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LOOKING FOR COMPANIES THAT AN ACQUIRER MIGHT LIKE MORE THAN THE MARKET DOES
Omnicell is Roger King’s kind of stock. In barely a year the medical information company has let down WallStreet with its quarterly earnings and seen its market value shrivel 68% to $173 million. But King, comanager of the Fountainhead Special Value Fund, believes Omnicell could be worth $300 million and that one day the company will prove it. “Omnicell will make it on its own,” says the 62- year-old Houstonian, “or somebody’s going to put it under their umbrella.” After 36 years in the investing business King has settled on several ways to root out stock bargains. His favorite among them is to find stocks selling for less than what a buyer of the whole company might pay, the so-called private market value approach.
It is largely a matter of guts, King explains, as impatience or jitters will always lead certain investors to sell stocks at prices below their true economic worth. “If there’s a significant discount,” he says, “we’re interested.” Chasing those discounts has worked well for King over the long haul. He cofounded King Investment Advisors in 1981 and now manages $700 million. Much of that total is in corporate accounts, but individuals can buy his no-load Fountainhead mutual fund ($16 million in assets), which has returned an annualized 11% since its launch at the end of 1996 versus 8% for the S&P 500.
Dealing in downtrodden stocks like Omnicell can lead to stumbles; King has had his share. In 2002 Fountainhead’s return was -44%, dragged down by losing bets on cable and wireless stocks. Yet the private market value approach has brought King dramatic successes, too. In 2000 shares of Boston Scientific, the medical device maker, fell to a split-adjusted $8. The drop looked excessive to King and his team, who reckoned that the company had a private market value of $22 billion versus a public market value of $7 billion. The fund still holds 14,800 shares, now trading at $29.
In calculating private market value, King starts with a prospect’s operating income in the sense of earnings before interest, taxes and depreciation. Trailing 12-month results will do, although King will also annualize operating income for the most recently reported quarter if a company is growing rapidly. Next he digs around in that same industry for recent acquisitions and determines what multiple of operating income was paid in those deals. He then multiplies that number by his pick’s operating income to determine a preliminary valuation. The private market value is that number less long-term debt, plus cash and equivalents. Determining the appropriate operating income multiple for a company is tricky. King’s team uses data from Mergerstat, a provider of M&A financials, and other sources to survey recent deals. But it is not as easy as downloading numbers.Link here.
Markets look forward, except when they look backward. At this moment the real estate market is looking backward. What it sees is comforting but irrelevant. In the past five years real estate investment trusts have outperformed the S&P 500: up 19.1% annually for the Bloomberg REIT index vs. negative 3.2% for the S&P. Mistaking the past for the future, people are pouring money into houses, shopping centers, office buildings, hotels, anything with a front door and a roof. They are paying some of the fanciest prices on record. Property bulls come in all sizes, shapes and net worths. “We are living with the greatest liquidity ever,” an eminent REIT promoter was quoted as saying in March in the New York Sun. “We’re not going to have a crash in the real estate market, there is too much liquidity.”
“Liquidity” is a term of art. It means lots of money. It can also mean – and, in 2005, does mean – “low interest rates”, “E-Z financing terms”, “low dollar exchange rate” and “value investors go away”. In an evident state of liquidity-induced euphoria, a Miami Realtor recently proclaimed to the New York Times, “South Florida is working off a totally new economic model than any of us have ever experienced in the past.” Not so. The “South Florida economic model” is the oldest in the book. An excess of dollars leads to a drop in interest rates. And a drop in rates to a rise in real estate prices. And a rise in prices to massive new building. Only later does the same surplus of dollars cause a rise in the inflation rate. This leads to a rise in interest rates. And to a drop in real estate prices, with the market now oversupplied by all that new building.
In the U.S. there are, of course, many buildings. Not all are equally overvalued. No doubt some are cheap, even now. But enough are sufficiently overpriced to give pause to careful investors. Jeremiah O’Connor, founder and managing partner of O’Connor Capital Partners in New York, is one of these conscientious appraisers of value. In his 35 years in the business, says O’Connor, he has never seen such a virulent case of a syndrome he himself has identified: AEL, for “aggravated excess liquidity”. O’Connor started his first REIT in 1971. For many years the standard cash return on income-producing real estate was 9%, O’Connor relates. In booms it was less; in busts, more – but 9% was the number to which it regressed. Today it yields 5% to 7% on average – with all signs pointing to even lower yields just ahead.
Not born yesterday, O’Connor has participated in three brutal property bear markets: 1974-75, 1980-82 and 1990-92. Note, he observes, that 13 years have passed since the last slump, enough time to have erased the institutional memory. What experience has imprinted is that because interest rates fall, property values rise. But interest rates stopped falling, and started rising, two years ago. The dividend yield on the Bloomberg REIT index stands at 5.4%, that of the Vanguard Prime Money Market Fund at 2.5%. A suggestion for the long-term investor: For the higher total return, pick the lower yield.Link here.
GO WITH THE SLOW AND STEADY ONES
Over the last two years the market, despite some recent faltering, has delivered double-digit index returns. Not all sectors have done uniformly well, however. The boom-and-bust cyclical stocks have been the fuel propelling the overall market. By contrast, the tried-and-true consumer companies have trailed noticeably. This imbalanced performance is really not that surprising. An inverse correlation exists between returns for cyclical stocks (like steel, paper, chemicals, appliances) and consumer stocks (such as services, retail, food, drugs). When cyclicals lead, consumer issues lag – and vice versa. The most recent cyclical rally began in March 2003, coinciding with the economy’s rebound. Since then the Morgan Stanley Cyclical Index has climbed 95%, while the Morgan Stanley Consumer Index is up only 33%.
I prefer high-quality, consumer-biased holdings with consistent and predictable earnings. While my slow and steady picks may trail during exuberant times, they do not suffer nearly as much in the bad times. Right now consumer issues are poised for a nice move. Why? Sky-high oil prices and rising interest rates will slow corporate profit growth. When things get tough, companies often ratchet back big spending on plants and equipment, but people still buy basic necessities. The following are a few of my favorite consumer-related companies, all with solid franchises and selling at bargain prices.Link here.
WHAT’S BAD FOR GM ...
GM has warned of a massive earnings shrinkage and the three leading credit ratings agencies’ will likely downgrade of GM bonds to junk. Stocks and bonds of the world’s largest automaker tanked as a result. But the damage to investors, particularly fixed-income holders, is only beginning. When GM’s bonds finally are declared junk, as I expect, more mayhem will ensue.
There is little hope for a reprieve from this unhappy fate. GM Chief Executive Richard Wagoner’s mid-March earnings warning, lamentably short on hard-nosed remedies, was in keeping with the company’s 40-year slide. Management still seems to believe GM’s preeminence is somehow part of the natural order. Its view is reminiscent of the good old days when Detroit’s 1950 auto cartel ruled and GM’s then-head, Charles (Engine Charlie) Wilson, declared: “For years I thought what was good for our country was good for General Motors and vice versa. The difference did not exist.” Such smugness allowed GM management to vastly underrate the import surge that started in the 1960s and the transplants that followed.
Today Wagoner appears reluctant to attack GM’s basic problem head-on: enormous dead-weight fixed costs. Wagoner says he plans to rethink incentives and introduce new models to replace GM’s nonselling big SUV gas-guzzlers. And he is sinking money into the hydrogen car of the future. None of that will be good enough. So old-tech GM will continue to slide, but does that matter to the economy? Yes. What’s bad for GM is bad for the country. The U.S. auto business accounts for 9% of GDP. And high-paid Big Three employees spend a lot of money.
