Worst to First

This rally has been fueled by the companies that got hit the hardest in the downturn, that is, the most cyclical companies and the most debt-laden companies. Yes, the “strong” companies did not get hit as hard when things turned south (and many of these “strong” companies were consumer staples companies), but these same companies have yet to bounce with the rest of the market. Looking forward, the upside for these highly-levered companies relies heavily on many quarters of robust economic growth and I just do not see that happening. We have way too many big picture issues to sort out before we can move higher (i.e. healthcare reform, bank regulation/standards, energy independence, national debt burden, etc.). I am looking to buy dividend-paying companies with strong balance sheets, such as Proctor & Gamble, Bristol-Myers Squibb, and PepsiCo.

Is Employment a "Green Shoot?"

I am still a little torn on the unemployment situation in America and some consumer spending habits. Yes, nearly 10% of Americans are officially unemployed (really it is about 17%), but I feel like the other 90% might be okay. This is my one “green shoot” for future growth as consumers account for about 70% of our gross domestic product. If you still have your job and your dividend paying stocks are still handing out cash, not much has changed for you other than the value of principal in your account is lower. Look at Apple's latest quarter...someone is still buying iPhones hand over fist! I am not sure if Apple is an anomaly or an indicator that the top 90% are better than most think (it also helps that Apple is part of a huge move toward mobile internet).

Unemployment data is a numbers game and the media often distorts it. If unemployment goes from 5% to 10%, we say it has doubled or gone up 100%. At the same time, though, the employment rate goes from 95% to 90% -- only a 5.3% decrease! Everyone knows job losses have slowed, so it is not really news. The big issue is job creation and when will it occur.

The Charts Can Lie

When people say you need to buy stocks because you do not want to miss the move or because prices are trending higher...WATCH OUT! For a trader, this is heaven, for a long-term, buy-and-hold investor like most Americans, UH OH! The average, everyday investor is the one who buys at the top and gets burned. I am not saying we will test the March lows again (mostly likely that will be the low for years to come), but the potential for upside in stocks is very, very limited given what available information we have. Yes, businesses are poised for ridiculous bottom-line growth given they have been stripped down to almost nothing, but ultimately, the top line drives the bottom line. Top line growth prospects are not on my radar screen given tepid consumer spending. The only sector that has some nice growth prospects is the technology sector, especially the mobile internet companies (some alternative energy companies might be sitting pretty, but they are too speculative/the government has too much influence for my liking right now), but these stocks are already trading at very high multiples.

Why I am staying away from stocks…

The monster move in stocks from the March low was people realizing the world was not going to implode (thank you, Ben Bernanke) and equity prices needed to be re-valued accordingly. People are misrepresenting this straight-lined “rally” with a robust, straight-lined recovery. This “growth” everyone is talking about is merely a bounce from unbelievably low levels, and looking forward, the growth prospects are very grim outside of government stimulus. A good analogy is like shattering your leg. The economy/stock market broke its leg in about twenty places and has about ten steel rods in it (relate the rods to new government programs to prop things up) and more surgeries will mostly likely be necessary in the future. You do not go from bed-ridden to playing sports in five months (hopefully technology will be that good someday though). You make the most progress, in terms of healing, in the first few months (because you are coming off such low levels), and stock prices are the first things that heal. Be patient, a true economic recovery will take some time -- maybe a long time. Wait for the fundamentals to improve or the prices to pullback.

Market Summary: Wednesday, June 3, 2009

• Private employers cut 500,000+ jobs in May and some say the economy is recovering!?

• Americans are saving a lot more of their money.

• Auto sales on the rise. People are still buying cars from bankrupt companies.

• Stephen Schork on oil…he’s a smart guy.

• Cool CNBC slideshow that looks at revenue and income per employee for the best and worst companies within various industries.

• Jim Rogers thinks the S&P 500 could rally to 50,000 if the government prints enough money...laughable

The Bear State

The eight largest economy in the world in 2005 according to the CCSCE(1) , responsible for 13% of the United States GDP, the world’s fifth largest supplier of food and agriculture commodities, home to the aviation and entertainment industry and 21% of the U.S. oil reserves, is the Bear Flag Republic of California. With all these advantages and resources, how is California on the brink of bankruptcy? To understand this you must review California’s state taxes, gargantuan spending habits, and inept politicians.

