air, and get away with it, then surely we have the wit to devise a method of neutralizing or canceling these things – of evaporating them into thin air!
Then go after the counterparties who have already received money and pry every stinking penny from their filthy money-grubbing fingers.
This is no conspiracy theory – it is fact. See here and here for two articles recently published on LRC – laugh or cry, it is up to you – but we have all been conned, scammed, stiffed or any other word you can think of – yet again.
The greatest scam in history has littered the world with banana skins. There is a lot more slipping and sliding to go before we emerge from this one – if we ever do – and in one piece at that!
PONZI PROSPERITY – BUILT-TO-FAIL ECONOMIC MODELS
Government actions seem primarily to be based on the recognition that Ponzi or pyramid games are only bad if they end.
Satyajit Das, risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives, manages in this piece to touch on basically all the major economic errors and pretentions which drove government policies that in turn fueled the credit bubble.
The whole idea of debt-driven growth is inherently unsustainable when the debt finances current consumption. Behind all the accounting, behind all the financial debt and equity instruments, the bottom line is that people are either producing goods and services for current consumption or they are producing capital goods which in turn will supply future consumption. Current consumption, of course, feels good – cue the fable of the ant and the grasshopper. People of intelligence and integrity can argue over the appropriate “optimal” breakdown between current and future consumption, but one knows the current percentage has become too high when the capital stock starts to decline – in the classic metaphor, when one is consuming one’s “seed corn,” i.e., next year’s crop. At this point a larger percentage of current production has to be directed to the capital stock to keep the standard of living from collapsing. (Note: Any intelligent person not hobbled by with an education in the current economics orthodoxy could have come up with this reasoning.)
It appears to us that we reached the point where current consumption became excessive ... certainly in the U.S. The signs were all there: excessive housing construction (we consider the housing stock at best to be a second-order component of the capital stock), consumption reaching a record high proportion of U.S. GDP, the savings rate going to zero, etc.
So what has been the U.S. and other governments’ major policy response to the bubble pop? Try to get consumers back onto the borrowing track. Stupid? We think so. So do the Austrian economists. We will take their company over the economic nabobs holding sway in Washington, Brussels, Tokyo, et al.
Lessons from the global financial crisis.
The global financial crisis (GFC) is financial, economic, social and increasingly ideological. French President Nikolas Sarkozy has pronounced the death of laissez-faire capitalism: “C’est fini.” Leaders have penned fevered attacks on “neo-liberalism.” Even religious leaders have taken to the pulpit to denounce capitalism.
Undoubtedly market failures, management excesses and errors caused the GFC. But the key lessons of the crisis may be subtler than first evident.
Global growth has been driven by cheap and abundant debt, and improperly costed carbon emissions and other forms of pollution. The reality is that this period of growth may be coming to an end.
All brands of politics and economics have been informed by assumptions about the sustainability of high levels of economic growth and the belief that governments and central bankers can exert a substantial degree of control over the economy. Harry Johnson, the famed Chicago economist, writing about England in the 1970s with his wife Elizabeth in The Shadow of Keynes (1978), provides a vivid description of this pre-occupation: “faster economic growth is the panacea for all” economic and political problems and “faster growth can be easily achieved by a combination of inflationary demand-management policies and politically appealing fiscal gimmickry.”
The current debate misses the point, that it may not be feasible to reattain the growth levels in the global economy of the last 20 or so years.
P.J. O’Rourke, writing in Eat The Rich (1998), observed that: “Economics is an entire scientific discipline of not knowing what you’re talking about.” The only quibble may be with the “scientific” part.
Recent global prosperity was founded on a series of elegant Ponzi schemes.
Consumption rather than investment drove growth, particularly in the developed world. A deregulated financial system supplied the borrowing that financed the consumption. In the new economy, to borrow from Earl Wilson, there were three kinds of people – the “haves”, the “have-nots”, and the “have-not-paid-for-what-they-haves”.
Growth in global trade was also debt-fueled. Since the 1990s, there has been a substantial buildup of foreign reserves in central banks of emerging markets and developing countries that became the foundation for a trade financing arrangement.
To maintain export competitiveness, many global currencies, including the Chinese Renminbi, were pegged to the dollar at an artificially low rate. This helped create the U.S. trade deficit driven by excess U.S. demand for imports based on an overvalued dollar. Foreign central bankers invested the dollars received from exports in U.S. debt to minimize the appreciation of their domestic currency that would make their exports less competitive. The recycled dollars flowed back to the U.S. to finance the spending on imports, helping keep U.S. interest rates low, which facilitated more borrowing to finance further consumption and imports.