For sure, GM’s pending downgrade to junk seems already priced into the market. The bonds right now trade as if they were C-rated junk, at yields five percentage points higher than comparable Treasurys. Anything related to autos has been sunk by the GM tsunami. The junk bonds of auto parts suppliers and the investment-grade obligations in the banking and energy sectors have sold off. That is only the prelude. Expect a second tidal wave once the ratings agencies, embarrassingly tardy at spotting credit disasters in recent years, finally push GM issues into junk status. Then GM’s huge debt (not counting the asset-backed portion of its finance subsidiary’s offerings) will be tossed out of the widely followed Lehman Brothers U.S. Credit Index, an investment-grade-only roster; GM makes up 5% of it. GM bond prices will drown anew in a torrent of selling.
So a lot of investors will be affected by a GM junk rating. Corporate junk bonds and their cousins, emerging nations’ obligations, have become very popular. GM’s junk designation will reverse the trend to upgrading bonds. So unload your junk and emerging market bond funds or individual issues. Investment-grade corporates will be pulled down, too. American International Group, mired in scandal, has had its AAA-rated bonds downgraded a notch. More will follow. Sell now. What else to do? Comb out of your stock portfolio the companies funded by junk issues. As new issues require much higher interest costs or become impossible to float, those companies’ earnings will be hurt – cable, telecom and gaming outfits, in particular. And all the planned mergers and acquisitions? They often require junk financing.Link here.
PAUL VOLKER SEES AN ECONOMY ON THIN ICE
The U.S. expansion appears on track. Europe and Japan may lack exuberance, but their economies are at least on the plus side. China and India – with close to 40% of the world’s population – have sustained growth at rates that not so long ago would have seemed, if not impossible, highly improbable. Yet, under the placid surface, there are disturbing trends: huge imbalances, disequilibria, risks – call them what you will. Altogether the circumstances seem to me as dangerous and intractable as any I can remember, and I can remember quite a lot. What really concerns me is that there seems to be so little willingness or capacity to do much about it.
If we can believe the numbers, personal savings in the U.S. have practically disappeared. To be sure, businesses have begun to rebuild their financial reserves. But in the space of a few years, the federal deficit has come to offset that source of national savings. We are buying a lot of housing at rising prices, but home ownership has become a vehicle for borrowing as much as a source of financial security. As a nation we are consuming and investing about 6% more than we are producing. What holds it all together is a massive and growing flow of capital from abroad. There is no sense of strain. As a nation we do not consciously borrow or beg. We are not even offering attractive interest rates, nor do we have to offer our creditors protection against the risk of a declining dollar.
It is all quite comfortable for us. We fill our shops and our garages with goods from abroad, and the competition has been a powerful restraint on our internal prices. And it is comfortable for our trading partners and for those supplying the capital. Some, such as China, depend heavily on our expanding domestic markets. And for the most part, the central banks of the emerging world have been willing to hold more and more dollars, which are, after all, the closest thing the world has to a truly international currency.
The difficulty is that this seemingly comfortable pattern cannot go on indefinitely. The U.S. is absorbing about 80% of the net flow of international capital. And at some point, both central banks and private institutions will have their fill of dollars. I do not know whether change will come with a bang or a whimper, whether sooner or later. But as things stand, it is more likely than not that it will be financial crises rather than policy foresight that will force the change. It is not that it is so difficult intellectually to set out a scenario for a “soft landing” and sustained growth. But can we, with any degree of confidence today, look forward to any one of these policies being put in place any time soon, much less a combination of all? The answer is no. So I think we are skating on increasingly thin ice.
A wise observer of the economic scene once commented that “what can be left to later, usually is – and then, alas, it’s too late.” I do not want to let that stand as the epitaph of what has been an unparalleled period of success for the American economy and of enormous potential for the world at large.Link here.
Don’t say he didn’t warn you.
Paul Volcker was Chairman of the Federal Reserve System’s Board of Governors from late 1979 until late 1987. He testified before Congress on a regular basis, as required by Federal law – the only law that Congress enforces on the quasi-autonomous Fed. At 6’7”, he is an impressive figure. He imitated Red Auerbach, the coach of the Boston Celtics, who would light a cigar when he thought a game was as good as lost for the Celtics’ opponent. Volcker puffed cigars at Congress. In contrast, Greenspan, a far less impressive figure, has adopted a linguistic strategy to befuddle rather than overpower Congressmen: verbal smoke rather than tobacco smoke. Both approaches work just fine. Volcker generally was forthright. He basically told Congress to fly a kite. He told them what he was going to do, and then he did it. They never laid a glove on him. He had a well-deserved reputation for not sugar-coating bad news.
Volcker has been sounding the alarm for months. The markets pay no attention. If Greenspan were this forthright, the capital markets would respond in minutes – downward. The truth of the analysis is not the question in the minds of establishment investors. What matters is the short-term power of the analyst. I did not believe Volcker in October, 1979, when he announced what he was going to do. I should have. I believe him this time. I think you should, too.Link here.
He made it worse ... then he made it better?
When things have gone badly wrong, the fastest way to lose friends is with remarks like, “Things must get worse before they can get better.” In fact, depending on the size of the crowd you say it to, you should probably have your bicycle nearby and be ready to pedal away really, really quickly. This is why I have always admired Paul Volcker, the former Federal Reserve Board Chairman. More than just saying so, he actually did make things worse in the late 1970’s – in the firm belief that he had to before things could get better.
The “things” I have in mind were of course the fundamentals of the U.S. economy at that time: GDP, interest rates, and inflation. Growth was low, interest rates were high, inflation was higher still. When Mr. Volcker became Fed Chairman in 1979, he bluntly declared inflation to be “public enemy number one”. He began a relentless series of hikes in the Fed’s discount rate, which in turn contributed to some of the highest lending rates in modern U.S. history: before it was over the prime rate rose above 21%; the yield on Treasury Bills peaked above 17%. These results were “things getting worse” indeed. But then they got better – much better. By 1984 the economy was so strong that Ronald Reagan’s election-year campaign slogan was, “It’s morning in America”. In 1987 Alan Greenspan took over as Fed Chairman, and many people still link his policies to the 1980s-1990s bull market. Yet he has never faced a decision that called for the degree of courage that Paul Volcker showed.
All this came to mind when I read Volcker’s essay in the Washington Post titled, “An Economy On Thin Ice”. While he says the “U.S. expansion appears on track”, he also gives this warning: “Altogether the circumstances seem to me as dangerous and intractable as any I can remember, and I can remember quite a lot.” From almost anyone else I would feel this was a boast; to know that Paul Volcker said it made me feel trepidation. He went on to outline ideas that would be unpopular in the short term but that could help in the long run. Then he emphasized the need “to act now – and next year, and the following year, and to act even when, on the surface, everything seems so placid and favorable.” Still, I got the sense that he does not believe action will come soon enough. There is no policy maker I can think of who will show the courage that Volcker showed. Still, his advice applies in spades to individuals. This could not be a worse time for investors to expect benefits from the “top down”. When it comes to your portfolio, you must be your own “policy maker”.Link here.
