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I am a gold bug. A gold bug is a believer in the public’s use of gold coins as the basis for a nation’s money supply. Because very few university-certified economists are gold bugs, and very few gold bugs are academic economists, there is enormous confusion on all sides regarding gold – why it is valuable, why it serves as money, why gold money is necessary for freedom, and why we do not need a government-guaranteed gold standard in order to have a gold standard. I begin with a recent observation by Hans Sennholz, the dean of the Austrian School of economics:
Money is no yardstick of prices. ... There is no true stability of money, whether it is fiat or commodity money. There is no fixed point or relationship in economic exchange. Yet, despite this inherent instability of economic value and purchasing power, man is forever searching for a dependable medium of exchange.
The precious metals have served him well throughout the ages. Because of their natural qualities and their relative scarcity, both gold and silver were dependable media of exchange. They were marketable goods that gradually gained universal acceptance and employment in exchanges. They even could be used to serve as tools of economic calculation because their quantities changed very slowly over time. This kept changes in their purchasing power at rates that could be disregarded in business accounting and bookkeeping. In this sense, we may speak of an accounting stability that permits acting man to compare the countless objects of his economic concern.
We can hope for usable price stability over the time period of accounting, but if we seek to establish a fixed-value currency, we will gain only government-issued money and monetary instability. So, the goal of price stability is an illegitimate goal. All that we can legitimately hope for is loose predictability of those specific prices that affect us as individuals, so that we can make accurate plans for the future. Any attempt by the government or its agent, the central bank, to attain general price stability is inherently self-defeating.
First, what matters is not some committee’s official price index, but rather specific prices as they affect acting individuals. To get the official national price index to stabilize, the planners must raise some prices, which would otherwise have fallen, and reduce some prices, which otherwise would have risen. This is beyond any committee’s ability to forecast or administer. Second, even if politics did not intrude – which it will – the central planners of money will be forced to adjust the money supply to the committee’s central plan. The wisdom of this market-insulated bureaucracy’s central plan will not match the combined wisdom of forecasters and entrepreneurs in an economy that has a gold coin standard.
If you have taken my free email course on gold, “The Gold Wars”, you understand the basics. To summarize, there is a naïve view of gold that teaches that the price of gold does not vary, whereas the value of paper money varies. Sennholz is arguing against this view. The price of every good and every service varies as supply and demand conditions change. There is no fixed standard. When you buy a gold coin – which I suggest you do – you should not do so on the expectation that its price will automatically rise when the dollar falls in value.
Gold bullion was an illegal investment for Americans from 1933 through 1974. This reduced the demand for gold. Gold’s price did not change on international markets from 1934 to 1967. People made money buying collector gold coins from 1967 to 1974. Then gold fell by almost 50% in 1975–76. Only after September, 1976, did it soar – from $106 to $850 for one day in January 1980. After that, it became a very bad investment until 2001. It was then that I began promoting gold once again. Yet year after year, 1934 to 2006, the dollar has depreciated. Decade after decade, the Federal Reserve System has created money to buy U.S. government debt, thereby lowering the purchasing power of the dollar, as estimated in terms of various official price indexes, private and governmental.
Anyone who bought collector gold coins after 1933 or gold bullion coins in 1973 lost money most of the time. There was a brief period of high profits, from 1975 to late 1979, but the losses sustained after mid-January, 1980, were horrendous. I repeat all this because I want readers to recognize the nature of gold. It is a hedge against serious and generally unexpected monetary inflation. But the investing public remains unfamiliar with gold. The big brokerage firms downplay gold. Gold and silver were bubble markets, 1975–1979. They popped in January, 1980. In terms of purchasing power, gold at $600 today is the equivalent of gold at $250 in 1980. But gold peaked at $850 in 1980. It will take unexpected and extensive monetary inflation to create a comparable boom in gold.
The case for gold is the case against the civil government’s manipulation of the money supply. Today, gold has been demonetized for everyone except central banks. Large nations’ central banks do keep some gold reserves as the legal basis of their nations’ currencies. But government bonds make up the bulk of central bank reserves – their national debt and foreign governments’ (mainly U.S.) debts. The fall in value of the dollar against the euro began in January 2002. The move upward of gold had begun in the previous quarter. People forget how long this decline of the dollar has been going on.
Gold peaked at $725 on May 12, 2006. The fall of the dollar against the euro has been attracting attention in recent months. If you follow the monetary statistics, you are aware that the crucial statistic, the adjusted monetary base, has barely moved since February. The other monetary indicators have also fallen from their highs late in 2005. Bernanke’s Federal Reserve has put on the monetary brakes. The fact that gold is down against the dollar since the May high is consistent with the Fed’s policy. What has surprised people is the fall of the dollar against the euro. This tells us that there is no one-to-one correlation between monetary policy and prices. At best, there is a broad correlation. Gold rose, 2001–2006. The euro rose, 2002–2006. But they did not rise in a straight line.
The dollar will decline. Of that, I am confident. At some point, it will begin to decline much faster than it is declining today. When that era comes, gold will be a fundamental investment to buy and hold. It will preserve purchasing power. We must not be naive about gold’s potential during an era of relative monetary stability, which we are in today. The Fed can shift back to inflation at any time. But Bernanke will resist this. He has bet his new career on fighting price inflation. He says that price inflation is too high. Yet the CPI, year to year, is under 2%. The Median CPI is under 3%. He will pressure the Board of Governors to accept a monetary policy that keeps all of the official price indexes under 2%.
When this monetary policy produces a recession, there will be great pressure put on him by Congress to lower interest rates to get the economy out of the doldrums. At that time, we will see how committed the Fed is to Bernanke’s litany about inflation being too high. But we had better take him seriously when he says that prices are rising too much.
Because of the war, which is not going away in 2007, gold should be in everyone’s portfolio. But because recession looks increasingly likely in 2007, the case for gold as an inflation hedge looks much less relevant. Long-term, the case for gold is the case against central banking. But central bankers have managed to gain power over money for over three centuries. Whenever they attain their goal, as they did in December 1913, they have not surrendered this control. As the government’s debt obligation increases, the politicians will look to the Fed to buy the debt with fiat money. But, in 2006, the Fed has bought almost no debt. It will take a lot of political pressure to force the Fed to create a sufficient amount of fiat money to get a replay of the bubble market of 1976–1979. Assume this when you buy gold.Link here.
FIAT MONEY: HISTORY REPEATS ITSELF
There is nothing funny about the potential for trouble as today’s purely paper dollar declines. It is trouble that has happened before, and history is, or should be, our best teacher. But as we will see, mankind seldom learns and rarely remembers enough from its mistakes.
One of the most riveting accounts of the catastrophic effects of replacing a gold-based or silver-based currency with paper money comes from Andrew Dickson White (1832-1918), the diplomat, author and educator who co-founded Cornell University. In the mid-1800s, White started to collect and analyze newspaper articles and documents that had appeared during the French Revolution, especially those pertaining to the Revolutionary issues of paper money. In 1912, he published Fiat Money Inflation in France, an essay that these days, once more, has gained a striking timeliness.
In 1789, on the eve of the French Revolution, the French government found itself in deep trouble with heavy debt loads and chronic deficits. A general lack of confidence in the business world had led to the decline of investment, and the economy was stagnating. “Statesmanlike measures, careful watching and wise management would, doubtless, have ere long led to a return of confidence,” writes White, “a reappearance of money and a resumption of business; but these involved patience and self-denial, and, thus far in human history, these are the rarest products of political wisdom. Few nations have ever been able to exercise these virtues; and France was not then one of these few.”
Instead, as politicians tend to do, France’s National Assembly looked for a shortcut to prosperity, and soon calls for the introduction of paper money were heard. Some prudent individuals, such as then-Minister of Finance Jacques Necker, urgently warned against it. After all, only 70 years earlier, the country had learned a tough lesson when Scottish economist John Law had presided over a system of fiat money with ruinous consequences. But Necker and his supporters were shouted down as “the pressure toward a popular currency for universal use grew stronger and stronger.” The plan sounded sensible. The government would confiscate the lands of the French Church – which then owned between 1/4th and 1/3rd of all French real estate – and issue a total of no more than 400 million livres in large notes of 1,000, 300 and 200 livres, called assignats, that would be backed by a piece of land. Moreover, every note would bear 3% interest, to encourage holders to hoard them.
The influx of fresh money would give the French treasury “something to pay out immediately ... relieve the national necessities ... stimulate business ... [and] give to all capitalists, large or small, the means for buying from the nation the ecclesiastical real estate.” From the proceeds, the nation would pay its debts and obtain new funds for new necessities – a bullet-proof proposal, or so it seemed. At first, the results of issuing the assignats appeared to be a dream come true, says White: “the treasury was at once greatly relieved; a portion of the public debt was paid; creditors were encouraged; credit revived; ordinary expenses were met. . . trade increased and all difficulties seemed to vanish.” Had the authorities stopped there, White suggests, the effects might actually have been beneficial. Regretfully, though, “within five months after the issue of the four hundred million in assignats, the government had spent them and was again in distress.”