Foreign central banks were lending their reserves to finance exports from the country. In essence, the exporting nations were not paid at least until the loan to the buyer was paid off.
Moderate debt levels are sustainable, provided the value of the asset supporting the borrowing is stable and significantly higher than the amount of the loan. The borrower or the collateral for the loan must generate sufficient income to service and repay the borrowing. In the frenzied market environment of low interest rates and ever-rising asset prices, the level of collateral cover and ability to service the loans deteriorated sharply. In 2005, rising interest rates and a cooling in the U.S. housing market set the stage for the GFC.
Taking the Cure
There is currently confusion between the “disease” – the high levels of debt – and the “cure” – the reduction of the level of debt now underway (known as “de-leveraging”).
Debt within the financial system is falling as some borrowers default, triggering problems for financial institutions, destroying both existing debt and also limiting the capacity for further credit creation by financial institutions. Total losses from the GFC are estimated by the International Monetary Fund at around $4.1 trillion of which $2.7 trillion will be borne by financial institutions.
Government ownership or de facto nationalization has become the primary option to recapitalize the banking system in many countries. Even after recapitalization, there is likely to be a capital shortfall in the global banking system (of around $1+ trillion), forcing a contraction in global credit of around 20% to 30% from existing levels, which affects the real economy.
The increased cost and reduced availability of debt to borrowers forces corporations to reduce leverage by cutting costs, selling assets, reducing investment and raising equity. This also forces consumers to reduce debt by selling assets (where available) and reducing consumption.
Recent excitement about the “stress tests” of U.S. banks misses an essential point. At best if you accept the premises of the test, the risk of failure of these institutions is much reduced. But the banks’ ability to support lending levels that prevailed in say 2007 has not been restored. In short, the “credit crunch” or shortage of borrowing will continue for a prolonged period.
This combination of factors may lock the global economy into a cycle of low growth, bringing an end to the age of Ponzi prosperity.
Sigmund Freud once remarked that: “Illusions commend themselves to us because they save us pain and allow us to enjoy pleasure instead. We must therefore accept it without complaint when they sometimes collide with a bit of reality against which they are dashed to pieces.” The GFC was the “reality” on which the artificial pleasures of the Great Moderation and Goldilocks economy were smashed.
National and international “committees to save the world” have rushed to announce and occasionally even implement a bewildering and constantly changing array of measures – dubbed WIT (“What it takes”) by British Prime Minister Gordon Brown – to counteract the financial and economic effects of the GFC.
Governments and central banks have sought to remove toxic securities from bank balance sheets and supply share capital to cover losses from bad debts. In some countries, such as Australia, the government has guaranteed the bank’s own borrowings to allow them to continue to raise funding. Bank of England Governor Mervyn King summed up the nature of the UK’s support for the banking system with a Freudian slip: “The package of measures announced yesterday by the Chancellor are not designed to protect the banks as such. They are designed to protect the economy from the banks.”
Governments have gone into massive deficit providing fiscal stimulus and support for the housing market (in the U.S.). Central banks have cut interest rates to levels not seen for decades. It seems “we are all Keynesians again.”
The success of these actions is not assured. John Kenneth Galbraith once observed: “In economics, hope and faith coexist with great scientific pretension.”
Credit conditions have not eased significantly. Money supplied to banks is not flowing into the real economy. Governments and central bankers, frustrated at the failure of policy actions to help the resumption of normal financial activity, have started to lend directly to business or drifted towards “directed lending” policies in an effort to get the economy going.
The policies miss the point that debtors still have too much debt that they are not able to service. Until the debt is written down and restructured, credit growth may not resume.
In the Trouble Asset Relief Program (TARP) Oversight Panel Report of April 8, Professor Elizabeth Warren observed: “Six months into the existence of TARP, evidence of success or failure is mixed. One key assumption that underlies Treasury’s ... approach is its belief that the system-wide deleveraging resulting from the decline in asset values, leading to an accompanying drop in net wealth across the country, is in large part the product of temporary liquidity constraints resulting from non-functioning markets for troubled assets. On the other hand, it is possible that Treasury’s approach fails to acknowledge the depth of the current downturn and the degree to which the low valuation of troubled assets accurately reflects their worth.”