California’s income and sales tax is the highest in the nation. The income tax is 10.55% while sales tax increased to 9% this past April. Many businesses as well as residents are fleeing the state to California’s tax friendly neighbors, Nevada and Arizona. The graph on the right shows the amount a single individual is taxed at the highest marginal rate. From 2000 to 2007 California lost 1.2 million residents, approximately the size of San Diego, to domestic migration(2). In that same time period California has grown by 7.5%, which equates to 2 million new legal immigrants(3). With California’s high tax rate, the state is taxing the established residents right out of the state.

California’s current budget deficit is $21.3 billion, down from $33.9 billion earlier this year. California has always had budget problems. In 1991, Gov. Pete Wilson faced a $14.4 billion deficit, and in 2003 Gov. Grey Davis received a special election to be kicked out of office because of a $35 billion deficit. Then came Arnold and his $21.3 billion deficit. California deficits seem to come and go with recessions, while the surpluses usually come in good economic times. However, the surpluses always seem minute compared to the deficits. To close the deficit politicians in Sacramento have resorted to budget cuts and accounting gimmicks, and then they asked Californians to vote for a tax hike. It was not well received as you might imagine. The most recent attempt, voted on Tuesday, May 19th, was Propositions 1A, B, C, D, E, and F. All but Prop 1F failed. Prop 1A was for California to set up a rainy day fund, except it allowed state legislature to raid rainy day funds when needed. Prop 1B allowed $9.3 billion from the rainy day fund to be diverted to education. Prop 1C, D, and E allowed the state to raid trust funds and use surpluses to pay current general fund bills. The only proposition to pass was 1F, which blocked pay raises for lawmakers if they failed to balance the budget – finally some accountability. I wonder if Washington is watching? Decidedly not with another $50 billion marked for Grand Misappropriation…whoops, I mean GM. With these measures voted down by California residents, the Govenator is turning to new and creative ways to reduce the budget gap.

The state’s current plan calls for major cuts to education, healthcare and borrowing from municipal governments. This will, however, only get California a third of the way to break-even, maybe halfway if the cuts are large enough. The other half or so will come from bonds, elimination of the Cal grants, and loans from Wall Street, according to Arnold. Arnold was recently in Washington lobbying the Feds to back California’s next $6 billion bond issuance. A Wall Street loan might be too pricey for California which could result in a federal bailout. Can the American people stomach another bailout? Only if Obama wills it. California has also discussed releasing prisoners to save extra money. The last ditch effort calls for selling state infrastructure such as fair grounds and racetracks. My personal favorite is selling the LA Coliseum for $400 million, last appraised in 2001 at $16 million and depreciating. So how does California become Golden once again?

The first step is for California to stop paying for local education. The state currently pays for education from its general budget unlike other states that use local property taxes. Proposition 13 was passed in 1978 placing strict limits on property taxes with those taxes going to local communities. When the proposition passed it reduced property taxes by 57% on average statewide. If Prop 13 gets repealed California could obtain enormous amounts of funding for its school districts and cut primary and secondary education entirely from the budget leaving only higher education. California currently spends about 52-55% of the State General Fund Budget on K-12 and higher education(4). The state can also cut teachers’ salaries and benefits, which currently rank 35% above the national average. But with the Teachers Union running the show in Sacramento it is doubtful that will happen, unless done by federal mandate. Until then Sacramento’s best bet is to break into the U.S. mint in San Francisco and print its own money.

1)Center for Continuing Study of the California Economy, January 2007
2)Demographia State Domestic Migration 2000-2007 December 27, 2007
3)Demographia State Domestic Migration 2000-2007 December 27, 2007
4)http://www.dof.ca.gov/HTML/BUD_DOCS/question.htm#question7

Weekend Commentary

Let me first touch on Treasurys.  Everyone “knows” Treasury prices are going lower because the Treasury is issuing massive amounts of debt to pay for all of its bailouts and to keep the economy afloat.  It is simple Econ 101 supply & demand – the supply of available Treasurys is increasing (and demand is weakening as people fear a downgrade of America’s credit rating and because of heightened inflation worries); therefore, prices will be lower.  But are they already “lower?”  Has the market already taken all of this information into account?  I think it has. 