Immediately people throughout the country started to cry for another issue of notes. Paper critics cautioned that there would be no stopping once the nation had stepped onto the slippery slope of inflation, but others dismissed the warning, saying “the people were now in control and that they could and would check these issues whenever they desired.” Here is where the disturbing parallels to modern-day America begin.
By 1790, the paper-pushers had persuaded themselves that specie (precious metals, coins) was an outmoded form of currency ... after all, what could be better than money backed by land that would only appreciate in value? It eerily reminds us of the U.S. housing boom and the easy, no-holds-barred mortgage deals that have been sold to sub-prime borrowers. It was a done deal, and France began its slide into inflation ...
The resulting hyperinflation hurt the rich, but it absolutely devastated the working class. According to historian Heinrich von Sybel, “Financiers and men of large means were shrewd enough to put as much of their property as possible into objects of permanent value. The working classes had no such foresight or skill or means. After the first collapse came up the cries of the starving. Roads and bridges were neglected; many manufactures were given up in utter helplessness.”
Unbelievable ... and a great lesson for us. Interpreting and comparing the signs – the stagnation in real wages, the public’s unfettered euphoria about the already faltering economy, the nearly word-for-word pep talks spanning centuries – we may be closer to the point of no return than we think. And do not make the mistake to think those French politicians were morons, warns Andrew Dickson White. “[The] men who had charge of French finance during the Reign of Terror and who made these experiments, which seem to us so monstrous ... were universally recognized as among the most skillful and honest financiers in Europe ... [which shows] how powerless are the most skillful masters of finance to stem the tide of fiat money calamity when once it is fairly under headway; and how useless are all enactments which they can devise against the underlying laws of nature.”Link here.
WORLD ECONOMY AT RISK FROM CHAOS OF BUSH REGIME
The world survived 2006 without a major economic catastrophe, despite sky-high oil prices and a Middle East spiraling out of control. But the year produced abundant lessons for the global economy, as well as warning signs concerning its future performance.
Unsurprisingly, it brought another resounding rejection of fundamentalist neo-liberal policies, this time by voters in Nicaragua and Ecuador. In neighboring Venezuela, Hugo Chávez had an overwhelming electoral victory: At least he had brought some education and health care to the poor barrios, which previously had received little of the benefits of the country’s enormous oil wealth.
Perhaps most importantly for the world, voters in the U.S. gave a vote of no-confidence to President George Bush, who will now be held in check by a Democratic congress. When Bush assumed the presidency in 2001, many hoped he would govern competently from the center. More pessimistic critics consoled themselves by questioning how much harm a president could do in a few years. We now know the answer – a great deal. Never has the U.S.’s standing in the world’s eyes been lower. Basic values that Americans regard as central to their identity have been subverted. The unthinkable has occurred ... an American president defending the use of torture. Likewise, whereas Bush was hailed as the first “MBA president”, corruption and incompetence have reigned under his administration.
The Middle East chaos wrought by the Bush years also represents a central risk to the global economy. Since the Iraq war began in 2003, oil output from the Middle East has not grown as expected to meet rising world demand. Although most forecasts suggest oil prices will remain at, or slightly below, present levels, this is largely due to a perceived moderation of growth in demand, led by a slowing U.S. economy.
Of course, a slowing U.S. economy constitutes another major global risk. At the root of the U.S.’s economic problems are measures adopted early in Bush’s first term. In particular, the administration pushed through a tax cut that largely failed to stimulate the economy. The burden of stimulation was placed on the Federal Reserve, which lowered interest rates to unprecedented levels. While cheap money had little effect on business investment, it fuelled a real estate bubble, which is bursting, jeopardizing households that borrowed against rising home values to sustain consumption. This economic strategy was not sustainable. Higher interest rates and falling house prices do not bode well for the U.S. economy. According to estimates, roughly 80% of the increase in employment and almost two-thirds of the increase in GDP in recent years stemmed directly or indirectly from real estate.
Making matters worse, unrestrained government spending further buoyed the economy during the Bush years, with fiscal deficits reaching new heights, making it difficult for the government to step in now to shore up economic growth as households curtail consumption. Meanwhile, persistent global imbalances will continue to produce anxiety, especially for those whose lives depend on exchange rates. Though Bush has long sought to blame others, it is clear the U.S.’s unbridled consumption and inability to live within its means is the major cause of these imbalances. Unless that changes, global imbalances will continue to be a source of global instability, regardless of what China or Europe do.
In light of these uncertainties, the mystery is how risk premiums can remain as low as they are. With the dramatic reduction in the growth of global liquidity as central banks have successively raised interest rates, the prospect of risk premiums returning to more normal levels is itself one of the major risks the world faces today.Link here.
THE SLIDE INTO MANAGERIAL CAPITALISM
The SEC recently decided that executive stock options should be disclosed in the table of management compensation only over the life of the deal, not up-front. It knew it was being naughty, so it announced this the Friday before Christmas. Only the unsleeping vigilance of incoming House Financial Services Committee Chairman Barney Frank (D-Massachusetts), ever watchful for malfeasance among Republicans and big corporations, awakened the media to this new attack on shareholder rights.
Management and shareholders are natural opponents. Always have been, always will be. After an entrepreneur has constructed a company, and sold it to outside shareholders, subsequent management consists of hired hands whose main objective can easily become to appropriate as much of the shareholders’ property as possible. The SEC’s new rule assists management in this effort, since it enables it to disguise large stock option grants in the year they are given, reporting them only in later years when they will be regarded as “water under the bridge.”
Before 1929, most large corporations were still controlled by their founders, or by titans of finance such as J. Pierpont Morgan. In the 1930s and 1940s, the prevailing public ethic was so anti-business and the business climate so unpleasant that there were few examples of management malfeasance at the expense of shareholders. Even in the 1950s and 1960s the relationship between management and shareholders remained tolerable.
At that time many companies were still controlled by small groups of very wealthy individuals, while management was modestly rewarded but allowed an existence of country-club coziness. For a top manager in such an environment getting another job was very difficult, and ripping off shareholders involved potentially alienating people who might well prove to be more powerful than him, both socially and politically. With low levels of debt on most companies’ balance sheets and thus a relatively low-stress environment, most managers contented themselves with the psychic satisfaction of doing a good job for the shareholders. This was capitalism as it should be, and in 1947-73 it resulted in the highest productivity growth in U.S. history, far higher than anything since.
Since 1980, this has all changed. In the 1980s, allegedly sleepy managements were attacked by leveraged buy-out companies, who generally replaced management without providing it with particularly generous severance pay or other opportunities. Management resented this, and rightly so.
As well as the 1980s LBO boom and its associated denunciations of corporate management, a number of other factors affected the shareholder/management relationship at around the same time. Institutional shareholdings, which had represented around 15% of share capital in public companies in the 1950s, rose steadily after 1960 as high taxes, especially estate duty, and inflation decimated the capital of the wealthy while assets held in pension funds and mutual funds slowly built up. By 1980, institutional shareholdings in the S&P 500 companies exceeded 50% of share capital, a level they have maintained to this day. Thus the typical large shareholder is now a mid-level institutional money manager, with no long term commitment to the company beyond its share price performance, with no particular social or political power, and representing only a large group of faceless workers or small investors. Naturally, once shareholders no longer had non-financial power, management bad behavior at their expense was no longer socially or politically dangerous.
Another factor in management’s changing attitude was the Steiger Amendment of 1978, which widened the gap between income tax rates and capital gains tax rates, followed by the Reagan tax cut of 1981, which lowered the top rate of income tax. Before 1978, there was little advantage to a top manager in earning enormous sums either in income or capital. They simply attracted punitive tax rates. The Steiger Amendment and Reagan tax cut revived U.S. entrepreneurship and venture capital activity, as they were supposed to. They were equally effective in making existing corporate management greedier and less scrupulous.
This combination of factors caused management to entrench itself. The Delaware merger moratorium law of 1990 allowed mergers to be put on hold for 3 years unless approved by an 85% vote, thus effectively preventing hostile takeovers. In addition the “poison pill” defense was developed in the 1980s, by which “shareholder rights” are triggered by an acquisition of even a large minority of shares by a single holder. Both these provisions should have been struck down by the courts in a system that adequately protected shareholders. They have had the effect of entrenching management against both hostile takeovers and its own shareholders. Needless to say, the orgy of management remuneration followed, exceeded only by the inventiveness of management in devising new ways not to disclose such remuneration to shareholders.
Nothing in economic theory suggests that managerial capitalism of this kind works in the long run, or does anything except entrench a privileged class of corrupt apparatchiks. Adam Smith’s “invisible hand” by which participants in the economy, by exercising self-interest, increase the welfare of all is no longer operational, since management’s greatest self-interest arises from increasing the share of the corporate pie that can be diverted into its own pockets. Management can still enrich itself by doing a good job and maximizing shareholder value. However, since this involves competing against other able managers and capable companies, it is far less attractive and easy than several other methods of self-enrichment, including using various short-term measures to boost the stock price and the value of the options management has awarded itself, while indulging in creative accounting to hide how much it is paid, thereby deflecting possible shareholder outrage (the SEC, as mentioned, has now been very helpful to them in this endeavor).