Well-intentioned government spending programs, such as infrastructure spending, will take time to have any meaningful effect. The return on poorly costed and targeted infrastructure investment is also not necessarily high. If this were otherwise, then Japan, which has concreted the country over several times, would have much higher rates of growth than it does.
Governments, some with significant budget deficits and also substantial levels of outstanding public debt, must also borrow to finance their spending. In 2009, governments around the world will have to issue $3 trillion to $4 trillion in debt.
The U.S. alone will need to issue around $2 trillion in bonds. China, Japan, Europe and other emerging countries have been major buyer of this U.S. debt. Wen Jiabao, China’s prime minister, provided a reminder of this in February 2009: “Whether China will continue to buy, and how much to buy, should be in accordance with China’s needs, and depend on the safety and protection of value of foreign exchange.” Yu Yongding, a former adviser to the Chinese central bank, recently sought guarantees that the value of China’s large holdings of U.S. government debt will not be eroded by “reckless policies.” The U.S., he stated, “should make the Chinese feel confident that the value of the assets at least will not be eroded in a significant way.”
In 2009, some German bund (government bond) auctions failed with insufficient bids to cover the amount of issues. One U.K. gilt auction and more recently, a U.S. 30-year bond auction encountered significant difficulty and lack of investor support.
At best, the government debt may crowd out other borrowers exacerbating existing financing problems. At worst, there is a risk of a collapse of the growing “bubble” in government debt markets as investors refuse to purchase debt at current rates triggering additional losses.
Since January 2009, long-term interest rates throughout the world have moved up sharply as markets start to absorb the import of government initiatives. As James Carville, Bill Clinton’s campaign manager, once noted: “I want to come back as the bond market. You can intimidate everybody.”
The current strategy is a variant of the “hair of the dog that bit you” cure. Current problems can be traced to high levels of debt accumulated by banks, consumers and companies that is now being replaced by government debt. Debt-fueled consumption of consumers and companies is being replaced by debt-funded government expenditure.
The ineffectiveness of repeated fiscal shock therapy to rouse the Japanese economy from it somnolent state provides a worrying precedent for current policy.
Government actions seem primarily to be based on the recognition that Ponzi or pyramid games are only bad if they end. All efforts are now seemingly directed at keeping the game going for as long as possible!
Governments and central banks can smooth the transition but they cannot prevent the necessary adjustments taking place. In 1976, British Prime Minister James Callaghan delivered the following grim assessment of Britain’s economic situation that is still relevant today: “We have been living on borrowed time. We used to think you could spend your way out of a recession and increase employment by cutting taxes and boosting government spending. I tell you in all candor that that option no longer exists.” That warning is as relevant today as it was some 30 years ago.
Built to Fail
The key lesson of the GFC may be that the current economic order is “built to fail.” The ability to sustain high rates of economic growth, required by governments and central bankers, is questionable.
Aggressive use of debt globally resulted in a sharp increase in sustainable growth rates. Four dollars to $5 of debt was required to create $1 of growth. Approximately half the recorded growth in the U.S. over recent years was driven by borrowing against the rising value of houses (mortgage equity withdrawals). A similar pattern is evident in Great Britain and Australia. As the level of debt in the global economy decreases, attainable growth levels also decline.
Debt allowed consumption to be accelerated. Spending that would have taken place normally over a period of many years was squeezed into a relatively short period because of the availability of cheap borrowings. Misreading demand and assuming that the exaggerated growth would continue indefinitely, businesses over-invested, creating significant over-capacity in many sectors. For example, the global car industry has production capacity of over 90 million units compared to peak demand of around 60 million that has now fallen to 40 million.
The nouveau Jeffersonian trinity – “whoever dies with the most toys wins;” “shop till you drop;” and “if it feels good, do it” – has proved to be unsustainable.
Global trade, on which Australia is heavily dependent, was also “built to fail.” A model where sellers of goods and services indirectly financed the purchase is not sustainable.
The GFC has already reduced global trade and cross-border capital flows. Global trade is forecast to fall for the first time in 2009. The Institute for International Finance forecasts net private sector capital flows to emerging markets in 2009 will be less than $165 billion – 36% of the $466 billion inflow in 2008 and only 1/5 the record amount in 2007. Many emerging market nations, such as India, face severe funding difficulties in the near future.
In an essay titled “The Great Slump of 1930,” published in December of that year, Keynes observed: “We have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand.”
Governments have limited available tools to address the deep-rooted problems in the current economic models.