THE DRUMBEAT OF PROTECTIONISM
It was inevitable. With America beset by record trade- and current-account deficits, the drumbeat of protectionism is getting louder and louder in Washington. Not surprisingly, the assault is taking dead aim on China – by far the biggest bilateral piece of a U.S. trade gap that hit $617 billion in 2004. Is this just political saber-rattling, or a threat to be taken seriously? The U.S. Senate is leading the charge. In a broad-based show of bipartisan support, on 6 April the Senate tacitly endorsed the so-called China Currency Bill (S. 295), introduced by Charles Schumer (liberal Democrat from New York) and Lindsey Graham (conservative Republican from South Carolina); this law would levy 27.5% tariffs on all Chinese products sold in the U.S. Schumer and Graham are as far apart on the U.S. ideological spectrum as you could imagine. Yet they have come together, united in their conviction that blame for th U.S. trade gap should be pinned on China. Their bill is effectively a renminbi “undervaluation tax”.
I have said from the start that the odds of passage for such legislation are low. Those odds are now increasing, in large part because of the shifting context of America’s trade dilemma – an exploding overall deficit and an increasingly visible role played by China, which accounted for 26% of the total U.S. trade gap in 2004. Washington has had a number of long-simmering concerns with respect to Chinese trade – especially over furniture, semiconductors, and intellectual property rights. But the recent surge of Chinese textile imports into the US could well be the proverbial straw that breaks this camel’s back.
The real message in all this is not that tariffs on Chinese imports are coming. I still believe that is a very remote possibility. But the die is now cast for an open and acrimonious debate on U.S.-China trade relationships over the next several months. I am concerned, but not surprised, by this unfortunate turn of events. While the actions are predictable, that does not make them right. The macro I practice suggests that the scapegoating of China is a huge mistake.
For starters, there is a clear misunderstanding over the character of the so-called Chinese export threat. Contrary to widespread impressions, China’s export surge is not an outgrowth of aggressive market-share penetration by rapidly growing indigenous Chinese companies. To the contrary, the bulk of the export surge has been dominated by Chinese subsidiaries of global multinational corporations and cross-border joint-venture operations. Who is the New China? These numbers suggest that China’s so-called export prowess is traceable more to “us” in the West than it is to them. This is not a conclusion that resonates with U.S. politicians. I have made this point repeatedly in congressional testimony in Washington, and it almost always falls on deaf ears.
But there is even a broader macro issue to hammer home – the basic roots of America’s current account and trade deficits. In my view, the U.S. external deficit is, first and foremost, an outgrowth of America’s unprecedented shortfall of domestic saving. The net national saving rate – the combined saving of consumers, businesses, and the government sector, all adjusted for depreciation – has plunged to a record low of 1.5% of GDP since early 2002. Lacking in domestic saving, American must then import surplus saving from abroad to keep its economy growing – and run massive current-account and trade deficits to attract the capital. If the U.S. Congress were to close down trade with China today, a saving-short America would then have to run a deficit with a higher-cost producer somewhere else in the world – the functional equivalent of a tax hike on the American public. The fact that China accounts for the biggest portion of the U.S. trade deficit is actually a good thing – it offers America access to high-quality, low-cost goods. Alas, macro logic never seems to carry much weight in Washington.
In my view, the wisest course of action for China would be pre-emptive action aimed at defusing these tensions. The currency is the most obvious candidate, but there are other options. Beijing’s initial response to the Schumer-Graham foray is not encouraging – it pins the blame solely on America’s saving deficiency. While that is quite consistent with the argument I made above, it misses the political angle completely. In the end, global rebalancing is a shared responsibility. A failure of China to participate in this global adjustment process would leave it isolated.
As the drumbeat of protectionism grows louder, financial markets could certainly suffer. The dollar undoubtedly would be first to go. Given the extreme nature of America’s massive trade deficit, the currency correction could well be swift and severe. That, in turn, would probably trigger a sharp back-up in long-term U.S. interest rates – having a cascading impact on over-valued property markets, asset-dependent consumers, earnings expectations, and U.S. equities. Emerging market debt spreads – already far too tight for my liking – look especially vulnerable in a scenario of mounting trade frictions; the fundamental underpinnings of these export-led economies would get turned inside out if global trade flows slacken significantly.
Chinese intransigence could well be the biggest risk. With the China-bashing train having left the station in Washington, that could well turn the low-probability threat of the tariff option into reality. China might then retaliate by reducing its purchases of U.S. Treasuries – sparking a full-blown dollar crisis that would have the potential to take an even more serious toll on world financial markets and the global economy. It is clearly in the best interest of all parties to avoid such an outcome. The question is, Can they?Link here.
The danger zone of global rebalancing.
Trade tensions are spilling over into the political arena. That is the case in Washington and it could well be the case in Europe if Asia continues to resist on the currency front. All along, the biggest risk of global rebalancing is that the onus of adjustment could shift from economic and financial forces to the politics of trade frictions and protectionism. As global imbalances mount, those risks are now rising – pushing the world into the danger zone of global rebalancing.
The theory of globalization counsels patience – that it takes time for the flowers of the virtuous circle to bloom. Yet politicians have no such patience – or at least they run out of it very quickly. Forever focused on the next election, political leaders have a very different time horizon than that provided by the evolutionary forces that may be reshaping the world, in general, and conditions in their home countries, in particular. Politicians need short-term results to withstand the howls of protest from equally myopic voters. And so they intervene in an effort to temper the impacts of global imbalances on their constituents. This then sows the seeds for trade frictions and protectionism – always the weakest link in the ideal world of globalization. Recent actions in Washington are especially disconcerting in that regard.
History warns that we are now in precisely the phase in the globalization cycle when protectionism and geopolitical instability have reared their ugly heads in the past. That was the case in three of the most recent episodes of globalization – the integration of the Atlantic economy in the second half of the 19th century, the global integration in the first decade of the 1900s, and the globalization in the inter-war era of the 1920s. In each of these instances, the initial rush to global convergence was characterized by a sharp expansion of world trade and global capital flows that seemed unstoppable at the time. Unfortunately, there came a point in all of those periods when that convergence was undermined by mounting instabilities, similar to those very much in evidence today. For a world that is currently afflicted by record imbalances, those are hardly precedents to take lightly.
Two extreme scenarios bracket the wide range of global rebalancing alternatives – the benign outcome, where the adjustments are gently spread over a long period of time, and the disruptive outcome, where the adjustments are concentrated in a relatively short period of time. Everyone favors the benign outcome. Financial markets are priced for that possibility and, not surprisingly, global policy makers express confidence in the painless fix. I fear this confidence is at odds with mounting political risks. By upping the ante on trade frictions and protectionism, politicians are shifting the odds into the danger zone of global rebalancing and the dollar crisis that might trigger. It would not be the first time a rush to globalization sowed the seeds of its own demise.Link here.
EXCESSIVE ASIAN RESERVES?
Reflecting a fetish for hard currency similar to the Mercantilist obsession with gold, East Asia’s foreign-exchange reserves have more than doubled since the turmoil in 1997-98. Japan’s foreign reserves of over $840 billion were the highest in the world while China has the world’s second-largest foreign reserves of almost $610 billion of the end of 2004. Taiwan has the third largest reserves of around $242 billion, exceeding half the size of its GDP. South Korea is fourth on the list with foreign reserves up by $3 billion from late December to $202.1 billion as of the end of February, about 29% of its GDP. In turn, Asian central banks collectively hold about $2.4 trillion worth of U.S. Treasuries and other securities. These foreign exchange balances provide a cushion so that importers have adequate access and that there are sufficient fund to repay overseas creditors. At the same time, a large stock of hard-currencies tends to ward off currency speculators. Unfortunately, these continuously rising reserves push up the cost of holding them while central banks show growing valuation losses on their balance sheets from a depreciating dollar.