If there are no controls on management embezzling shareholder property beyond management’s self-restraint, then we are no longer in a society in which property rights are respected. Barney Frank made this point in response to the SEC’s decision. Culturally and politically, I would never have expected to agree with Frank, but I do this time. Managerial capitalism is the system practiced in Boris Yeltsin’s Russia, under which the oligarchs made themselves billionaires by fraudulent privatizations of state property. There is no reason to suppose than a move to managerial capitalism in the U.S. will work any better than that did.
Needless to say, this change in environment has had the usual Darwinian effect in changing the nature of U.S. corporate top managers. Intelligence is no longer a particular asset, since its benefits are primarily long term. Thus only seven of today’s Fortune Top 50 CEOs went to top-tier colleges – an unimaginably small percentage a generation ago. Conversely, aggression is absolutely vital, particularly when combined with a lack of scruples. Higher stress and higher rewards in the executive suite have naturally resulted in behavior deterioration. Former Tyco CEO Dennis Kozlowski – he of the $6,000 shower curtain – a graduate of Seton Hall University now serving 8 to 25 years in jail, is the archetypal CEO of the modern era.
Solutions? There are not many. Institutional investors need to band together against management in shareholder votes far more than they do currently. Most important, every detail of management’s arrangements with the company needs to be put to a separate shareholder vote, as does the appointment of the auditors (as I have written previously, proposals to carry out audits should be presented to shareholders directly, not to management). The poison pill and merger moratorium laws need to be removed, if necessary by Constitutional amendment specifying that corporations must be run for the primary benefit of shareholders. This is all a long term proposition. Meanwhile investors should seriously consider alternative markets such as Japan, Germany or India, where their interests are better respected.Link here.
A warning shot by investors to boards and chiefs.
Arrogance has never been attractive in a leader. Now, in corporate chief executives anyhow, it may be a career ender. The surprising defenestration of Robert L. Nardelli, head of Home Depot and one of the nation’s most imperious and highly paid chief executives, was a victory for shareholders hoping to force corporate directors to be more accountable on the increasingly incendiary issue of executive pay. Even though the board gave him $20 million that was not a part of his employment contract, perhaps smoothing his way out the door, the departure seemed to be a watershed. No longer can executives demand – and directors happily grant – contracts worth hundreds of millions of dollars without at least some shareholders uttering a peep.
Indeed, Mr. Nardelli’s resignation seems to indicate a rising fear among Home Depot’s directors that they would be subject to even more investor ire and personal embarrassment during the 2007 proxy season than they encountered in 2006, when Mr. Nardelli ran the annual shareholder meeting like a lord over his fief. “The departure of Nardelli is good news for shareholders,” said Frederick E. Rowe Jr., a money manager in Dallas and president of Investors for Director Accountability. “To borrow from Winston Churchill, this is the end of the beginning in the war to make directors accountable to the shareholder owners they represent.”
Mr. Nardelli’s fall from the executive firmament was fairly stunning. In just six years, he went from being one of the most sought-after chief executives, forged in the management crucible that is General Electric, to a top target of investors outraged by his $245 million in total pay over the last five years. That amount was seen as completely at odds with the dismal performance of Home Depot stock on his watch. The day he was fired the shares closed at $41.07, almost 6% lower than they were the day Mr. Nardelli arrived. Shareholders have been smoldering for several years about the company’s executive pay practices. Back when Mr. Nardelli arrived, for example, shareholders raised eyebrows after the company granted him a $10 million loan that it subsequently forgave. He has earned $20 million to $37 million each year since he joined the company.
In 2004, the company quietly changed the measurement it used to calculate long-term incentive pay for executives, upsetting investors when they learned of it later. Previously, the performance measure was based on a peer-group comparison, but the new measure involved only the company’s growth in earnings per share. It was more easily reached because it was based solely on Home Depot’s performance not that of other companies. To some shareholders, changing the performance target in the middle of a year seemed an attempt to ensure a payout despite a dismal performance. “[S]hareholders don’t get to change the terms under which they bought their shares midstream,” said Bess Joffe, manager for the Americas at Hermes Investment Management, a money management firm owned by the British Telecom Pension Scheme.
But it was not until last year that Home Depot’s shareholders began to express serious disenchantment with the company’s directors over Mr. Nardelli’s pay. Last March, the board was named one of the 11 worst executive pay offenders by the Corporate Library, a corporate governance research firm. In the weeks leading up to the meeting in May, shareholder advisory firms recommended withholding votes from directors to voice their dismay over the disconnect between performance and pay at the company.
But Mr. Nardelli’s biggest error, and the act that may have set his demise in motion, was his shocking decision to run the annual meeting alone, insisting that his directors stay away and limiting questions from the shareholders. Stockholders were outraged. At least 30% of shareholders voting at the meeting withheld support from 10 of the company’s directors. Some 32% withheld support from Mr. Nardelli. Almost 36% withheld support from the director who had headed the compensation committee when the company changed its performance goals midstream.
It seems that “my way or the highway” – Mr. Nardelli’s message to Home Depot’s beleaguered shareholders in recent years – does not play that well anymore.Link here.
NEW YEAR’S REVOLUTION
“The dollar’s weakness is definitely a factor for stocks right now. The good news is we don’t think it will get much worse from here.” ~~ Elizabeth Weymouth, global investment specialist, J.P. Morgan.
The world’s dollar-holders are in the process of revolting against the dollar’s reserve currency status. So far this “quiet revolution” has caused very little blood-letting ... and very little consternation in the U.S. financial markets. But as the revolution progresses, things might get a little bloodier.
The human mind is often quick to dismiss impending disaster. “It’s not so bad,” we humans seem so quick to tell ourselves. Like the officers on the deck of the Titanic meeting to report to the captain. “Ah yeah, small rupture in the hull,” they say. “Definitely a factor. The good news is we do not think it will get much worse from here.” Or like Napoleon’s great push into Russia. His normally reliable marshals gather after the first snowstorm. “Yes, the snow will slow us down. Definitely a factor,” they say with a certain nonchalance, drawing their cloaks in closer. “The good news is we do not think it will get much worse from here.” And so it is with the dollar. The market seemed to shrug it off, “Just a flesh wound. Rub a little dirt on it and keep going.”
I had to chuckle when I read Weymouth’s precise forecast. According to the Journal, “Ms. Weymouth says her firm expects the dollar won’t fall much below 74 European cents in the next few months.” What is the dollar worth now, after the most recent bloodletting? A mere 76 European cents – down 10% in 2006 and at lows not seen since March 2005. Not a lot of room for error in that forecast. And what proprietary measures went into such a forecast? A bunch of highly compensated individuals sitting around a room tossing out guesses? “Well, it is at 76 cents now,” someone says. “Let’s say it will not go below 74 cents.”
The prestigious Financial Times offered its own upbeat thoughts on the dollar. The old editorial crew, though, must have been out to lunch at the local pub. The headline boldly declared, “A Lower Dollar Helps the Global Economy.” Wow! So why not just obliterate the dollar and grind it to powder? Let’s keep making the dollar worth less and less. Oh wait ... we are already doing that.
The surest bet in all of finance is that the dollar will lose value over time. The dollar’s value has dropped more than 95% since the creation of the Federal Reserve in 1913, which is very ironic when one considers that the Federal Reserve is the government agency responsible for safeguarding the dollar’s value. Ever since the severance of the link between the dollar and gold in 1971, dollars are no harder to create than pressing a few buttons. Of course, the picture is more complex than “strong dollar good” and “weak dollar bad”. There are nuances ...
Let us think about the consumer. The average consumer labors under higher energy prices on the doorsteps of winter. He works to stay ahead of rising costs for health care and medicines. The stock market, despite recent strength, is not much higher than it was six years ago. So no help from the old portfolio. Plus, as we have seen, the consumer finds his house is suddenly not worth as much as it was last year. For years, every time the homeowner wanted a few extra bucks, he simply refinanced and “extracted equity” from his house. But today, he finds there is not much equity left to extract. And now he finds his dollars do not go as far as they once did. Buying the stuff that the rest of the world makes costs more today than it did last year. The slide in the dollar, therefore, is a tax on the purchasing power of American consumers.
However, there are a few folks who benefit from a weaker dollar – mostly foreign tourists and U.S. exporters. Not that the euro is such a hot currency. It is the dollar’s sickly sister. What is to like about the euro? It, too, is a product of governments – none of which can control how much they spend. Some might make the case that the European economies are stronger than America’s. Perhaps.
But in the matter of paper currencies, it is mostly a race to the bottom. Eventually, all paper currencies find their true level at the zero mark. That is bad news for dollar-holders, but good news for the holders of gold, commodities and tangible assets of all sorts. We are tempted, therefore, to say, “Join the New Year’s revolution. Sell dollars. Buy tangible assets.”Link here (scroll down to piece by Chris Mayer).
WALL STREET SPIN-MEISTERS ARE AT IT AGAIN
To quell investor concerns during the inflating dotcom bubble, Wall Street offered soothing commentaries from analysts such as Henry Blodget, Jack Grubman, and Mary Meeker, that explained why the “old economy” rules no longer applied. The latest twist on this “black is white” spin was offered by Bear Stearn’s chief economist David Malpass, who in a recent editorial in The Wall Street Journal outlined why in the new global economy borrowing and spending, rather than savings and production, are the true engines of economic strength. Just as Blodget and the gang tried to justify ridiculous valuations for profitless internet stocks, Malpass uses similar logic to justify why America’s enormous trade and current account imbalances are good for our economy.