Given that interest rates are now at or approaching zero in many developed countries, there is little or no scope for further monetary action although central banks have creatively embarked on a program of “quantitative easing” – code for printing money (also know as the Weimar or Zimbabwe solution).
Government spending, if it can be financed, may not be able to adequately compensate for the contraction of consumption and lack of investment made worse by over capacity in many industries. Government spending has little multiplier effect or velocity. The badly damaged financial system means that the circulation of money in the economy is at a standstill. Government spending provides a short-term demand boost. Capital injections may partially rehabilitate banks. But it is far from clear what will happen when all these measures are reversed.
David Rosenberg, an economist from Merrill Lynch, described the process of adjustment that world is embarking on in the following terms: “This is an epic event; we are talking about the end of a 20-year secular credit expansion that went absolutely parabolic from 2001-2007. Before the U.S. economy can truly begin to expand again, the savings rate must rise to pre-bubble levels of 8%, the U.S. housing stock must fall to below 8-months’ supply, and the household interest coverage ratio must fall from 14% to 10.5%. It is important to note what sort of surgery that is going to require. We will probably have to eliminate $2 trillion of household debt to get there, this will happen either through debt being written off, as major financial institutions continue to do, or for consumers themselves to shrink their own balance sheets.”
The economic model itself is now seen as the problem. Zhou Xiaochuan, governor of the Chinese central bank, commented: “Over-consumption and a high reliance on credit is the cause of the U.S. financial crisis. As the largest and most important economy in the world, the U.S. should take the initiative to adjust its policies, raise its savings ratio appropriately and reduce its trade and fiscal deficits.”
More ominously, Chinese President Hu Jintao recently noted: “From a long-term perspective, it is necessary to change those models of economic growth that are not sustainable and to address the underlying problems in member economies.”
The GFC also marks the end of unquestioned advocacy of free markets. Wang Qishan, China’s vice premier, tartly observed: “The teachers now have some problems.”
Limits to Growth
The GFC coincides with another crisis: the GEC or Global Environmental Crisis. “Toxic debt” and “toxic emissions” increasingly clamor simultaneously for politician’s attention.
Irreversible climate change, scarcity of vital resources (food and water) and falling biodiversity are not unconnected with the existing economic system. Economists and politicians implicitly assume that high levels of growth drive increased living standards, rescuing people from poverty and social development. No limit to economic growth is recognized.
The GFC brings into question much of established orthodoxy of economic models and approaches. It calls into question social and political models based on high levels of economic growth and financial rather than real economy driven growth. It also questions the ability of mandarins to control the economic engines. The world needs to adjust to a new economic order and a world of reduced expectations.
As Keynes wrote in 1933: “We have reached a critical point. We can ... see clearly the gulf to which our present path is leading. ... [If governments did not take action], we must expect the progressive breakdown of the existing structure of contract and instruments of indebtedness, accompanied by the utter discredit of orthodox leadership in finance and government, with what ultimate outcome we cannot predict.”
LESSONS FROM THE INDUSTRIAL REVOLUTION
In the case of the enormous human advance of the Industrial Revolution, understanding how the past happened enables us to avoid mistakes that would prevent further such advances today.
Yet another fascinating history lesson from Martin Hutchinson. A new book, The British Industrial Revolution in Global Perspective – “a major intellectual breakthrough,” according to Hutchinson – has interesting implications today. In short, while benign government policies and the rule of law are certainly important, some of the unthinking “free” market/“free trade” orthodoxy, e.g., as promulgated by the likes of the IMF and World Bank, are off-base.
Robert Allen’s new book, The British Industrial Revolution in Global Perspective, is a major intellectual breakthrough. Allen, Oxford professor of economic history, has used long-term price data only now available though computer database technology to demonstrate definitively why the Industrial Revolution happened when and where it did. The causes? Imperialism, cheap coal and happy sheep. Max Weber’s Protestant work ethic had nothing to do with it! Allen’s conclusions have interesting implications for the global economic position today.
To take the causes roughly in chronological order, happy sheep were the result of the 1348 Black Death, which wiped out 1/3 of England’s population and resulted in the restoration of much good agricultural land to grazing. As a result, English sheep, fed on richer diets than previously, grew longer coats, from which were created the “new draperies,” finer in quality than competitive textiles and hence market-dominant. The depopulation of the Black Death also caused wage rates to rise and, in England, reproductive patterns to change, producing a decline in fertility. England’s lower fertility ensured that the impoverishing 16th and 17th centuries were less impoverishing than elsewhere in Europe and wages remained relatively high. One of Allen’s more startling discoveries is that real wage rates in Vienna in 1825 were 1/4 of their level 400 years earlier; in England, this immiseration did not happen.