Various factors contributed to the recent increase in reserves. Initially, declining business investment after 1997-98 accompanied by high household savings rates allowed East Asian economies to move from external deficits to external surpluses. These large current account surpluses and net capital inflows were boosted by remittances from expatriate workers. Recent rises of the value of the euro and yen against the dollar also increased the dollar value of assets denominated in other foreign currencies. But most importantly, interventions in foreign-exchange markets to curb appreciation of their currencies contributed to the increase in reserves held in Asia by about 35% during 2003.
Continued attempts to weaken their currencies while attempting to boost exports will cause further build-up of their dollar holdings that transfer purchasing power to Americans. If Asian central banks allow their currencies to appreciate, they will experience significant losses since most of their assets are in dollars while their liabilities are in the local currency. Currency market interventions have caused many Asian currencies to be “undervalued” relative to the dollar. Conversions of foreign funds to local currencies tend to fuel growth in local money supplies that push up loan growth and contribute to investment bubbles. This untenable condition can lead to the sort of turmoil in foreign currency markets last seen in 1997-98. Massive currency realignments and high volatility devastates balance sheets, especially in those countries with weak financial sectors and poor corporate governance. China faces the biggest problems with its policy mix. An estimated inflow of $50 billion of “hot money” to gamble on the revaluation of the renminbi has contributed to a growth in the domestic money supply and contributed to price instability.
It is impossible to know the “optimal” level of foreign currency reserves, but there are signs that the levels of reserves held in many Asian countries is excessive. In all events, indefinite accumulation of dollar assets (or denominated in any other foreign currency) weakens domestic monetary systems of these economies. This is because the rapid growth and current high level of reserves will exacerbate instability in consumer and producer prices while increasing the likelihood of an asset bubble. When exports exceed imports, the accumulation of reserves requires a decline in domestic consumption and investment. Building reserves from a trade surplus means that export earnings are unavailable for private investment.
It turns out that most Asian companies and governments have placed their reserves in low-yielding US assets. For example, Asians hold about 20% of the debt of Freddie Mac, the American mortgage-finance company. Purchases of U.S. securities are part of an unsustainable shell game whereby Asians finance the large external deficit of the U.S. so Americans can buy more Asian exports. The key to this global Ponzi scheme is a flood of liquidity from the U.S. due to “cheap credit” orchestrated by the Fed’s monetary pumping. Of course, this orgy is rapidly coming to an end. If they insist on holding such massive reserves, East Asian countries should manage them more effectively.Link here.
CORPORATE PROFITS LOCOMOTIVE PRODUCTION OR INFLATION?
Not that we set too much store by aggregate statistics, but the latest U.S. Dept of Commerce report on corporate profits makes for some interesting reading. Comparing the final three months of last year with the like period in 2003, we can see that business, in general, seems to have done rather well. Combined sales for manufacturers, miners, wholesalers, and retailers rose 16.6% – or $320 billion – boosting operating profits an impressive-looking 31.5% – equivalent to nearly $30 billion extra for options grantees, shareholders (and the state) to share among themselves. However, we do have to ask just how much extra wealth this represents and how much is merely the result of extra money chasing much the same physical quantity of goods, i.e., inflation.
One rather revealing clue is that for every $4.50 in extra sales recorded, as much as $1 was rung up by just two sectors – “petroleum & coal” and “primary metals”. Moreover, if we assume a good part of this added to wholesalers’ sales and then boosted retailer’s receipts, in turn, the proportion attributable to these two activities rises even further. Yet more striking, these two sectors accounted for more than $1 in every $2 of all the extra profits earned! But did America’s miners, refiners, millers, and founders really dig up and process 30% more ore-bearing rock? Did Big Oil pump 43% more black stuff out of the world’s depleting oil fields? Or was that much more gas and coal wrested from the bowels of the earth by men with hard hats and bulging biceps? Or rather was it that metals prices rose 30%, as the LME’s broad index suggests they did? Might natural gas’s 35% gain, crude oil’s 50% rise, or coal’s 73% jump have anything to do with it, instead? You make the call.Link here.
DON’T ROCK THE BOAT
With the help of some very talented peers, I have been thinking recently about the future of the economic relationship between the governments of the U.S. and Japan. Setting the stage for this analysis: Creditors do not want to see their assets lost through debtor default. Therefore, it is not uncommon that a creditor will work with a distressed debtor. I postulate that to this end, Japan and the U.S. have had a meeting of minds. Under such circumstances, areas for negotiation between a creditor nation and a debtor nation could include: increasing the difference between paper currency valuations; adjusting interest rate differentials; and changing the repayment terms.
In the short term, I envision an induced downturn by design. The U.S. economy will slow, stocks will rise for distribution only to decline, layoffs will occur, demand for oil will wane, and domestic bondholders will be squeezed. In other words, the U.S. will swallow a large dose of Japanese deflation. The balance sheets of the U.S. government (as borrower-spender) and the Japanese government (as lender-saver) must be protected. The only way to do this will be to extend more credit. Conditions are being set to enable this to happen. The negotiating areas I mentioned above are in play.
Beyond the global economy, the U.S. and Japan are structurally intertwined, and to great extent isolated together in a hostile world. It is probable that this was the major consideration of this recent adjustment. Energy-starved Japan needs the U.S. because its military umbrella provides Japan with access to Middle East oil. Stretched thin against global political trends, the U.S. needs Japan to become militarized as its partner. Perhaps, in the future, some economic event could be used as a reason (or an excuse) to drive this synergy of common interest forward. It could be used to break specific provisions in MacArthur’s post-war Japanese constitution.
In terms of currency, cooperative synergy exists between the U.S. and Japan. If global free trade wanes either in importance or in sustainability, it will be replaced by a new regionalism, with U.S.-Japanese cooperation growing into a distinct power block. I offer this as a distinct rather than ingrained possibility.Link here.
JAPAN AND EUROPE: ANY CONNECTION?
After a 15-year struggle, Japan’s economy cannot seem to reverse its bad luck. It all started in late 1989, when the NIKKEI climbed to an all-time high of 38,915, reversed, and spent the next 14 years going down, down, down. The Japanese economy followed the suit, and the country spent most of the 1990s in a deep recession. In April 2003, the NIKKEI hit a 20-year low of 7699. But soon after, the index recovered and by May 2004, it rallied to just over 12,000. The economy followed again, and in the fourth quarter of 2004 Japan even posted a modest GDP gain – a welcome hopeful sign.
But in May 2004, the NIKKEI began losing momentum. Since then it has gone up and down, and up again … but mostly sideways. Today it stands where it was last June. And now the Japanese economy is showing signs of trouble again. The Bank of Japan reports that in the fourth quarter of 2004, “optimism at Japanese companies declined sharply,” unemployment rose, and production and sales fell. In February, consumer prices suffered their steepest drop since June 2003 – a sign that the country remains mired in a nearly seven-year battle with deflation. Surely you have noticed a pattern already. As the NIKKEI went up and down, so did the Japanese economy. It is one more illustration of the fact that the economy usually follows the stock market.
Meanwhile, European stocks have been rallying for two years now, but the EU economic numbers are still weak. Because of those “weak fundamentals”, the EC just slashed their 2005 eurozone growth forecast from 2% to 1.6%. But if you look at a chart of European stocks – and keep in mind that the economy is a lagging indicator – you will realize that the EC’s decision was probably premature. The latest European rally began in August 2004. For the past eight months, the stock market has been pointing to an economic upswing in Europe. It is not showing up in economic numbers yet, but you can bet that Europe will be seeing more and more positive economic numbers soon, surprising many economists. That is when things will get really interesting for European stocks. Once the “fundamentals” improve and the rising social mood continues to work its magic, many new investors will be drawn into the stock market, swoon by the “positive economic news”. The question is – should you follow?Link here.