Back in the 1990’s, corporate losses were touted as evidence of a bright future. We were told it was a cyber “land-grab” where eyeballs and page views replaced sales and earnings. The calculations were necessary to keep the IPO spigots open and Wall Street profits flowing. Just as red ink was supposedly a sign of strength in the dotcom era, Malpass now tells us that America’s gargantuan trade deficits and its lack of domestic savings and real goods production are actually signs of its growing economic might. Investors who buy into this nonsense will suffer the fate of those who bought shares of pets.com.
To rationalize why trade deficits can be a good thing, Wall Street is pointing to the seemingly positive benefits of the “capital account surplus” that mirrors the deficit. “Surpluses” are good, right? However, having a surplus of bad things, such as poverty, hunger, crime, etc, is not a good thing. Capital account surpluses reflect the sale of American assets, such as real estate, stocks and bonds, to foreigners, that in turn represent future obligations in the form of rents, dividends, and interest. A capital account surplus is really a surplus of liabilities. This is not a good thing. If our capital account surplus is good then by extension Japan’s capital account deficit must be bad. Does Wall Street really expect us to believe that a nation is better off being a debtor than a creditor?
The situation is analogous to a consumer justifying his purchase of a big screen TV on credit because it is offset by his rising debit balance. The bill the consumer eventually gets is in effect a statement of his capital account surplus. By running a trade deficit with the electronics store, the consumer simultaneously runs a capital account surplus with the retailer as well. He gets their big screen without paying for it (his trade deficit) and the retailer gets his IOU in exchange (his offsetting capital account surplus.)
A corollary to this argument is that America’s capital account surplus exists because returns on American assets are superior to those available elsewhere. This difference supposedly induces foreigners to sell us their products so they can earn the money necessary to invest in our assets. This ignores the fact that for the past seven years U.S. markets have underperformed just about every other market in the world. Also the vast majority of the capital account surplus consists of bonds, the majority of which are being purchased by foreign central banks precisely because private investors do not want the lousy returns they offer.
The dangers of America’s trade deficit have been a common refrain in my past commentaries. Rather than repeating myself here I refer to my commentary from March 2005 entitled “Even Stephen Roach has it Wrong”. In addition, I completely debunk the myth of global dependence on American consumption in my forthcoming book entitled “Crash-Proof”. As you ring in 2007 why not resolve to protect your wealth and preserve your purchasing power before it is too late.Link here.
PRIME NEW YORK NEIGHBORHOODS OVERRUN BY BIG BANK LOCATIONS
Everyone knows that banks are paying up to $500 a square foot and pricing stores and restaurants out of certain prime New York neighborhoods. Once-lively shopping stretches of Midtown, like Third Avenue in the 40s and 50s, now resemble banking malls. Landlords are signing leases for Godzilla-size branches like the 10,000 square-foot Chase soon to open at 1775 Broadway. “It’s a bizarre trend, but it seems to go on and on and on,” said Prudential Douglas Elliman retail Chairman Faith Hope Consolo. “I don't have a bank lease out that’s less than 10,000 feet. It”s mind-boggling.”
Why does a bank need 10,000 square feet, when nearly all customers use the ATM or do their business online? Are all these Chase, Citibank, North Fork, Bank of America, Commerce Bank and Washington Mutual branches not empty most of the time? “I don’t see them crowded,” Consolo agreed. “There’s never anybody in them. They’re like a big poster for what they are.”
One day soon, a bank honcho is going to wake up and start putting locations up for sublease, as has occurred in earlier cyclical contractions. That will be followed by other banks. And suddenly, the healthy retail market will seem a lot less healthy, with oodles of choice corners up for grabs at the same time.Link here.
CREDIT MANAGERS’ CONFIDENCE PLUMMETS
Confidence in the economy among corporate credit managers has apparently been slipping for quite a while. The monthly Credit Managers Index, which fell for the 5th consecutive month in December, now stands at its lowest level since April 2003. And year-over-year, nine of the 10 components that comprise the index fell. The drop has been driven mostly by deterioration in the services sector, according to The National Association of Credit Management, which has conducted the monthly survey of the business economy from the standpoint of commercial credit and collections since January 2003.
The data “strongly suggests” a slowing economy, according to NACM, which pointed out that seven of the 10 components that comprise the index declined in the most recent month. For the CMI survey, the association asks about 500 trade credit managers to rate favorable and unfavorable factors in their monthly business cycle. Favorable factors include sales, new credit applications, dollar collections, and amount of credit extended. Unfavorable ones include rejections of credit applications, accounts placed for collections, dollar amounts of receivables beyond terms, and bankruptcy filings.
While the scores of credit managers in the manufacturing sector, buoyed by increased sales, have risen in the past two months, service-sector scores fell for the third straight month, dragging down the overall index. A CMI score of more than 50 reflect a view that the economy is expanding, while a reading below 50 suggests a declining economy. Year-over-year the total CMI Index fell 3.6, from 58.3 to 54.7.Link here.
WHAT HAPPENS WHEN THE “WAVE OF LIQUIDITY” EBBS?
2006 was the “Year of the Junk Bond”, says Forbes. Lenders lent to marginal enterprises as if they were the last borrowers on earth. So did lenders lend to marginal homebuyers. Junk mortgages – where buyers borrow more money than they can pay back to buy houses they cannot really afford at prices that are higher than the houses are worth, promising to pay back the loan only when – and if – they can get around to it – also hit record numbers.
So many records were broken in 2006, we could barely keep up with them. Private equity was on a roll by year end, with twice as many deals as the year before – financed, of course, by record lending on the part of recordly reckless lenders with a record amount of loose change in their pockets. Mergers and acquisitions, too, hit record levels. Corporate profits reached record levels. Real estate deals in New York City hit noteworthy records. And of course, so did derivatives. And the Dow itself, as everyone knows, was at record levels.
The great guru, Joe Granville, once walked onto stage to give a speech and immediately dropped his pants. “This is just to show you the importance of shorts,” he told the audience. But in 2006, hedge funds forgot the lesson. They stopped hedging in order to attract more money. Everyone seems to think he can get rich by speculating, but you cannot get rich speculating on the down side while the bubble is still hitting new records. So, the hedge funds dropped their shorts and started speculating on the long side, along with every other addled gambler with a drink in his hand and a dollar in his pocket.
Records are meant to be broken, but we did not realize that so many of them had to be broken in such a short period. Housing properties all over the world hit record levels. Even in places like Bombay, India, you can pay as much for an apartment as you would in New York. House prices in England rushed up 10%, even though they began the year already at extraordinarily high levels. All over the world stocks hit new highs, with the Chinese leading the way. Chinese stocks doubled in the last year, hitting – naturally – a new record. So did commodities. Tin reached a 17-year high by year-end. Corn is at a 10-year high. And uranium is near an all-time record high last month, closing at nearly twice the level at which it began the year.
Many consumer prices, too, reached record highs. Housing, of course. Gas prices rose nearly two cents over the past two weeks, to a record high of $3.02 per gallon of self-serve regular, a national survey reported Sunday. But health care, transportation, and education rose too. But the record we find most intriguing is in the art market. Overall, the Mei-Moses art index rose a record 22%. In the summer, a Gustav Klimt sold for a record $135 million. No one had ever paid that much for a painting. And then, a few months later in the year, along came someone with more money to spend. He laid out $140 million for a Jackson Pollack.
And here, we have to sit down and compose ourselves, our pulse races so. The buyer chose to remain anonymous. What a shame. Anyone who would spend $140 million on a dreadful painting deserves notoriety. In fact, more than that, he deserves clinical study. That amount of money would produce about $7 million in income each year, if invested at 5%. What kind of person could get $7 million dollars worth of pleasure from looking at a Jackson Pollack painting each year? What kind of person would be willing to look at it at all? We need to know more. Obviously, he has a lot more money than we do. But if he is so rich, how come he is not smart? Or are we the dumb ones? If he cannot get $7 million in annual – or about $20,000 in daily - satisfaction from the painting, perhaps he can rent it out. Surely you would pay $20,000 to have an oeuvre of Jackson Pollack’s on your wall for 24 hours. Who wouldn’t? Unless the owner can get a return of $7 million he must be counting on something other than yield. He must be counting on capital gains! He is probably betting that there is an even greater fool. And he may be right.
What is the source of all this record-breaking activity, you might ask? A “Wave of Liquidity”, says the Financial Times. Bank Credit Analyst, in Montreal, picked up the idea, predicting that the “wave of liquidity” would continue in 2007. The Wall Street Journal, meanwhile, modified the idea slightly, referring to investors riding “rapids” of cash. Rapids, waves, swells, tsunamis ... no matter what you call it, there is a huge amount of liquidity in the world. And at of the close of 2006, it was still pushing up asset prices and setting new records just about everywhere.