Imperialism, next, added both to the wealth of the country and to its urbanization (which increased returns to agriculture, thus further increasing rural wage levels.) Extensive trade in exotic goods and the construction of large merchant and naval marines both provided high-wage urban employment and generated large amounts of capital. The safety valve of North American emigration worked against any Malthusian fall in rural wages, ensuring that new generations were adequately fed and at least modestly educated.
Cheap coal was not a resource unique to England. Belgium, the Ruhr and Poland had extensive coal deposits. Its availability in quantity for early industrialization was, however, due to the rapid growth of London, which generated a building industry large enough to experiment with chimney designs, thus producing houses that could be heated by coal as its cost advantage over wood grew. Once coal production for fuel was substantial, the mining districts in the Midlands and the Northeast had fuel costs far below those anywhere else in Europe, making highly inefficient experimental technologies such as the Newcomen steam engine commercially attractive.
Once British industrialization proceeded down the learning curve, the cost advantages of steam technology, mechanized cotton production, etc., became so great that they allowed those technologies to be adopted in other countries; thus Britain’s early industrial success eventually ended its monopoly on industrialization.
Thus policy genius did not produce British industrialization, nor did policy incompetence allow Britain’s early lead to slip away. There were a number of social and policy preconditions, notably secure property rights, without which industrialization could not have happened, but by 1700, several countries had these. Only Britain’s island status, preventing it from being subjected to devastating war as in 17th century Germany, gave it a special ability to make the crucial first steps.
There are nevertheless a number of modern policy lessons that can be learned from Allen’s analysis. First and most obvious, trade is essential to rapid economic development. By allowing rapid arbitrage between high cost areas and low cost areas, it generates capital accumulation, which lubricates other economic activity. A world in which trade becomes bureaucratized and atomized lessens the possibilities of new wealth generation both directly through placing barriers to economic system optimization and indirectly through lessening the accumulation of capital.
While rapid arbitrage of goods through free trade is highly desirable, rapid arbitrage of labor through free migration is not.
While rapid arbitrage of goods through free trade is highly desirable, rapid arbitrage of labor through free migration is not. No society where unskilled labor is in excess supply has ever been able to use that labor to improve its wealth. Undifferentiated low-cost human labor has been in excess throughout the vast majority of humanity’s experience; it is only labor scarcity and skill that have raised mankind’s living standards above the Malthusian level. Low-skill, undifferentiated labor does not pull up its own living standards, though if its supply is limited, its living standards may be raised by the efforts of others.
There is thus a huge distinction between trade policy, in which the maximum possible freedom is desirable, and immigration policy, in which complete freedom of migration produces an excess of unskilled labor that drives down wages for the unskilled to Malthusian levels. This is not only the case in high-wage economies such as the United States. In low-wage economies such as pre-1980 China, India and Africa, the first requirement for economic growth is to reduce the birth rate sufficiently that the society can afford to educate the majority of its young people, and not leave them as a pool of intermittently employed surplus unskilled labor driving down living standards and causing disturbances. In England, the Black Death produced the first increase in workforce living standards above subsistence levels. In today’s world we cannot rely on disease to help, but must pursue policies of population restraint, particularly in countries such as Kenya, where population growth above 2% annually renders economic improvement impossible.
It is important to be the very best or the very cheapest. Mediocrity and average performance win no prizes in economic development.
Another lesson from the Industrial Revolution is that it is important to be the very best or the very cheapest. Mediocrity and average performance win no prizes in economic development, because they do not provide that margin of cost advantage without which the first faltering steps in a new technology cannot be profitable. Revolutionary new technologies will eventually produce products desirable for everybody, and/or costs far below the previous alternative. However, in the initial phases of a new technology, the cost advantage or performance benefit of a new technique or product is slender. Hence that new product will only be profitable for the producers with the very best capability in an area, or the very lowest factor costs (which will not generally include low-cost labor because Malthusian survival puts an effective floor on that cost, making labor-cost advantages impossible to sustain.)