Benjamin Graham said it best: “While it may seem easy to foresee which industry will grow the fastest, that foresight has no real value if most other investors are already expecting the same thing.  By the time everyone decides that a given industry is ‘obviously’ the best one to invest in, the prices of its stocks have been bid up so high (or low in our case) that its future returns have nowhere to go but down.”  (p. 16-17 of The Intelligent Investor)

You must remember that markets are forward looking and anticipate the future.  See crude oil – prices have risen sharply but demand has yet to pick up.  Given this, I am not surprised at the rebound in Treasury prices Thursday and Friday.  Yields peaked at 3.75% Thursday afternoon and finished the week at 3.47% (bond prices and yields move inversely).  Everyone “knows” the Treasury is going to issue record amounts of debt this year (and probably for the next few years too) but the easy money has already been made.

 

Now I’ll touch on a piece of information that was completely overlooked Friday.  The Chicago PMI (purchasing managers’ index) was extremely weak.  The May reading was 34.9 compared to 40.1 in April.  The estimate was 42.0.  Any reading below 50 signifies overall business contraction.  I did not hear one person mention this very bearish data and pretty much every asset class rallied Friday in the face of this news.  The economy is still very weak and people are getting ahead of themselves with their second half recovery talk.     

 

Market Summary: Friday, May 29, 2009

Some links thanks to Dave…

• The moral of the story is do away with pensions.  401(k)s are less expensive and give people the opportunity to manage money to fit their risk tolerance, and upon retirement to move that money to an IRA and manage it however they want.  The argument about bondholders being diversified and former employees not is dead-on but not in the way he meant it – there is no reason anyone should be solely dependent on any one company (also see Enron – about time we learn from this). 

• Mean Street: the new conflict of interest in GM 

• GM/Chrysler checks and balances on the bailouts.  When you need checks and balances you obviously need Ralph Nader (who now lists his title as “consumer advocate”). 

• Treasurys and mortgage rates on the up…not good for housing problems. 

• Felix one-liner on Treasurys – looks at the moves in the 7- and 10-year over the last two weeks 

• Just when you think he’s down, Buffett’s Coke round 2? 

• Still waiting for sorry from Clinton

Market Summary: Wednesday, May 27, 2009

• Two great videos covering credit markets, rising Treasury yields, the Fed’s monetary policy, our trade deficit, and other macro economic issues: Video 1, Video 2

• An in-depth look at malls and why so many are closing

• A piece on inflation and rising bond yields

• Home prices are back to “normal” levels but there is still a ton of mortgage debt out there

• Jeff Macke, one of the talking heads on CNBC, went crazy last week

• Nice summary of today’s action

 

More chatter on newspapers

Talk over the "death of" the newspaper industry is getting to be a bit worn as it enters its nth week of doom-saying, but I bring it up again because Congress, chaired by John Kerry, who was concerned losing the Boston Globe, has finaly sparked an interest and held a few hearings.

My journalism-student friend who showed me footage of a speaker at the hearings who really impressed me. David Simon, who used to be a reporter for the Baltimore Sun, made an enthralling and insightful speech about his take on the environment, and the many sins of both sides. Mr. Simon doesn't hold the same conflict of interest as current-day newspapermen, having left newspapers in the mid-90sand. He has since gone on to create and write the acclaimed HBO series, The Wire. Sweet.

Check out this video of his full speech here, David is an enthralling speaker.

Unfortunately, despite doing a fantastic job defining the context and urgency of the issue, and fairly painting both sides as to blame, I don't think David Simon offers a feasible solution.

I'll leave the context painting to David, and jump to his 3 proposed solutions, which he gives near the end of his speech. Again, if you're not familiar with the matter, or if you want to get the skinny from someone who can really sum up the entire problem from both sides in a fair and balanced manner, please watch the video.

1. David says: 

"...a non-profit model intrigues. Especially if that model allows for locally based ownership and control of news organizations. Anything the government can do in the way of creating non-profit status for newspapers should be seriously pursued."

Interesting idea, but how would it work? This seems to conflict with a sentiment he expressed right before saying this - that newspapers should bite any hand that feeds them. Who would own them?Corporations? Wealthy locals? And what local interests would be willing to fund journalism on an international scale?