WHY IS THE BOOK SELLING SO WELL WITH THAT TITLE?
A couple of months ago we discussed a 76-year old Princeton professor emeritus who recently published a book that goes by the title, On Bulls**t. The book’s purpose, of course, is not to increase bulls**t but to limit its spread. Public support for this purpose is strong enough to be measured: On Bulls**t hit the New York Times bestseller list a few weeks ago, and today stands at no. 3 for hardcover fiction.
This amazes some people, especially because the book was first written as an 8,000-word essay in 1986; it never had a “following” beyond a small universe of professors and their philosophy students. The book’s appearance has provoked a number of reviews and opinion pieces, yet none has satisfactorily explained why an obscure essay written years ago should suddenly find a huge audience. Writer/critic Roger Kimball, in The Wall Street Journal, wondered if the book is “a marketing stunt, not so far removed” from its own theme; he rhetorically asked, “Can we imagine such a book selling so well without that title?” Wrong question. Instead he should ask, Why is it selling so well WITH that title?
The answer comes by understanding where we are in the cycle of social mood, and how that mood shows up in fashion, movies, and the bestseller list. The long-term trend turned from optimism to pessimism in 2000: As we have explained, we are in a time of growing discord, polarization, anger, and unhappiness. This being the case, is it really a big surprise that many people have a dwindling tolerance for bulls**t? Social mood also explains the trends in politics, the economy, finance, and lot a more – including the stock market.Link here.
LBO’S SEE RISE IN DEBT RATIOS
Debt is becoming a larger component of the capital structure of leveraged buyouts, according to The Wall Street Journal, but some sponsors are having trouble raising the money to complete the deals, thanks to rising interest rates and growing concerns for credit quality. This year’s first quarter saw $31 billion in LBO deals, according to the Journal, citing Standard & Poor’s. On average, equity accounted for less than 30% of the deals’ total value for the first time since 2000, the paper noted. Meanwhile, debt exceeded earnings before interest, taxes, depreciation, and amortization by 5.2 times, the widest ratio since 1998, when deals were booming. In fact, loans for leveraged buyouts reached $16.24 billion in the first quarter, the most in at least 7 years, according to Bloomberg, which also cited S&P.
In the first quarter, the average time between the initial LBO and a dividend payout for the sponsors dropped to 11 months, added the Journal, which observed that the dividends increase the debt loads even more. Large, leveraged deals are no longer a slam dunk, however. “The market has essentially shut down for the type of low-quality borrower that we saw prior to March,” said Mark Hudoff, a portfolio manager at bond powerhouse Pacific Investment Management Co. “The hurdle has gotten a lot higher” for high-yield borrowers. Investors in junk bonds have become more cautious of late, partly due to fears that General Motors may be downgraded to below-investment-grade status. Bloomberg also pointed out that last week, yield spreads on junk bonds swelled to 3.59 percentage points, up from the low this year of 2.71 percentage points just a month ago.Link here.
EL NIÑO WEATHER PATTERN MAY BE SET TO RETURN
El Niño, the weather pattern that caused $96 billion of crop and property damage in 1997 and 1998, may be returning. An unexpected warming of the Pacific Ocean in February reduced air pressure from Tahiti to Australia to a 22-year low. A similar change eight years ago developed into an intense El Niño that caused droughts in Asia, floods in South America and tornadoes in the U.S. “It’s more than double the normal risk,” said Roger Stone, an associate professor of climatology at the University of Southern Queensland in Australia. The chances of an El Niño pattern developing by midyear are about 50%, compared with 20% normally, Stone said.
The return of El Niño, which emerges first in Australia and takes months to develop, may worsen droughts that parched coffee trees in Vietnam, sugarcane fields in India and Thailand and soybean plants in Brazil, boosting the cost of products such as Procter & Gamble’s Folgers coffee. Already, GE Insurance Solutions, a unit of General Electric, halted sales of agricultural policies to new clients.Link here.
SPRINGTIME ON WALL STREET
Springtime has finally arrived on the island of Manhattan … and the signs of its arrival are abundant. The indigenous fauna have emerged from their lairs to saunter along the sidewalks of the city. A few of the most exotic species have shed their winter coats almost entirely, as if relying only on the sun’s warmth to maintain their body heat. The local floral have also emerged from a long winter of dormancy … Daffodils and crocuses seem to blanket every park on our little island. Yes indeed, it is a delightful time of year.
Down here on Wall Street, meanwhile, the signs of spring are somewhat less evident. Even so, a stock market rally seems to be budding. This sporadic bloomer does not always germinate, but the early indications seem quite promising this year. We first mentioned the probability of a springtime rally in our March 31 column entitled “A Seductive Scenario”. Option-buyers had become a bit too bearish, we observed, which, as a contrary indicator, suggested that stock prices might soon advance. “The market is heading toward a ‘tradable low’,” options pro Jay Shartsis predicted at the time. “Some put/call gauges are showing high levels of pessimism, as we near what looks like the final stages of a decline.” The Dow has dipped about half a percent since then, thereby making us neither geniuses nor complete fools. Meanwhile, the evidence for an imminent rally continues to mount.
First up, put-buying is still on the rise, especially among the out-of-favor Nasdaq stocks. Option-buyers have purchased $1.50 worth of puts for every $1.00 worth of calls, vs. the market top last December, when this measure got down to about 53 cents traded in puts for every $1.00 in calls (high optimism). Also worth noting, according to Shartsis, is that fact that the American Association of Individual Investors sentiment survey continues to register extremely high numbers of bears. The four-week average of bulls to bears has fallen to lows that have been seen only three times in the past five years: July 19, 2002, Oct. 4, 2002 and Feb. 7, 2003 through March 7, 2003. Those were the three most important buying opportunities since the market peak in 2000.
Meanwhile, an entirely different gauge of investor sentiment seems to corroborate the signals that Shartsis has observed. Mutual fund investors within the Rydex fund family have been moving their money from “bull” funds to “bear” funds – a trend that often presages a stock market rally. By monitoring the cash flows into or out of the various Rydex funds, one can gauge the approximate mind-set of investors. When they are bullish they buy “bull” funds, and when they are bearish they buy “bear” funds like Ursa. These trends function well as contrary indicators because Rydex investors often become too bullish at market peaks and too bearish at market lows. Cash flowed heavily into bear funds last August, just as the market was about to launch a major rally. Presently, Rydex investors are once again upping their allocation to bear funds and money market funds, which suggests that a rally may be approaching.
Lastly, the implied volatilities on call options for the XLE (an ETF of oil stocks) compared to the S&P 500 tell a very interesting tale. Currently, the volatility on XLE call options is DOUBLE that of S&P 500 call options. We would expect these volatilities to re-converge, as the crude oil price continues to correct or the S&P rallies or both. … At least that would be our best guess. In short, we continue to await a springtime rally almost as giddily as we await warm weather, while bracing for a springtime sell-off in commodities. Therefore, try to catch a short-term stock rally if you like, but do not forget to re-commit at lower prices, hopefully, to the long-term bull market in commodities.Link here.