There is a reason why innovation tends to happen in rich countries, in spite of poorer countries’ lower labor costs and in many areas similar skill levels. High labor costs force innovation, and by increasing the return to acquiring superior skills raise the quality of the labor force itself. The German approach to economic growth, in which expensive labor is balanced by its superb quality, is entirely economically viable and produces rapid innovation. Similarly, U.S. innovation tends to be concentrated in high-cost areas such as Silicon Valley, Boston or New York, even though in many cases, large numbers of skilled graduates are available from top universities elsewhere. In a high labor-cost environment, the pressure to excel, for both companies and the workforce, is inexorable and highly productive.
It thus follows that H1B visa programs in which labor costs in high-skill areas are forced down by introducing numerous apparently qualified recruits from overseas may well be counterproductive. By turning the workforce from an expensive critical resource into an undifferentiated cost-controlled mass, innovation is stifled. In an environment in which the wages of engineers and computer scientists are suppressed by mass immigration, the best graduates will go to law school, heading for an activity where competition from immigrant labor is less.
Intelligent resource development is extremely important.
A further lesson from the Industrial Revolution, in particular from the centrality of coal availability, is that intelligent resource development is extremely important. Many countries had large coal deposits in 1700, but only in England did the development of coal fires for London housing increase the size of the coal mining industry to a level at which energy costs in areas close to the mines were a 10th or less of those for competitors not so located.
Today, Brazil seems to have learned the importance of this best. Its ethanol program to substitute for gasoline was begun 30 years ago, before others, and relied on the optimum ethanol source, sugar cane, which produces ethanol about eight times as efficiently as the main U.S. source, corn. Consequently, Brazil is today the global leader in ethanol technology, an advantage which it can use to develop its capability in other areas.
Similarly, Brazil’s exploitation of the Carajas iron ore deposits has allowed Vale to become the world’s leading iron ore exporter, an immense economic and geopolitical advantage for the country. Petorbras’s offshore petroleum operations in the Tupi basin are likewise notable for the intelligence with which they have been developed, and will make Brazil a major player in the global oil industry, particularly as its domestic needs are suppressed by the successful ethanol program. Using resources to bully neighbors, as in Russia, or frittering away resource advantages through environmentalist obstacles, as in the United States, produces a major competitive disadvantage which blights innovation as well as hampering the economy generally.
Finally, the development of industry and high-productivity agriculture in England was dependent on benign government policy, as has been guessed, but each was also dependant on the other. English agricultural productivity rose steadily from an already high base after 1660, providing crucial income to the labor force as well as food for the growing cities. Productivity growth put on a particular burst of speed in 1800-1850, the period of the Corn Laws. After 1850, with English agriculture exposed to a “level playing field” of cheap international competition, the growth of agricultural productivity ceased altogether for almost a century. England’s unilateral trade disarmament through its 1846 repeal of the Corn Laws crippled its agriculture and in the long run, sped the competitive decline of its industry. It was an enormous economic policy error.
Analogies abound today. In Britain, the 1986 Financial Services Act opened the City of London to international competition without adequate protection for British institutions battered by the economic chaos of the previous decade. Consequently, Britain’s unique capability in financial services has effectively been lost, and that business is likely to migrate increasingly away from London in the decades ahead. In the United States, the Waxman-Markey “cap and trade” energy bill, before the House of Representatives earlier this month, would almost certainly be a similar mistake, crippling U.S. industry against international competition for a goal that is still not scientifically established with any precision.
“Those who cannot remember the past are condemned to repeat it,” said George Santayana. In the case of the enormous human advance of the Industrial Revolution, understanding how the past happened enables us to avoid mistakes that would prevent further such advances today.
A BANK RUN TEACHES THE AMISH ABOUT THE RISKS OF MODERNITY
Some Amish lived it up until hard times hit; dinners out and LED-appointed carriages.
In a fascinating and sad example of how a credit bubble ultimately leads to degeneration of culture and community, the people of the Amish community in northern Indiana were tempted into the conventional economy by the easy money available from participating there. With the sudden, if temporary, wealth came not only consumption patterns inconsistent with traditional Amish values – big weddings, second homes in Florida, fancy decked out carriages – but a fraying of the practices that kept the community together. People started hiring outsiders to do work rather than asking for help, in order to not have to reciprocate. Community members proved all to vulnerable to the “keeping up with the Joneses” status acquisition instinct.
Chastened by the end of the bubble economy, a back-to-basics movement shows signs of life. The Amish are growing more of their own produce. Businesses run from home or near the home are being started. Neighbors “are more considerate of each other now,” notes a community member. But some of the fractures will be hard to mend. Many men leave their families for weeks at a time for out-of-state jobs, and some younger families have moved to other states.