And what type of non-profit would newspapers be classified as? 501(c)(3) non-profits are strictly prohibited from engaging in politics. I'm classifying newspapers as a 501(c)(4) might work,despite the fact that (c)(4)'s are not allowed to further the private interests of those with financial stakes in them. This happens at public accounting firms, and essentially would mean that folks who work at newspapers can't own stock in anything their newspaper is reporting on whose story they can influence. However, C-4s are at least allowed to lobby and campaign politically. 

Otherwise, Congress could simply write newspapers in as their own new 501(c), the real challenge remains figuring out how to finance the non-profit, all this would do is ease their tax burden.

2. Another of David's ideas: 

"And further, anything that can be done to create financial or tax based incentives for bankrupt or near bankrupt newspaper chains to transfer or donate non-profitable publications to locally based non-profits should also be considered."

A short term solution, not one which is going to do anything but save a few brands and create tax haven for inventive accounting schemes. Such regulation issues could stem far into the future unless you set a real short sunset-clause on such a bill. How many companies that put out "news" or that own subsidiaries that are news organizations do you think will try to take advantage of a hastily drawn bankruptcy loophole in tax law? 

And to what end would this serve, anyway? We are simply handing off a broken business model to some other company who won't know what to do with it. Such scaling back by a new owner would likely follow a Private Equity model, which would break any unions in bankruptcy court, then strip the company of assets and lay off a ton of people, building operations from the ground up again. I doubt this is what anyone has in mind for saving the "industry."

3. Third Simon idea, and this is the big one: 

"Lastly, I would urge congress to consider easing anti-trust prohibitions to that the Washington Post, The New York Times, and various other newspapers can openly discuss protecting copyright from aggregators, and plan an industry-wide transition to a paid, online subscriber base."

Simon says it costs money to maintain the current model sending people places. That's abosultely right, it does cost money to do this, and it will always cost money to do this. But how in the world are you going to prevent people from accessing this information for free? 

Let's look at how things work, currently. Information is released to the public through the website, and the two prevailing ideas are either people pay a flat-rate for all access, or make micro-payments for each article.

WSJOnline works with the flat rate for all access, and hybridizes the model by letting some of it remain free to the public, probably trying to incent new customers to subscribe by giving them a taste, while supporting the free part somewhat through banner ads. I have my doubts on this model, as I have not heard it working too well for WSJ, and nobody else seems to want to try it. Perhaps the micro-payments option could "work" once the infrastructure is in place (i.e., people find it easy and convenient to pay a few pennies to click on a link). This system can and will be developed, and I'm sure if newspapers won't pioneer this technology, amazon or ebay will, as they make the online payment process faster and easier. It's another question entirely as to whether or not customers will buy-in.

However, I think these suggestions are treating a symptom, not the disease. So people aren't paying for newspaper articles online. Fine, there's the symptom. The disease comes from the fact that readers are just getting the information from elsewhere. As David Simon explains, the blogosphere

"does not deliver much first generation reporting. Instead, it leeches that reporting from main-stream news publications whereupon aggregating websites and bloggers contribute little more than repetition, commentary, and froth. Meanwhile, readers acquire news aggregators, and abandon its point of origin, namely the newspapers themselves."

This is not only absolutely true, but describes what our website does in it's entirety!

Can we stop blogs from doing this? Look at how difficult it has been to police illegal music and movie file-sharing. And that's data where the content (i.e. the syntax) doesn't change. Imagine how difficult it would be to police for stolen semantics? That aside, by chasing quotes or hyperlinks alone, our government would need to invest in an incredibly expensive and difficult-to-maintain technological regulation program that would almost certainly infringe on our first amendment rights. In fact, the mere act of policing for everything written in newspapers sounds in itself, to pull from Simon's panoply of references, Orwellian.

This is why, although David Simon can complain and enlighten, he does not deliver a feasible solution. Technology is always going to be disruptive. I'm fully aware how frightening that this time, it is disrupting an important and necessary public good, but that isn't going to turn back the tide.

Is this death of journalism as we know it as bad as everyone assumes it to be? Ask yourself how mediocrity was allowed to flourish prior to the internet, which is what Mr. Simon purports. What do you need to combat that mediocrity? Obviously, newspapers aren't the best answer - otherwise we wouldn't have had an industry which "butchered itself" (Simon's words) in quality. And certainly, this is not a sin of the newspaper industry limited to our times, lest I cite the period of "yellow journalism" at the turn of the 19th century.