The big question is this: When will this “wave of liquidity” finally begin to ebb? We do not know, of course. It is not given to man to know his fate. So we have to make our guesses and take our chances. And our guess now is that too many people are betting too heavily that this wave of liquidity will continue – and some that it is not temporary, but permanent. Whenever too many people crowd onto one side of a trade – like piling onto one end of a teeter-totter – we want to take the other side. It is almost sure to pay off. So let us imagine what might happen from this contrarian perspective:
Most of the records for 2006 reflected record levels of hope, faith and recklessness. We do not know what is ahead for 2007, but we warn readers that for every high there is a record low. For every year of hope and expectation there is a year of helplessness and desperation. And for every fool? There is some wise guy waiting to take advantage of him.Link here.
Is liquidity like water?
“For every long there is a short.” That is one of the comforting myths of the present credit bubble. Yes, there are more derivatives than there are people ... but no, they are not supposed to pose a threat to the world economy. Why not? Because there is always someone on the other side of the trade, say the experts.
Every dollar lost by one trader in London is recovered by a trader, say, in New York or Berlin. The total amount of “money” or “liquidity” remains constant. One man’s loss is another man’s gain. But is it true? Is liquidity like water? Does every drop lost to evaporation come back as rain? Is it like energy and matter, of which the world supply is constant, unchanging and irreducible? There is the problem, is it not? We know very well that the world’s supply of liquidity has recently grown at the fastest rate ever recorded. If it can increase, it is obvious that it can decrease too. And when it does go down, who gains?
One of the remarkable features of this entire remarkable period is the disappearance of what is called “short” interest – interest in selling. We mentioned yesterday [article immediately above] that the people who are supposed to have shorts – hedge funds and young, female celebrities – have been forgetting to put them on. Life is so pleasant... so safe ... they do not think they need them anymore. What was supposed to make hedge funds different from mutual funds or other collective investments was that they “hedged”. They went short in order to protect themselves on the downside, thus trying to achieve decent returns even when the broad market went up.
Time goes on and hedge fund managers lose track of where they are and how they got there. Today, a “hedge fund” is merely an unregulated pool of money in search of investors’ cash. Warren Buffett describes hedge funds as a compensation plan disguised as an asset class. By that he means that hedge fund managers pay themselves so richly – typically, 2% of assets and 20% of profits – that is it unlikely there will be much left for investors. We have said so often ourselves. But the burden of today’s comments is not to curse the darkness of the hedge fund industry but to light a small candle in order to try to see who is on the other side of these massive bets, and what will happen to all this “liquidity” when the bets go bad. We have faith, dear reader – faith in the eternal verities – including that every dollar created out of thin air eventually goes back from whence it came.
But let us return to our first question: if there is a buyer for every seller, how come the world’s supply of riches – cash, credit, liquidity – does not remain constant? First, it is worth pointing out that as a credit bubble expands, short interest does not expand with it. It shrinks. Look at the hedge funds themselves. They dropped their shorts because, as prices rose, short-selling became unnecessary, and chances to do it became harder to find. “We’re having a tremendous amount of trouble finding short ideas,” says Paul Mampilly, managing director of investment group Kinetics Advisers LLC. “We prefer to be more long than short.”
Who wants to short prices when they are going up? Only someone who is worried that they might go down. But the longer prices continue to go up, the less concerned about a reversal investors become. A hedge fund that actually hedges has a disadvantage in the marketplace, as its short positions – though adding greatly to investors’ security – depress the performance numbers. “Two and twenty” works a lot better on $50 million at 20% growth than on $25 million at 10%.
The other thing that happens in a big, long expansion of liquidity is that as the interest in hedging goes down so does the price of it. Thus, there are fewer and fewer actual dollars on the short side. Yes, if the market goes down, a few short sellers will make a lot of money, but nowhere near as much as the bulls will lose when their asset prices collapse. If the price of Google shares falls to $50, hundreds of billions of dollars simply disappear into a black hole. Except for the short interest, everyone is worse off. The money has gone away, up to “money heaven”, never to be seen again.
You can see even more clearly how this works in the residential property market. A man who has a house worth $500,000 thinks he has a lot more wealth than the same man when his house falls to only $250,000. He is out a quarter of a million dollars. And who was on the other side of the trade? Who made the money he lost? Where is the short interest in the residential housing market? It did not exist. When house prices fall almost everyone is worse off – except for new buyers. Owners feel poorer. Lenders make less money from new transactions ... and old ones comes back to haunt them. Realtors make less. Builders make less. Appliance makers, toolmakers, furniture makers, Home Depot and other retailers – all make less; people are unwilling to put a lot of money into a house that is falling in price.
And imagine what happens if the dollar falls. The U.S. national debt is nearly $9 trillion and growing at $1.24 billion per day. Gerald Ford sounded the alarm back in 1974 when the national debt was a grand total $30 billion. Now, it grows by more than that amount every month! Well, imagine that the dollar is suddenly worth only 50 cents. People who thought they had nearly $9 trillion in assets suddenly realize they have lost $4.5 trillion. Where did the money go? The lenders are out trillions while the borrower – the U.S. government – has achieved debt relief of the same amount. But it never actually had that amount of money – that is, it never had the money to pay back the loans, and never would have. In effect, the trillions would just be “written off” like a bad debt. This does not mean people are necessarily worse off, but they definitely would have less cash and credit – less liquidity – than they had before. And other asset prices would collapse.
Of course, if the dollar were to fall in half, all of America’s dollar-based assets would be marked down 50% too. Farms, factories, labor, stocks, bonds, tools, cars – everything would be reduced in price. The whole country would be about $35 trillion dollars poorer, at least on paper. And where is the short interest? A few speculators betting against the dollar, but what else? Again, the world would not necessarily be a worse place. U.S. industries would be more competitive. Foreigners would stream in to buy U.S. assets at fire-sale prices. The working man might finally get a real pay increase. But, there would less cash around ... fewer dollars ... much less liquidity to flush up asset prices.
No, dear reader, when a credit bubble implodes, it swallows up what people once mistook for wealth. All of a sudden, they have less money to spend, less money to lend, and less money to invest. Asset prices go down, consumer spending goes down, and an economic recession comes up. What they once took for granted they now take to court – hoping to collect 10 cents on the dollar, if they are lucky.Link here.
THE WORLD’S PUSH FOR POWER
You remember the blackout of 2003? It was the biggest blackout in North American history, affecting more than 10 million Canadians and 40 million Americans. The loss of power rippled through the whole Northeast region. Communications failed. Rail services shut down. Border protection systems failed. Thousands of businesses closed. There were some reports of looting. It even fouled up water supplies. Raw sewage poured into open rivers. Millions lived under a “boil water advisory”. Estimated financial losses totaled more than $6 billion.
Think we will see it happen again? I think we will. Over the past five years, we have had several significant blackouts. Those are portents and signs of more to come. America and Canada have neglected their power grids like gardeners who have allowed their flowerbeds to fill with weeds. The North American grid is the largest in the world. Much of it was built in the first half of the 20th century. Despite its age, from 1975-1998, investment in North America’s power grid declined every year. That is a 23-year stretch of declining investment in maintenance and upgrades. Things have not gotten much better over the last five years. Investment in our power grid has averaged about half of what it was in the prior two decades.
Now add to that an ever-growing number of users. The U.S. population just topped 300 million people. And consider the growing reliance our economy places on electricity. North American Electricity Reliability Council’s most recent report found that demand is growing three times as fast as supply. The capacity margin, or the ability of the system to meet the unexpected (e.g., extreme weather), is below the minimum target of 15% in most of the U.S. Put simply, the system is old and overworked. Yet we keep pushing it to the brink like never before. Mix that aging power grid together with increasing demand and what do you get? You get a bitter cocktail of repeated blackouts.
It took a lot of years to dig ourselves this ugly hole. It will take a lot of years, and a lot of money, to get out of it. The blackout of 2003 opened some eyes. Changes were soon made that would help kick off a spending boom the likes of which we have not seen in more than 30 years. The bottom line for investors is this: Investment in the North American power grid should top $10 billion annually sometime over the next few years. In total, utilities expect to spend more than $100 billion by 2015 on the power grid.
The spending boom on the world’s power grid is pretty simple in its outlines. You do not need to know all the details to make money here. In fact, I have not even gotten to the best part yet. The amount of money other countries will spend on their power infrastructure dwarfs North America! Let us start with India. I recently finished reading a book titled India: An Investor’s Guide to the Next Economic Superpower by an analyst named Aaron Chaze. While Chaze is bullish, as you might expect, he is downright giddy when it comes to infrastructure. “India now has the best potential for investment in infrastructure, not only in Asia, but in the world,” he writes. A good slice of that potential is in power generation. As with North America, there has been a widening gap between demand and supply. That gap has just exploded over the past decade. India plans to spend more than $180 billion to create the largest power grid in the world.
China, as you might imagine, also figures prominently in the story. Much of rural China still lacks basic electrification. China plans to spend over $140 billion through 2012 to bring electricity to all of its citizens. That is hundreds of millions of new consumers. In urban areas too, demand should soar as households purchase more TVs, air conditioners, refrigerators and the like. Outside of China and India, Russia is the next biggest market for spending on electrical infrastructure. Yes, Russia. There is more than $90 billion on tap to modernize Russia’s old and strained power system.