So we see how dishonest money tears the social fabric of human existence. In this effect it is similar to many other programs emanating from central government.
Sudden wealth even in an honest money regime is a severe enough test of character. Fake wealth accruing to people who have not really earned it is a tougher test still.
“When you have plenty of money, you have a tendency to slowly drift away,” says a member of the Amish community in Indiana. “I think people begin to forget who’s really in control.”
TOPEKA, Indiana – Dan Bontrager is a 54-year-old Amish man with flecks of gray in his long beard. He is also treasurer of the Tri-County Land Trust, an Amish lending cooperative created to support the Amish maxim that community enhances faith in God.
This past spring, Mr. Bontrager was startled when a number of men he has known most of his life tied their horses to the hitching post outside his office and came inside to withdraw their money from the Land Trust.
“We had a run,” Mr. Bontrager says. “I don’t know if you know anything about the Amish grapevine, but word travels fast. Somebody assumed it was going to happen, and it started a panic.”
In Amish country, a bank run is about as familiar as a Hummer or a flat-screen TV. For decades, the more than 200,000 Amish in the U.S. have largely lived apart from the mainstream, emphasizing humility, simplicity and thrift. Known as “the plain people,” they travel by horse-drawn buggy, wear homemade clothing and live with very little electricity.
But the Amish in northern Indiana edged into the conventional economy, lured by the high wages of the recreational-vehicle and modular-homes industries. And they wound up experiencing the same economic whiplash millions of other Americans did.
There has been some fraying of the ties that bind the Amish, many in the community say.
“When you have plenty of money, you have a tendency to slowly drift away,” says Steve Raber, 37, an Amish owner of a furniture-manufacturing business in Shipshewana, near Topeka. “I think people begin to forget who’s really in control.”
The Amish in northern Indiana date their community to about 1850. About 20,000 of them live on the flat, fertile farmland 120 miles east of Chicago below Michigan’s southern border.
Like Amish in other parts of the U.S., the Indiana community strayed from their traditional reliance on farming in recent decades as their numbers grew and land prices rose. Many opened family businesses, often in furniture and other wood crafts.
By 2007, more than half of Amish men in these parts were working full time in manufacturing, and earning, on average, $30 an hour, says Steven Nolt, a professor at Goshen College in Goshen, Indiana, who studies the community.
The great increase in discretionary income spawned a “keeping-up-with-the-Joneses mentality,” says Mervin Lehman, 39, an Amish father of four who says he was making more than $50-an-hour and working up to 60 hours a week as an RV plant supervisor before he was laid off in November.
Some Amish bishops in Indiana weakened restrictions on the use of telephones. Fax machines became commonplace in Amish-owned businesses. Web sites marketing Amish furniture began to crop up. Although the sites were run by non-Amish third parties, they nevertheless intensified a feeling of competition, says Casper Hochstetler, a 70-year-old Amish bishop who lives in Shipshewana.
“People wanted bigger weddings, newer carriages,” Mr. Lehman says. “They were buying things they didn’t need.” Mr. Lehman spent several hundred dollars on a model-train and truck hobby, and about $4,000 on annual family vacations, he says. This year, there will be no vacation.
It became common practice for families to leave their carriages home and take taxis on shopping trips and to dinners out.
Some Amish families had bought second homes on the west coast of Florida and expensive Dutch Harness Horses, with their distinctive, prancing gait. Others lined their carriages in dark velvet and illuminated them with battery-powered LED lighting.
Even the tradition of helping each other out began to unravel, Bishop Hochstetler says. Instead of asking neighbors for help, well-to-do Amish began hiring outsiders so they would not have to reciprocate. “Factory work doesn’t eliminate fellowship, but it does not encourage togetherness,” the bishop says.
Last fall, the recreational-vehicle industry began to lay off workers. Facing financial hardship, the Amish traditionally have sought aid within the community. But with nearly half of households depending on manufacturing income, Amish bishops this year reluctantly decided for the first time that laid-off workers could seek unemployment benefits.
Combined with falling property values, job losses bred concerns that the unemployed would be unable to make their mortgage payments – and that would cripple the Tri-County Land Trust.
The trust was established in 1993, and is similar to lending arrangements set up in other Amish communities. Only Amish people can join. The trust’s 2,100 depositors receive annual interest of 3.2%, while borrowers pay 3.5% interest on loans. There are no credit checks. Monthly mortgage payments can be no more than 33% of a borrower’s gross income.