RETAIL CHAINS CAUGHT IN SHOPPING FRENZY, FUELED BY CHEAP MONEY AND REAL ESTATE VALUES
Already this year, America’s biggest department store chain, Federated Department Stores, has bought the second biggest, May Department Stores, in a deal valued at $16 billion. K-Mart bought Sears. Jones Apparel Group bought Barney’s. Toys “R” Us was bought a few months ago by a group of private equity firms and a real estate trust. The retail industry is rife with rumors of who’s next: Is it KB Toys? Or J.C. Penney? Or Blockbuster? Or Pier One? The retailing industry is gripped by frenzy. Chain stores are selling for prices that would have been considered exorbitant a few years ago. The price for Neiman Marcus, which has only 37 stores and some clearance centers, is a minimum of $5 billion, say executives familiar with the offering. The opening bid for the 232 stores in the Saks department store group, they said, was around $3.5 billion.
Fueled by billions of dollars of private equity and venture capital that must be spent or returned to investors, plus low interest rates that are inexorably moving higher, sellers are feeling there may never be a better time to get out of the fundamentally risky business of retailing, which is based largely, after all, on the whims of fashion. “This is a kind of perfect storm for the retailers,” said Peter J. Solomon, the chairman of the Peter J. Solomon investment banking firm. “These deals are being fueled by real estate expectations and cheap money and not wanting to be left behind.”
Analysts agree that the retailing world changed on Nov. 17, 2004, when Edward S. Lampert announced that he would buy Sears. Mr. Lampert popularized an increasingly important way for potential buyers to look at chains: for their valuable real estate. And now, most private equity firms hire a real estate consultant to advise them or may even ask it to become part of a joint venture. And according to Allan J. Ellinger, the senior managing director at M.M.G., an investment banking firm, “Right now, in the fashion business, every company fits into one of three columns. There’s buyers, and there’s sellers, and third, there’s those who are temporarily undecided which they are going to be.”Link here.
BERKSHIRE HATHAWAY IS IN FOR A BRUISING
One of the most glaring and disconcerting features of the current insurance scandal is New York Attorney General Spitzer’s insistence that Warren Buffett, the CEO of Berkshire Hathaway, is merely a witness in his insurance probe – and not a target. Just this Sunday on ABC’s This Week, Spitzer said that Buffett was “not a subject or a target of our investigation”, even though Buffett knew about a Berkshire deal that is being examined by Spitzer and other regulators. The deal, which Berkshire subsidiary General Re did with insurance giant AIG, is a type of finite reinsurance, a product that regulators are targeting because it is often used to give a fake boost to the financial statements of insurance companies.
Due to Berkshire’s involvement in a number of finite reinsurance transactions, and the refusal of other regulators to give Buffett an easy ride, Spitzer’s kid-gloves approach will not look tenable for much longer. It is almost impossible to see how Berkshire can emerge from the insurance scandals without suffering some legal penalty and a dent in its reputation. And as Berkshire’s finite deals come under greater scrutiny, Buffett will likely be called on again to say whether he was personally involved in them.
Buffett’s only public comment on the AIG deal came on March 29, when Berkshire said that its CEO “was not briefed on how the transactions [between Gen Re and AIG] were to be structured or on any improper use or purposes of the transactions.” Reportedly, Buffett stuck to this position when questioned by officials from the SEC and Spitzer’s office. So, why not take Buffett’s word for everything and go along with Sptizer’s view that he should be viewed only as a witness? First, Spitzer’s motives may not align with good justice. Payback could be a partial motive: Berkshire’s lawyers have provided regulators with much material that has helped them corner Greenberg and AIG. The same material could be used against Berkshire, of course, but the case against Berkshire might be slightly more sophisticated, given that the company appeared to be providing the questionable insurance and not using it to improperly enhance its own financial statements.
Moreover, Spitzer’s tactic again and again has been to put recognizable figures in the spotlight and then leak like crazy to the media so as to try his targets in the court of public opinion and bully a settlement out of them. Buffett is way too popular with investors and “ordinary people” to make that approach easy; indeed, he may be one of the few sacred cows left in American capitalism. It is also important to recognize how far Spitzer has gone out on limb in classifying Buffett solely as a witness. A person familiar with the SEC’s stance said that the agency was not approaching Buffett merely as a witness and had not ruled out the possibility of the executive being a potential target. It is not often that the SEC takes a markedly tougher stance than Spitzer.
The AIG-General Re deal is clearly shaping up as Buffett’s word against that of Ronald Ferguson, the Gen Re exec who worked with AIG to put the deal together. Buffett says that he did not know the details of the deal, but the Washington Post, citing an unnamed regulatory source, says that Ferguson has testified that he gave Buffett details of the deal. No outsider to the deal or the investigative process can know who is right. But it is noteworthy that Buffett reportedly did tell regulators that he and Ferguson did discuss Greenberg’s alleged desire to boost reserves. Buffett knows that if an insurance company wants to boost its reserves, it just goes ahead and boosts them. Of course, that usually means a hit to earnings and capital. So eyebrows should be raised as soon as any insurer expresses the desire to boost reserves without taking any real dent in its income statement or balance sheet.
It is also a mistake to get too wrapped up in this one AIG deal. There are other Gen Re transactions that will be looked at in due course. There is no indication yet of Buffett’s involvement in these, but regulators have not really delved deeply into these. However, there is a wealth of detail available on a 1998 deal that National Indemnity, another Berkshire subsidiary, did with a shaky Australian financial company called FAI. The transaction made FAI look far healthier than it was. FAI was then bought a few months after the National Indemnity deal by another Australian insurer, HIH, which later crashed, in part due to the hidden weaknesses at FAI. An Australian government report shows in meticulous detail the role National Indemnity played in the FAI deal, and this deal could come under the SEC’s scrutiny.
While it is still debatable whether Buffett himself will end up in real trouble, it is hard to argue that Berkshire will not get penalized in some way. Its role in helping AIG carry out an apparently improper deal is really no different from the roles that J.P. Morgan, Citigroup, and Merrill Lynch played in allegedly providing Enron with products that allowed the failed energy giant to make its financial statements look stronger than they were. The SEC obtained highly embarrassing settlements from each financial institution in connection with the products they provided to Enron.
And it is not even certain that Berkshire has been accounting for its finite deals properly. The Wall Street Journal last month reported that Gen Re’s lawyers have said that the unit accounted for the AIG transaction properly. But how does an insurance company account for a deal that is not really insurance, as appears to have been the case with the AIG-Gen Re deal? The onus is on Berkshire to walk us through this, especially as Buffett has called for transparent financial statements in the past. If the finite deals are found to be improper, this might prompt restatements, which would be highly damaging to Berkshire and Buffett.Link here.
Spitzer crusade grabs Greenberg, bypasses Buffett.
Why is New York Attorney General Eliot Spitzer, who has not shown any signs of backing away from a fight so far in his one-man crusade to reform corporate America, not going after Warren Buffett with the same relish he seems to have pursued Maurice “Hank” Greenberg? The difference in Spitzer’s attitude to the two is fascinating and puzzling, given that Buffett’s company, Berkshire Hathaway, was on the other side of the transaction that cost Greenberg his job as chairman and chief executive officer of American International Group, the world’s largest insurer.
While Buffett “is not a subject or a target of our investigation”, Greenberg is “a CEO who did not tell the public the truth” and might face a civil or criminal case, Spitzer said on ABC television on April 10. Buffett was interviewed by regulators the following day. Buffett would be a formidable adversary even for Spitzer, who plans to run for the New York governor’s office in elections next year. A poll of voters published Feb. 10 showed he would beat the current chief, George Pataki, by 54% to 30% if Pataki sought a fourth term. Would Spitzer risk hurting his ratings by pursuing the Sage of Omaha? Buffett has been an outspoken critic of corporate malfeasance with a reputation for living a humble, simple existence characterized by straight talk and cheeseburgers. He holds a special place in the affections of U.S. retail investors, who dream of replicating his investing acumen.Link here.