Isn't it clear that the best model will come from one which people can describe as important to them as soon as it happens, and which the powers that present the issues can aggregate these concerns and speak about them in one cohesive voice? Mr. Simon recalls when Baltimore newspapers stopped reporting on social services, despite the fact that 50% of adult black males in Baltimore were without a job, or now newspapers were ignoring the Baltimore criminal courts, despite the high degree of crime in the city. Contrast this with Google, which now can literally save lives by tracking when and where spikes of "flu symptom" search queries appear, and notify the CDC or regional health care groups, who can act to combat an outbreak before it becomes an issue. Whatever solution to journalism comes about, if its input is crowd-sourced, it will truly have a finger on the pulse of what people care about. Thic can easily be done by noting what people talk about in a traceable public forum (like the blogosphere and twitter) that would help whatever replaces the current journalism model concentrate its efforts.

Obviously, news does much more than this, by also enlightening its audience on issues people who didn't know they cared about. I don't know how this can be done reliably. However, to the extent that these issues are corruption, I think we can at least start by trying to better frame the problem. I think that journalism fights corruption in places where there isn't enough transparency. The real issue in solving corruption, therefore, must be in increasing transparency. This is something technology is very good at doing.

Lastly, I take issue with Simon's opinion of the quality of the blogosphere - not in terms of how it gets its information, Snow describes our sins with great accuracy there, but rather by the manner in which people treat the writing. I find it quite easy to know when to stop reading a blog post, or a comment on a blog post, as I've developed an eye for a quality argument. There are enough bloggers out there who I have grown to trust and respect who add value even if it isn't first-generation news. I also find it much easier in this new technological environment to do the appropriate fact-checking, or get a contrary opinion. And hopefully, as more data is published on the interenet and search becomes more inteelligent, that fact checking will have to rely less and less on other journalist articles, and more on the real, unbiased data or record (take, for example, what is expected of data.gov, especially considering when powerful search tools like Wolfram|Alpha integrate with those services). 

Anyway, the same skepticism over honesty, integrity, and completeness has always held true over newspapers as well. Why else do people complain over Fox News, or say that one does not get a real perspective of a news story unless they read 2 or 3 different papers?

How do we save newspapers? I guess Simon has cited the best ideas the industry has going it - force paid content and imbibe the industry with tax exempt status. Will that actually work in the long run? Doubt it.

Maybe we should be asking how else the world can find out about what is going on...

Market Summary: Tuesday, May 26, 2009

• Bill Ackman talks about his Target proxy fight and being an activist investor…FANTASTIC, Video 1, Video 2

• Home prices continue to fall.  Take it with a grain of salt because this data is from March so it’s a little backward-looking.

• Not everyone is happy with Obama’s appointment to the Supreme Court.

• Consumer confidence soars and sparks a huge rally on Wall Street.

• Kim Jong-Il keeps trying to scare the you know what out of everyone.

• GM and Chrysler update; GM bondholders reject offer.

• Facebook valued at $10 billion.

 

Are the "Green Shoots" Wilting?

Do you believe what everyone is saying about a second half recovery?  Do you think the worst is behind us?  Do you think we are out of the woods?  Not so fast! 

In early March, when the stock market bottomed, everyone was talking about how Armageddon was upon us.  Now, just two and a half months later, everyone is talking so optimistically about how the economy is recovering nicely.    

This bear market rally – yes, we are still in a bear market and will be for some time – was caused mostly by short covering.  That is, people who were betting stocks would fall reversed their bets when the market turned higher after Citigroup said it was “profitable” the first two months of the year (I’ll touch on the banks’ false profits later).  Some of the worst performers from 2008, which were the most heavily shorted stocks, have led the market higher. 

I am not a buyer of this false rally and all the economic “green shoots.”  Right now, the path of least resistance for stocks is lower because all the “good” news has been priced into stocks.  Everyone is a little too optimistic about a recovery in the near term (I think we will be trending sideways for a long time) even as some economic indicators are worsening. 