The trust’s structure reflects the Amish philosophy of sharing. It is not insured by the Federal Deposit Insurance Corp., but by its own bylaws it maintains at least $1 million in cash reserves. The trust has never exercised its authority to foreclose on a home.
Today the trust has about $40 million in assets that its treasurer, Mr. Bontrager, says are managed conservatively.
Last fall, as layoffs drained income from the community, deposits into the trust fell to about $600,00 from between $1 million and $1.5 million a month, Mr. Bontrager says. In November, the trust suspended lending.
Over the winter, rumors began to circulate that the trust was running out of money. The run, as Mr. Bontrager describes it, began in April. It lasted about six weeks. Mr. Bontrager says about 100 depositors made significant withdrawals, and some emptied their accounts. The $1 million reserve fund was wiped out. The trust has not yet resumed lending.
The past year’s experiences have left many here shaken. With the unemployment rate in the area reaching 17.8% in April, a growing number of men have left their families for weeks at a time for out-of-state construction jobs. Some younger families have moved to other states.
In Indiana, a back-to-basics movement appears to be taking root. More patches of produce have sprouted behind Amish homes this summer. Restaurants are entertaining fewer Amish customers. Mr. Lehman says neighbors “are more considerate of each other now.”
Some men have started their own businesses close to home. Mr. Lehman makes mattresses in his workshop. Harlan Miller, a 34-year-old father of five who was laid off in February, started making fruit butter, which he sells at a local market. Freeman Miller (no relation), 54, who was laid off after 30 years in manufacturing, builds wooden caskets for pets.
“We were all going way too fast,” Freeman Miller says. “This has made everybody stop and realize we’re just pilgrims here, the Almighty is in charge.”
Manhattan Apartment Prices Drop as Lehman Hits Home
Manhattan apartment prices dropped for the first time since 2002 in the second quarter as the collapse of Lehman Brothers and Bear Stearns caught up to property owners in the nation’s most expensive urban market.
The median price fell 18.5% from a year earlier to $835,700, New York appraiser Miller Samuel Inc. and broker Prudential Douglas Elliman Real Estate said [on July 2]. The number of sales plunged by half, the most since Miller Samuel began keeping data in 1989.
“The standstill that existed after Lehman Brothers has been broken, and it was the sellers that cried uncle,” Pamela Liebman, chief executive officer of New York-based property broker the Corcoran Group, said in an interview.
Values are falling broadly in Manhattan for the first time in the almost 4-year U.S. housing recession, with declines now seen in co-operatives and condominiums of every size and price. Private-sector employment in the city dropped by 91,200 jobs, or 2.8%, in the 12 months through May as Wall Street losses and asset writedowns topped $1.4 trillion.
The price of studio apartments declined 16% from a year ago to a median of $405,000, according to Miller Samuel. One-bedrooms dropped 17% to $650,000 and 2-bedrooms fell 23% to $1.27 million. 3-bedroom units fell 37% to $2.35 million and 4-bedrooms plummeted 47% to a median of $3.92 million.
The Miller Samuel-Prudential data reflect for the first time what sellers have known for at least six months: The way to lure a buyer in the current market is to cut your price.
7 Surefire Tips to Selling a Home FAST!
If you are looking to sell your home in a matter of days rather than months, you might want to take some tips from 32-year-old Mona Ross Berman.
To get her Washington, D.C., townhouse ready for sale, the interior designer went through every room, sweating the details. She rearranged furniture, added sophisticated coffee-table books and strategically placed vases and throw pillows to create a cozy environment. She then organized every closet to showcase her ample storage space. Finally, she removed all personal items, including her wedding photos, so potential buyers would not associate the house with someone else. She made the property “Q-tip” clean (meaning that every nook, cranny, and air conditioning vent was cleaned and polished. “I think that if you can get a home to show well, it can get you [better results] than it really should,” Berman says. Her strategy worked. Within four days of placing her property on the market, she had five offers in hand.
Long gone are the days when you can simply throw some cookie dough into the oven and get an offer for your house. Thanks to the Internet, home buyers are more sophisticated and demanding than ever before. Over 80% of buyers now pre-screen their selections, neighborhood, and pricing online before viewing a property. Your ability to convey the property through words, pictures, and value are imperative. At a bare minimum, would-be sellers need to dispose of clutter and make any necessary repairs. But to really make a property stand out from the crowd and sell quickly, sellers might need to do the following. ...
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