Already, consumer spending is showing signs of fatigue, even though the rising rate cycle is barely out of diapers. The Commerce Department just reported that retail sales, excluding auto and gasoline sales, FELL in March. Even more troubling, general merchandise store sales dropped 0.7%, while clothing store sales tumbled nearly 2%. Also crossing the tape on Wednesday came word that Harley Davidson failed to sell as many “Hogs” as anticipated last quarter, which prompted management to lower its sales forecast for the rest of the year. The stock plummeted about $10 on the news. Rising interest rates – it is no secret – often slow economic activity, including the economic activity of riding brand new Harley “Road Kings” off the showroom floor. But we suspect the upcoming cycle of rising rates – a cycle that appears to be underway already – will do more than SLOW activity, it might halt activity as abruptly as an oncoming tractor-trailer halts a “Road King”.
Thus far, the effects of rising rates during this particular economic cycle have been more than offset by the ingenuity of mortgage lenders. The proliferation of adjustable-rate mortgages, and more recently, interest-only mortgages, have enabled homebuyers to buy much more home that they could otherwise afford. The resulting low mortgage payments have enabled many folks to buy more baubles and gadgets from American retailers than they could otherwise afford. But this seeming prosperity is contingent upon interest rates behaving themselves. As rates rise, our “Ownership Society” becomes an “Income-Deficient Society” that struggles both to meet mortgage payments and to maintain consumer spending. “Adjustable-rate mortgages are the new thing, interest-only hybrid ARMs, the new-new thing,” observes James Grant, editor of Grant’s Interest Rate Observer.
No surprise then the trend-setting state of California is setting the mortgage trend as well. Nearly half of all California mortgages are of the interest-only variety, up from almost none four years ago. The rest of the nation is rapidly adopting California's home-financing fashion. Adjustable-rate mortgages now account for a record-high 36.6% of all American mortgages. Therefore, as long as interest rates remain near 40-year lows, adjustable-rate mortgages will continue to provide the joy of home ownership at affordably low interest rates. However, if interest rates continue to rise, adjustable-rate financing will impart the misery of mortgage servicing at unaffordably high rates.
Unfortunately, California’s trend-setting mortgage industry is setting a trend that may prove toxic for the nation’s retailers. That is because rising rates cause rising mortgage payments, which, all else being equal, cause falling discretionary spending. EZ credit terms only serve to increase the eventual risk to consumer spending. In other words, money borrowed and spent today by marginal borrowers is, at best, money that will not be spent tomorrow. To be sure, not all holders of interest-only mortgages are skirting the edge of solvency, but we would guess that most are close enough to the edge that rising rates would force them to sharply reduce their discretionary spending.Link here.
AN ECONOMY ON STEROIDS
April is here, and baseball is back. The atmosphere surrounding baseball is not as light and joyous as it has been in years past, though. When Jason Giambi or Barry Bonds hits one over the fence this season, fans will wonder: Would he do that more often if he were still on steroids? The recent spate of CEOs on trial begs a similar question: When a company you have invested in reports “muscular” quarterly and year-end numbers, will you ask if they are real or on steroids? Steroids is a fitting metaphor for the new millennium: baseball players on performance-enhancing steroids, the U.S. economy on credit-enhancing steroids, and corporations on bottom-line-enhancing steroids. Look around and notice how just about everything is “juiced”, as baseball players like to say:
The markets, the economy, and corporations have become so used to performing on juice that they have forgotten how to perform normally. The main culprit supplying the juice is the Federal Reserve, which for three years pumped up the economy with incredibly low interest rates. And bankers and mortgage companies were more than happy to re-package the juice and sell it to consumers who gladly “stick” themselves. When the economy and the markets got pumped up in the past, we called them bubbles. But that word is oh-so-passé now, compared with the chemically enhanced version of pumping it up. Taking steroids for too long, though, takes its toll, and, eventually, you have got to get off of them. Then watch what happens to a baseball player’s homerun statistics, to corporate financial results, or to the markets’ trends.Elliott Wave International April 13 lead article.
TWO STOCK IDEAS WORTH INVESTIGATING
Valero Energy (NYSE: VLO) is the top U.S. processor of “sour” crude oil. Its ability to turn cheap, high-sulfur, heavy crude into gasoline and other top-end petroleum products is what has spelled success for the company. While other refiners typically compete for pricier “light, sweet” crude that requires less effort to turn into gasoline, Valero tooled its refineries to run a higher percentage of viscous, smelly, sour grades. A year ago, a barrel of sour crude from Saudi Arabia sold at a $4.50 discount to benchmark West Texas Intermediate, a light, sweet crude. That discount has since nearly tripled to $13.20 a barrel. Company CEO William Greehey, has been stating, in very clear English, that his company will earn more than Wall Street expects over the next couple of years. At 10 times estimated “worst case” 2005 earnings, the stock is arguably still cheap, notwithstanding that it has more than tripled in less than two years. More analysis here.
Bandag Inc. (NYSE: BDG), has a dominant 45% of the retreaded truck tire market. Retreaded tires get about the same mileage as new tires, but at only about 25% of the cost – $100/tire vs. $400. At 18 tires per truck this is no small difference. According to the Tire Retread Information Bureau, it takes about 22 gallons of oil to make a new truck tire, while retreading a tire requires only 7 gallons. The blowouts that you sometimes see on the road are almost always due to internal damage to a tire’s steel casing and not to loose-fitting retreads. Nonetheless, it takes quite a bit of craftsmanship and precision handwork to make a safe, quality retreaded tire. Bandag’s process creates a higher-quality retreaded tire with better performance characteristics, and its products sell for higher prices than many of its competitors’.
Bandag has a rock-solid balance sheet, with cash balances greatly exceeding total debt, which will it see it through tough times and allow it to make good investments and take advantage of opportunities. Selling at between 12 and 13 times 1995 earnings estimates, and below the price it sold for in 1993, if the company can grow 10-15% over the next several years it looks pretty cheap. More analysis here.
A SURPRISING SOLUTION TO HIGH OIL PRICES
It is clear the demand for oil is only going to rise, just based on China alone. When you factor in India and the rest of Asia, there is a real potential for global demand to out-produce near term potential supply. Any increase in demand over supply by 2 million barrels a day will ultimately mean much higher oil prices. Now let us be clear that nobody really knows how high oil prices will go in the rest of this decade. Personally I think that a rise to $70 oil would start to negatively impact the American economy, and increase the likelihood of a recession. The U.S. recession will affect the rest of the world negatively, and thus we should see a drop in the price of oil.
But there are numerous unpleasant political possibilities. Some of the less stable oil-producing parts of the world could seriously, even if temporarily, spike the price of oil to $100. Anything is possible, but not everything is likely. While I do think we will see $100 oil in the coming decades, I would be surprised if we see it that high in this decade. Ironically, in my opinion, $100 a barrel oil is the solution for high oil prices. Has anybody noticed that ethanol is selling for less than unleaded gas on the futures market? Today, unleaded gas on the futures market is $1.66. Ethanol June futures are “only” $1.21. In the future, it may be cheaper to run you car on environmentally-friendly emissio–free ethanol. And yes, I know the government subsidizes ethanol. But a $0.45 differential is huge. Who would have thought that would be the case five years ago?