Then there is Europe. The story in each of these places is so similar it feels repetitive. Here is a snippet from a recent Financial Times article: “Europe faces the growing threat of electricity shortages because growth in demand has outstripped investment in new power stations.” Sound familiar? In Europe, spending on electrical infrastructure comes in at around $40 billion by 2010.
These are the biggest markets spending the biggest dollars. And yet there are similar stories in many smaller markets in the Middle East, in Africa and in the emerging economies of Southeast Asia such as Vietnam. This is a mammoth trend, one that will take years to play out. For investors, the playbook is fairly straightforward. The companies that will build all this stuff should enjoy a strong bull market in their businesses over the next five years – at least.Link here (scroll down to piece by Chris Mayer).
A HEALTHY GLOW
Cigar Lake, in Canada’s Saskatchewan province, is home to one of the richest uranium ore bodies on the planet. At 232 million pounds of proven and probable reserves, the economic value of the find is nearly $14 billion by recent spot price. Cigar Lake production was expected to save the day for hungry nuclear power utilities – 103 of which operate in the U.S. The plan was to have 7-8 million pounds of production online by 2008, with as much as 18 million pounds a year not long after. Cigar Lake was expected to supply 50% of all new uranium production within five years. Then the walls caved in. Literally. Concrete-reinforced steel doors were in place to hold back the lake, but an underground rockfall caused the doors to give way. The mine was flooded.
The flood is a costly setback for Cameco (CCJ: NYSE), 50% joint owner of the Cigar Lake mine, and a major headache for uranium buyers in general. Uranium prices are surveyed and quoted on a weekly basis by various industry watchers. The recent move from $56 to $60 a pound was “the largest weekly increase on record,” according to Eric Webb of Ux Consulting. Long-term forecasts of $75 and even $100 a pound now appear justified. Uranium would have to trade above $111 a pound to break its inflation-adjusted highs from 1978.
This is more than just subterranean cave-in blues. The uranium spot price has not seen a down month since 2001. For years now, uranium producers have met just 60% of total annual demand – the other 40% coming from government stockpiles and decommissioned nuclear warheads. This can go on for only so long. The tightness of supply comes at a time of atomic resurgence. Three large-scale factors have turned the tide in favor of nuclear energy: geopolitics, global warming, and developing world growth.
So where will the uranium to fuel a nuclear resurgence come from? With government stockpiles covering 40% of present demand, the question looms large. For one, Cameco is confident that Cigar Lake will eventually be up and running. The costs will be high, but that uranium is too valuable not to be accessed – and Cameco should recoup its recovery costs and more in the long run. An important future source could be Australia, home to 38% of the world’s low-cost uranium reserves. Surprisingly, for a country so rich in the stuff, Australia does not operate a single nuclear power plant – yet. Another country keen on nuclear power is Russia. Home to an estimated 15% of world uranium reserves, Russia could yet go from exporter to importer in the coming years.
On the positive side, existing government stockpiles of uranium can act as a buffer against volatile demand. Construction costs make up the lion’s share of investment for a new nuclear power plant, with ongoing fuel and maintenance costs relatively small in comparison. The hitch is that a steady supply of fuel – the uranium itself – should be locked up in advance, preferably via ironclad contracts. This puts a lot of power in the hands of financiers, who like to see a reasonably steady production stream before committing funds. The financiers are thus relieved to know that governments are on their side, with a willingness to act as swing supplier in the event of temporary shortages. The U.S. government in particular is doing all it can to get the nuclear resurgence jump-started, including making generous offers of “regulatory insurance” to utilities who get the ball rolling.
All in all, the pieces are in place. The rise of safe, clean nuclear power is in most everyone’s best interest – except the petrocrats who want to keep the world as addicted to fossil fuels as possible. Uranium producers could have some very good years ahead.Link here (scroll down to piece by Justice Litle).
The first law of thermodynamics tells us that energy can neither be created nor destroyed. The second law tells us that there is no such thing as a perfect energy transfer – a little something is always lost. These laws cannot be broken. Nor can the world’s growing thirst for energy be slaked easily. And so our global dependence on fossil fuels increases, simply because no easy, large-scale alternatives exist. Yet. But the sun is pretty “large-scale” and it produces an awful lot of energy. The sun bathes the earth in more potential energy than we could ever hope to use.
These two considerations – the hidden cost of fossil fuels and the sun’s prodigious output – have spurred rich-world governments to subsidize the solar power industry. The pragmatic Germans were the first to really get this party started. A few years back, the German government dreamed up a mouthwatering incentive program: encourage consumers and businesses to sell solar-generated electricity back to the grid at above-market rates. The program made Germany the biggest consumer of solar panels in the world by a hefty margin.
National and local governments on multiple continents soon followed Germany’s example, encouraging the development of solar technology through various rule changes, tax breaks and incentive programs. And in the U.S., California and New Jersey are leading the renewable energy charge, with dozens of states following in their wake. Unfortunately for the solar power industry, the overflow of enthusiasm proved too much too soon. An ongoing shortage of silicon – the stuff used to make semiconductors and solar panels – has led to tapped-out suppliers, idled installers and skyrocketing production costs. Many small solar outfits have found themselves bruised and battered.
Ultimately, the future for solar is very bright (sorry). The long march to “grid parity” – the point at which solar-generated electricity costs are on par with conventional electricity from the local grid – is well and truly under way. As for now, though, the industry is still young and fragmented. Most of the pure players are small and vulnerable minnows, while the bigger players are diversified behemoths, like Sharp, Kyocera, British Petroleum and General Electric. Yet there is one company, founded in the Yangtze River Delta, that is a breed apart. This company is set to stride atop the solar world like a colossus, dwarfing its competitors in profitability and scope. It could dominate the industry in much the same way that China dominates its neighbors – and for similar reasons to boot. The company is Suntech Power Holdings (STP: NYSE).
With the help of a little entrepreneurial elbow grease, STP was founded as a joint venture in cooperation with the city of Wuxi, near Shanghai, in 2001. Local investors ponied up $6 million. Founder Dr. Shi Zhengrong ponied up the technology, the expertise and $400,000 worth of personal funds. Things were a struggle at first. Business was good, but costs were high – and investing in expansion seemed prohibitively expensive. After wrestling with this problem for some time, Dr. Shi realized Chinese labor was so plentiful that it made sense to forego high-tech machine production where low-tech human labor would do. The savings generated gave Suntech the elbowroom and scalability it needed to achieve rapid growth. Eventually, Dr. Shi arranged a buyout of his local investors on generous terms, paving the way for a listing on the NYSE.
There are a number of reasons why Suntech Power is poised to dominate like no other. For one, Suntech’s cost advantages are huge. To summarize, Suntech has the lowest expansion costs, the lowest production costs, and the lowest overall costs per watt by far in comparison with its peers. Suntech is both profitable and expanding. This is somewhat remarkable in light of the silicon crunch that has severely hampered, and in some cases crippled, various competitors. The silicon shortage has played directly into Suntech’s strengths. Armed with the advantage of low production and expansion costs, Suntech was able to purchase silicon aggressively in the spot market. Suntech has aggressively expanded market share at a time when less efficient competitors have either fallen back or sustained losses in a frantic effort to keep pace.
In 2006, silicon represented a whopping 80% of Suntech’s cost of goods sold. When the input cost of silicon falls – as it inevitably must, as a result of new supply and technological advance – Suntech’s inherent advantage as the low-cost producer will become even more apparent. We should see the beginnings of this in 2007, as Suntech’s material mix shifts from aggressive spot market purchases to longer-term, fixed-rate supply contracts.
Suntech fully expects the market price of solar panels to fall steadily over time as technology improves and the industry moves closer to “grid parity”. The good news is that costs should fall even faster, and thus profit margins could expand as the company continues to expand. With a $5 billion market cap, Suntech is already a sizable market player. But as the company scales up further, it will enjoy better rates on bulk purchasing and wring more efficiencies from the production process. Nor is Suntech a laggard in the innovation department. The company’s CTO, Stuart Wenham, recently won the World Technology Award for Energy.
Suntech is unique in being the only pure solar play with the capacity to dwarf its competitors in both scale and profitability. It is already a major player in Europe and a growing presence in the U.S. As a Chinese company with local roots and government ties, it is well positioned to ride an explosive wave of future growth at home. I expect sunny days at Suntech for a very long time.Link here.
THIRD MORTGAGE COMPANY IN A MONTH CURTAILS OPERATIONS
Mortgage Lenders Network USA (MLN) stopped making new loans through its wholesale arm, becoming the third mortgage company in a month to curtail operations as housing sales slowed and defaults by borrowers rose. The company said in a statement it will “temporarily discontinue” wholesale lending. The Connecticut-based company is “involved in strategic negotiations with several Wall Street firms” about the unit, which includes a network of independent mortgage brokers who bring in applicants and the employees who field their calls. Workers at the wholesale unit were furloughed for two weeks, Executive Vice President James Pedrick said in an interview.
“The economics of this market are not good, and it deals with the performance of loans, and to a lesser extent the value of homes,” Pedrick said. The company will continue lending to retail customers and handle billing and collections for its $17.8 billion mortgage-servicing portfolio, he said. Lenders including Ownit Mortgage Solutions and Sebring Capital Partners LP, which also specialize in “sub-prime” mortgages, were among companies that closed operations and cut staff in 2006 as loans to high-risk customers soured. Sub-prime mortgages are made to people with low incomes, a track record of missed payments or limited credit histories. Nationwide, late payments on sub-prime loans rose during the third quarter to 12.56% of the total, the most since the first quarter of 2003, the U.S. Mortgage Bankers Association said.
California-based Ownit, the 16th-biggest issuer of sub-prime home loans, filed for bankruptcy court protection last week. Texas-based Sebring closed in December. Morgan Stanley bought mortgage lender Saxon Capital Inc. for $706 million early last month and announced plans to slash 170 jobs. “What you’re seeing is a shakeout as it relates to the lower-tier mortgage players,” said Rui Pereira, a managing director in the residential mortgage group at Fitch Ratings.
MLN opened a decade ago with seven people. It grew to employ 1,800 people as falling interest rates early this decade spurred record mortgage applications. Closely held MLN is the 15th-biggest issuer of sub-prime mortgages, with $3.3 billion of loans in the third quarter, according to the industry publication National Mortgage News. Brokerage firms including Morgan Stanley, Merrill Lynch, Barclays Plc, and Deutsche Bank AG have been buying mortgage companies, including sub-prime lenders and servicing units, so they can repackage home loans into larger securities, which spreads the risk of default.
Pedrick confirmed in an interview that the company will not fund any more mortgages arranged by brokers, even if they have already received final approval. “We’re talking to a group of Wall Street firms about the feasibility of an alliance,” Pedrick said. Such discussions would have to conclude within a “short window of time,” he said, because employees may start looking for other jobs. MLN’s announcement left at least one mortgage broker scrambling to line up alternatives for his customers.Link here.
JUNK BONDS LURE CROWD TO BULGARIA STEEL, KIEV CHICKEN
A dozen Merrill Lynch clients endured a flight to Serbia and a 5-hour taxi ride last month on their way to visit a Soviet-era steel mill whose bonds were plunging. Kremikovtzi AD’s notes had just tumbled 30% after the Bulgarian steelmaker said it would post a $7 million loss for the year. Investors were alarmed because the company estimated a $34 million profit in April, when Merrill arranged the sale of €325 million ($427 million) of 12% bonds.
Investors bought Kremikovtzi’s securities because those yields are hard to find outside emerging markets. Bondholders who used to get 24% on Xerox Corp. in Stamford, Connecticut, or Remy Cointreau SA in Paris now finance a Kiev chicken farm and a Moscow ball-bearing factory for half the rate of interest. “People are having to go further and further down the ratings scale to get yield,” said Alex Moss, who holds Kremikovtzi’s bonds among the $94 billion of assets he helps oversee at Insight Investment Management in London. “It was risky, but people thought they were getting paid for the risk.”
European bonds rated below investment grade yield 2.3 percentage points more than government debt, down from 16.5 percentage points in 2001, according to indexes compiled by Merrill. Nowhere have yields fallen more than for securities with the lowest credit ratings. Bonds ranked Caa by Moody’s and CCC by S&P, the category above default, pay 4.6 percentage points more than government securities, down from 42 percentage points five years ago, Merrill data show. Kremikovtzi is among 10 companies that sold a record €5.5 billion of bonds with the lowest ratings in 2006, data compiled by Bloomberg show. The steel mill is rated Caa1 by Moody’s and CCC+ at S&P.
Investors poured a net €1.7 billion into high-yield corporate bond funds, double the €864 million in 2005, according to data from FERI Fund Market Information in London. The increasing demand is making it easier for companies to sell bonds, no matter how risky. “People need to reach for yield, so they’re buying into riskier assets”q said Axel Potthof in Munich, who oversees European non-investment grade bonds for Pacific Investment Management Co., manager of the world’s biggest bond fund and a unit of Allianz SE.
Bondholders will keep buying riskier securities until an increase in defaults makes them wary, said Adam Cordery, who manages $750 million at Schroder Investment Management Ltd. in London. He favors junk bonds over investment-grade debt. “The credit market went a little bit crazy last year and will continue to be crazy this year,” Cordery said. “It normally takes a blow-up somewhere before investors stop buying high-yield.”
Investors are turning to the newest EU members because their economies are growing the fastest. Yields on junk bonds are falling even as companies take on more debt. The average non-investment grade company in Europe owes 5.4 times annual earnings, up from 4.2 times five years ago, according to S&P’s LCD. “You’re seeing for the first time companies as far east as Ukraine and Russia doing high-yield offerings,” said Carter Brod, capital markets partner at law firm Baker & McKenzie in London, which advised MHP on its bond sale. “It appears investors can’t get enough bonds from eastern Europe.”Link here.
SMALL-CAPS DEFEAT THE LARGE-CAPS ... AGAIN!
The beginning of January is one of my favorite times of year. The market’s numbers are in the books and we can assess which stocks were the big winners and losers, and make mental notes of who was right and who was wrong. And the results this year are fascinating.
First off, we would be remiss if we did not make mention of the overall fantastic performance of the broader market. The Dow Industrials and the S&P 500 were both up about 16% for the year – well above long-term averages for the two indexes. The tech-dominated NASDAQ lagged the two large-cap leaders, but still had a good year itself turning in 9.5%. Mid-cap stocks actually showed pretty well in 2006 with the S&P Midcap 400 climbing 10.3% for the year. The Russell 2000, however – the benchmark small-cap index – outpaced all of them, with a 2006 return of 18.4%, making it clearly yet another year to focus on smaller capitalization stocks.
But if we dig down even further, small-caps were the real giant slayers of U.S. Equity markets in 2006. Of the top-50 best performing stocks of 2006, 46 of the 50 were small caps. Of those 50, the average return was 382%. Interestingly, the SEC would actually classify 12 of the top-50 performers as penny stocks. These stocks are a subset of the small-cap universe that we will be focusing on much more in 2007. But enough of these statistics. 2006 is over, and yet again we get more confirmation that small-cap investing is one of the best way for us to build wealth in the capital markets. Now is the time, if you have not done so already, to look forward to 2007 and beyond.
Ok, but what should you look at? I have been pounding the table on three themes for the past couple of months in all of my publications and they are still the three most important areas for investment:
THE BUY OF THE CENTURY
Even though the price of gold is near its highs, vintage coins have gotten crushed – creating what I believe is the buy of the century in pre-1933 graded U.S. gold coins. The price of vintage gold coins usually tracks the gold price. But since mid-summer, this relationship has broken down. Gold is near new highs, but pre-1933 graded gold coins have lost a third of their values. (Chart here.) It is extraordinary.
For following the rare gold coin market, the metric I like to track is the “premium over melt value.” To me, rare coins were too risky to even consider, until the Professional Coin Grading Service (PCGS) came along in 1986. PCGS grades rare coins and puts them in sealed containers. So the grade is no longer subject to a dealer’s opinion. The invention of PCGS was a revolution. It “democratized” the coin market. Nonexperts, like you and me, can now buy great coins without worrying about authenticity or quality, because PCGS assures both.
In recent years, rare gold coins have been trading at all-time lows in relation to their meltdown values. I want to own gold for the long run, and right now the best way to own gold is through graded pre-1933 U.S. gold coins. Your downside is limited, as they are closer to their melt value than they have ever been. And if gold keeps going up, I expect these will go up even more. In the last two coin bull markets, we saw prices rise 665% in 1987-89 and 1,195% in 1976-80. (Those are the returns of the PCGS 3000 rare-coin index.)
If a bull market in gold really takes off, these things will absolutely go nuts. The buy of the century – so far – is pre-1933 graded gold coins, right now. Don’t miss it.
More about gold coins.
In 2006, the U.S. Mint issued the first pure gold coin in America’s monetary history. It is called the 2006 Buffalo. The obverse features the profile of a Native American. The reverse features an American buffalo (also known as a bison). It is called the “Buffalo” because the design is based on the 1913 Buffalo nickel. They come straight from the mint. “First strikes,” they call them. They are in perfect condition. Only 300,000 exist. These coins are so beautiful they define the word “mint”.
Before 2006, it had been difficult to find gold coins in “Buffalo-mint” condition. The Mint had not produced a new gold coin since 1933. They say only 1% of these gold coins still exist today. Most of these were banged up anyway. A pre-1933 “Buffalo-mint” condition coin would cost tens of thousands of dollars per coin. The 2006 Buffalo could be purchased right off the U.S. Mint’s website. They were beautiful, unique, and they only cost $800 per coin. In the first few days, they inundated the Mint’s website and phone lines. Dealers and professional collectors bought all the coins they could. With so many orders coming in, the Mint was forced to limit sales to 10 coins per household.
A coin should always be worth more than its “melt value”. You know exactly what it weighs, plus it is convenient. A gold ingot does not have the same benefits. With spot gold above $700, $800 was probably a fair price for a limited-edition coin in mint condition like the Buffalo. But spot gold fell down to $560 right after the Buffalo came out. Right now, mint Buffalos sell for $700 on eBay. The mint has increased the limit to 5,000 coins per household, and according to the site there is still plenty of unsold inventory. At $700, I think Buffalos are a solid way to play gold’s bull market.