Dennis Gartman tells me the Athabasca Sand Tars in Canada is roughly three Saudi Arabias. They can now get oil out of the sand at a cost of roughly $11 a barrel. In the future, instead of buying oil from OPEC we will grow it in Kansas and mine it in Canada. $100 oil will force market solutions for other energy sources and whole new industries and technologies. The Cassandras who predict that the world will run out of energy simply do not get it. Yes, we will eventually see oil production peak and then begin to fall. But it will not be a calamitous over the waterfall type of event. It will simply be a gradual lessening of production. That need for energy will be replaced by other energy sources. Such a change will be disruptive, but then most change usually is. That change will of course increase the number of potential opportunities for investors. This is a sector that I want to keep a close eye on.Link here (scroll down to piece by John Mauldin).
WE DON’T POP NO STINKIN’ BUBBLES
Some people just do not know when to stop making their point, like certain people who insist that certain other people should spend more time in the yard and less time in the garage. “More time bush hacking and less time arranging tools you don’t know how to use,” they say. More time weed eating and less time moving stuff around to make space for a motorcycle because “You are “never, never, never going get one of those things,” they say. Point taken. Again.
The Federal Reserve is just as redundant, although at a lower volume. Just a few days ago Fed Governor Edward Gramlich told attendees at an economic conference that it is not the Fed’s job to worry about asset prices. According to Bloomberg’s John Berry, the Fed Governor said that Fed action to arrest asset bubbles “… would be a bad mistake” and that it qould “… often be destabilizing.” After an exhaustive 10 second search of the Fed’s website, a transcript of Gramlich’s comments was unavailable. But the proceedings probably went something like this:
Conference Host: “Good morning, and thank you for coming. It’s always good to attend a conference for economists because we all know that no productivity is being lost when a bunch of economists just sit around for a couple of days. So let’s get right to the speakers. Without any further decline in marginal utility, let me present Fed Governor Edward ‘Fast Eddie’ Gramlich.”
Gov. Gramlich: “Good morning and by the way, we don’t prick bubbles. Al has said it before and I am saying again. We don’t prick. We look at numbers and we vote, and sometimes we attend conferences like this. But we don’t prick. We just don’t do it. Now, let us move on to my PowerPoint presentation titled ‘Asset Based Lending and the Home Equity Loan Explosion’.”
Or maybe not. But the point is, the Fed seems a little touchy just because it failed to address the biggest stock market bubble in World History, and appears even touchier about its current “no prick” policy despite the biggest real estate mania since there was such a thing as a Savings & Loan. Bloomerg’s Berry deserves credit for his fine reporting because he did locate one conference attendee who said that it was possible to identify bubbles because, after all, there are all sorts of economic distortions associated with the darn things. That heretic was Stephen G. Cecchetti, a former research director at the New York Federal Reserve Bank. Now that Cecchetti is no longer bound by the “No Prick Oath”, he wondered if consumers could get a “false impression of wealth” and load up on debt.
Besides, the Fed not taking responsibility for asset bubbles is like an animal trainer who will not take responsibility for what happens to the wait staff when he takes his tiger to a vegetarian restaurant. Who do they think is blowing up these bubbles, a desperate Farrah Fawcett?Link here.
DISMAL MONETARY SCIENCE
Why not assure monetary virtue by trusting, not in the monetary wisdom of men, but in an objective standard? Why not emulate our great grandfathers and tie our currency to gold? Very few economists think this would be a good idea. So few economists indeed, that it is a statistical oddity. It is all the more curious given the miserable record of the fiat dollar for the past 35 years while it has been trying to make do without a link to gold. What makes the loser the winner, and the winner the loser? My explanation is that the economists have been bribed. The bribe money can actually be tracked as the record is in the public domain. Please bear with me as it takes some time to relate this incredible story.
In the check-kiting scheme of the U.S. Treasury and the Federal Reserve banks, the latter are the junior partners. The allocation of the profits from the scheme is not on a 50-50 basis. The lion’s share goes to the senior partner. The junior partners must be satisfied with the crumbs. But crumbs are plentiful to throw a jolly good party still. Why complain when the FR banks themselves can set the amount at which the “tax” is assessed? They are free to subtract any and all expenditures on frills before they come to the bottom line, undivided surplus.
And spend on frills they do. One item listed as legitimate expenditure is money subsidizing economic research. It is a big item, covering not only inhouse research, but also research grants paid to outsiders on contract at various universities and think-tanks. Now please estimate, if you will, the percentage of research funds that goes to economists analyzing the failure of the fiat dollar and studying the possibility of return to the gold standard as a remedy. You have got it: zero. From the point of view of the FR banks, the more money they spend on subsidizing economic research the less tax they pay. So funds are gushing forth abundantly, and are granted generously to subsidize research in dismal monetary science, taking good care to shut out any dissonant noise about the gold standard.
It should be clear that the funds dished out by the research departments of the FR banks are bribe money subsidizing dismal monetary science exclusively, having precious little to do with the search for and dissemination of truth but designed to entrench and aggrandize incumbent power. Small wonder that so few economists dare to express views that the regime of irredeemable currency is a disaster of the first magnitude, leading to an economic catastrophe worse than that following the experiment with fiat money in France at the end of the 18th century, admirably documented by Andrew Dickson White. Very few economists would express their view in public that tying the dollar to gold is the answer.
Consider once more how profitable the check-kiting scheme between the Treasury and the FR banks is. The latter can buy off an entire profession from the crumbs and trickle-down profits, and still have money left to award to economists from other countries willing to parrot the Keynesian demand-side theory of money. This goes to show the utter insidiousness of the regime of irredeemable currency. Not only does it allow vampirism plaguing the savers and producers of society through check-kiting while throwing the gates wide open to vote-buying by politicians, it also corrupts the mind and frustrates any impartial discussion of the underlying scientific principles. Irredeemable currency is cancer on the body economic, body politic, and body academic as well.
One of the more imbecile ideas of dismal monetary science is that devaluation of the currency helps the country to export more and import less, thus rectifying the trade imbalance. It is absolutely amazing that economists do not find it repulsive to parrot this trash, apparently on order from the grant departments of the FR banks (in whose interest the policy of currency debasement clearly is). In 1968, the exchange rate with Japan was around 320 yen to the dollar and there was a huge trade deficit run up by the U.S. To rectify it, a dollar-debasement policy was put into effect promising that it would cure the deficit and turn it into a surplus. In the next 10 years, the value of the dollar was pushed all the way down from 320 to 80, while the trade deficit – instead of turning into a surplus – ballooned tenfold. The question arises, how much more beating does the dollar have to take before a dent is made in the trade deficit?
The explanation for the perverse reaction of the patient to Keynesian therapy as advocated by dismal monetary science is actually quite simple. Naturally, it was never permitted to be publicized by the award-officers at the FR banks. Currency devaluation makes your terms of trade with the rest of the world deteriorate. This means that you can import less for every dollar of export earnings as a result of devaluation. Virtually all export items have imported ingredients, so devaluation makes them more expensive to produce, not less. While it may let you sell your existing inventory at bargain-basement prices to foreigners, this is a fool’s paradise. The boost in exports is strictly temporary.
Currency devaluation is not unlike self-mutilation. You do not cut off one of your arms while trying to compete with foreigners in the world market. Yet this is exactly what America has done to itself. The country’s deindustrialization is the direct result of the deliberate debasement of the dollar for the past 35 years. You have to pursue the argument of dismal monetary science ad absurdum to understand it. If a little bit of devaluation is supposed to be good for the country, then a big devaluation should be even better and, reducing the exchange rate to zero, Nirvana itself. Then the country could give away its goods and services to foreigners free of charge. That, finally, will really perk up exports.Link here.
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