Thing is, we have a still more interesting opportunity here. Last week, I called up my coin dealer and asked him about pre-1933, mint-condition gold coins. Thanks to the massive supply of Buffalos, he told me these mint-condition “vintage” coins are a real bargain at the moment. Here is what he means. As the table shows, the new supply of Buffalos flooded the market for rare gold coins, and prices have plunged since May. So even though the price of gold held up fine, the price of coins has slipped. Despite the big fall in price, these coins are still incredibly rare. This makes vintage gold coins the absolute cheapest way to invest in gold right now.
Buffalos will track the spot price with a 5%-10% premium over the next few years. If you are interested in buying some Buffalos, go to the U.S. Mint’s Web site. Vintage gold coins, on the other hand, could rise even if the gold price stays flat. But if gold goes up ... I expect to trade my hoard of vintage gold coins for an airy beach house on the Florida coast, complete with rose garden and membership to the local country club.Link here.
THE SPECTER OF DEFLATION
A specter is haunting the U.S. economy – the specter of deflation. The Fed and the Treasury – the central powers of Capitalism itself – have entered a holy alliance to exorcise this specter. The big question is, will they be able to do it?
From what we know of economic history, credit expansions lead to economic booms – this much is clear. What comes next is still up for debate. Austrian economist Ludwig von Mises tells us “The boom can last only as long as the credit expansion progresses at an ever-accelerated pace. The credit expansion boom is built on the sands of banknotes and deposits. It must collapse. There is no means of avoiding the final collapse of a boom brought about by credit expansion.”
Current Fed Chief Ben “Printing Press” Bernanke begs to differ. He earned his nickname in the now infamous 2002 speech, “Making Sure ‘It’ Doesn’t Happen Here” prior to his ascension to the Chairmanship. Though Bernanke never admits to it in his speech, the unspeakable “it” is more than just deflation, but the very “final collapse” that that Mises warns of. In his speech, Bernanke told us, “The sources of deflation are not a mystery. Deflation is in almost all cases a side effect of a collapse of aggregate demand – a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers. Likewise, the economic effects of a deflationary episode, for the most part, are similar to those of any other sharp decline in aggregate spending – namely, recession, rising unemployment, and financial stress.”
Bernanke goes on to tell us that the best way to cure deflation is to avoid it altogether by preempting it. After the dot.com collapse and the 9-11 attacks, the Fed lowered interest rates aggressively, making it clear that there would be liquidity for all - no need to panic - move along - continue on with business as usual. In spite of a mild recession, the Fed’s liquidity-for-all program helped the economy avoid a deflationary collapse ... by creating the housing bubble. The fear of deflation, at least in the press, reached its zenith in 2003, shortly after Bernanke’s speech, then all but disappeared. Until this year.
What happened? In my opinion two things: First the Iraq war began in 2003. War is always inflationary, and this one was no exception. Hundreds of billions of dollars were pumped into the economy via government spending on military hardware, software and personnel. But the second thing that happened was Bernanke’s genius mind game. Only now am I appreciating the audacity of it. In his “printing press speach” he finished, “We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.” In effect, when President Bush nominated Bernanke to head the Fed in late 2005, Bernanke became the credible threat. “An inflationary madman is coming to the Fed! Run for cover!” And everyone did. Look at how everyone’s favorite inflation indicator, gold, reacted to the threat.
That was a cool trick, Ben! But what are you going to do for an encore? With the housing collapse, worry about deflation is once again creeping in around the margins, and for good reason. In that sector, we already have deflation. Prices are falling and unemployment is rising.
Credit, which has grown steadily since the stock market bottomed in 2003, is being destroyed as housing continues its collapse. For those yet uninitiated into the secrets of modern money, credit is synonymous with money, because all money is debt – which is just the other side of credit. For example, say a bank extends credit to a borrower to buy a house. That credit becomes the borrower’s debt, but the bank’s asset. (More debts for the people means more assets for the banks.) The borrower uses his new credit to buy a house. Where did the bank get the “money” in the first place? Why, the Fed printed it of course! (Confusing? Don’t worry. It is meant to be). The point is that the recent inflationary spiral of printed money pushed housing prices up and up over the past years. When all the qualified buyers were exhausted, banks began loaning money to unqualified buyers to keep their assets growing and the credit expansion going.
But a recent study tells us that 2.2 million homes will soon be lost to foreclosure. When the bank takes a house back, suddenly a mortgage that was worth hundreds of thousands of dollars in cash flow to the bank over its 30 year lifespan is gone. In its place the bank has a house it does not want – one that undoubtedly has been trashed by its erstwhile owners as a way of “getting revenge on the man” who is repossessing his house. (Some angry former owners have stripped properties of appliances, cabinets, even light fixtures. More vindictive owners have been known to plug drains with concrete and turn on the water.) Furthermore, because of the declining real estate market there is little chance the bank can sell the house again for anything close to what it got the first time (especially if it has been trashed). But sell it must. This puts incredible downward pressure on prices because banks are the definition of “motivated sellers”. As opposed to regular sellers who will wait to get “their price” before selling, banks will sell at just about any price to get the property off their books. And thus begins the deflationary spiral. Credit is destroyed, jobs are lost, payments are missed, bankruptcies declared.
Um, Earth to Bernanke – we have a problem. If you want to preempt deflation, here is your chance! In the latter half of his 2002 speech, Bernanke launches into numerous ways the Fed could stimulate an economy suffering from deflation. This part of his speech is relatively boring, and you can practically hear him mumbling through the text. It all boils down to one thing anyway: lowering interest rates. This, Bernanke says, would solve deflation. But would it?
There is an old saying that you can lead a horse to water, but you cannot make him drink. The human corollary is that you can offer a man a loan, but you cannot make him borrow. In spite of what Bernanke says, the Fed does not “print” money. It must loan it into existence, but this requires willing borrowers. Consumer spending powers 70% of the U.S. economy. So how do lower interest rates translate directly into money in the pockets of U.S. consumers? That is what newly homeless consumers will need, in order to keep “powering” the economy. Of course credit card rates will go down, but will that be incentive enough to continue spending?
As the foreclosures work their way through the economy, you may begin to hear stories about how people you know have lost their home. But when it turns out that your neighbor or a close friend gets laid off from his well-paying, seemingly secure job and falls behind on his mortgage payments ... well, you might think twice about upgrading your 39” LCD TV to the new 52” plasma model – even if you can get it for 0% interest (for the first six months). More likely you will start thinking about building up a cash nest egg of your own. But saving, which for most Americans means paying down debt, is deflationary. Maybe you could sell some stock, while price are still high. (Also deflationary) Downsize your McMansion? Good luck, and also deflationary.
This brings us back to what Mises warned us of: There is no means of avoiding the final collapse of a boom brought about by credit expansion. Beranke, on the other hand, says “a determined government can always generate higher spending and hence positive inflation.”Link here. Which one of these men are you more inclined to believe?
Where will you be when the boat capsizes?
In watching the investment markets quite closely for the past decade or so, I concluded that trends often continue until their trajectory is accepted as inevitable. This is related to the Magazine Cover Indicator (MCI) that shows how a trend often reaches terminus when its acceptance is so great that it appears on mainstream magazine covers. Internet history demonstrates the usefulness of this – the link above is from June 2005, almost exactly when the housing bubble topped. The columnist was writing at that moment how the boom would continue, ignoring the MCI to which she referred. [Join with me, please, in a collective smirk at the irony.]
It is hard to go against the consensus. Imagine a tour boat, loaded to capacity. For whatever reason, everyone on the boat crowds to the port side, leaning on the rail. What happens? The boat rolls over, to port of course, and those in the crowd suddenly find themselves not only in the drink, but ever worse the structure of the boat is rolling down right on top of them.
If one-sidedness of discussion and the vitriolic criticism of a position are any indication, another article of faith is likely to join in the soon-to-be-marching failure parade. I Googled the word “inflation” and got about 50 million hits. “Deflation”, on the other hand, yielded less than 4 million, and most of those hardly argued in favor of its eventuality. Anecdotally, there appears to several camps regarding inflation, with some people certain that the U.S. government will inflate its way out from under the main entitlement programs to hide their de facto collapse and others certain that a Central Bank can always maintain a macroeconomic balance in favor of a growing monetary aggregate, and thus a stable inflationary bias, also known as the Goldilocks fantasy.
People who suggest, instead, that a 1930’s style deflation looms are treated to a chorus of catcalls, to say the least. Is everyone on one side of the boat yet?
Most people reading this can agree on the ultimate outcome when the monetary system and much of economic activity are centrally “planned”. Whether the denouement is a collapse in the value of the dollar (inflation) or collapse of outstanding credit (deflation), hard times are the inevitable result from decades of distortions layered into the U.S. (and world) economy. Time will tell how all this plays out, but with vast numbers of people embracing debt as never before on the belief that repayment will be with wheelbarrows of shrinking dollars, it seems like they might someday find themselves shivering in the water under the widening shadow of the boat’s superstructure.Link here.
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