The stock market has rallied 31% from its recent low, but it will not go much higher.  Current earnings estimates for the S&P 500 are $56.94 for 2009 and a whopping $73.37 for 2010. (source: Thompson Reuters)  Is it realistic that companies will improve their earnings 29% over the next 18 months?  I do not think so!  Earnings estimates will come down; therefore, stock prices will come down too.  Here’s why: 

1)      Companies are selling assets to raise cash (especially banks) and they will not have the same earnings power going forward.    

2)      Unemployment is expected to go to at least 10%.  Even though initial jobless claims are “stabilizing,” continuing claims hit a new record every week.  As more and more people lose their jobs, spending will decrease causing corporate earnings to decrease. 

3)      Taxes will go up to help offset the government’s massive debt.  Obama already said this is going to happen; it is a matter of when not if.  As personal income taxes go up, the consumer will get pinched and decrease spending.  Corporate taxes will also go up which will cause companies’ bottom lines to shrink.  To offset decreased profits, price increases (inflation) are very likely which will also hurt the already ailing consumer. 

Also, who wants to invest when the government keeps changing the rules and intervening?  First were restrictions for financial companies that took (or, rather, were forced to take) TARP money.  Next were the automakers.  The government should just cut its losses and forget about setting up a government-owned auto company that will buy GM’s “good” assets when it files for bankruptcy.  Ridiculous if you ask me.  Government cannot run government.  How is it going to run an auto company?  Now it is the credit card companies and new legislation preventing rate hikes when people miss their payments (in no way, though, am I saying what credit card companies were doing was right).    

Let me briefly touch on the banks’ “false” profits.  Goldman Sachs (GS) reported better than expected earnings because it shifted its fiscal calendar so December results were not included in its most recent earnings release.  GS had a $780 million after-tax loss in December that will go largely ignored. (source: nytimes.com) Citigroup and Bank of America were profitable because they were able to book “gains” (thanks to mark-to-market accounting rules) as their CDS spreads deteriorated.  Basically, they lowered the value of the liabilities on their books and this reduction was treated as a gain on the income statement. (source: Portfolio.com)   

That is enough negativity for now.  Let’s focus on some positives.  Below are some recent fundamental improvements in the economy. 

1)      Banks have been able to raise capital successfully in the equity market to meet the government’s stress test requirements.  Many of these offerings have been over-subscribed – a sign that investors have a higher appetite for risk.  Most notably, Bank of America raised $13.5 billion, Wells Fargo raised $8.6 billion, Morgan Stanley raised $4 billion, and U.S. Bancorp raised $2.5 billion. (source: Bloomberg.com) 

2)      Banks are not afraid to lend to one another anymore.  The overnight LIBOR rate currently sits at 0.46%, down from its high of 4.82% after the collapse of Lehman Brothers. (source: Bloomberg.com)   

3)      Corporations have been able to issue debt.  Recently, Microsoft issued $3.75 billion and Wal-Mart issued $1 billion.  However, only companies with the most pristine balance sheets have been able to access the debt market. (source: Bloomberg.com)    

4)      IPOs have started to pick up again after being non-existent for some time.  There were 296 IPOs in 2007, 57 IPOs in 2008, and eight so far this year.  Seven of the eight IPOs this year have taken place after the market bottom in early March. (source: MSNBC.com) 

5)      Mortgage rates are still near historic lows even as yields on longer term Treasurys have steadily risen.  The average 15-year fixed rate mortgage is 4.64% and the average 30-year fixed rate mortgage is 5.00%. (source: Yahoo! Finance)    

6)      Commodity prices are rebounding with the biggest gains coming in the energy complex.  Gasoline futures are up 132% from their late-December low of $0.785 and crude oil futures are up 89% from their mid-December low of $32.40.  Demand from the emerging markets remains strong as they avoided a lot of this financial mess, and OPEC is talking about cutting production again.  There is also talk that the “evil” speculators are back and they are the reason prices have rallied so strongly. (source: Barchart.com)  

Even though there may be signs that the economy is “not as bad” as before or that it is “stabilizing” (two phrases that I hate and hear way too often on television), there are many fundamental problems that remain.  Do not get caught up in the media’s effort to talk-up the stock market or the economy.  If you turn your head to the problems that still exist, like the media is doing, you will get burned when everyone finally realizes we are not out of the woods just yet.           

Gold Rally

The easy money has been made with the gold trade.  Futures hit a low of $681 in late October and have since rallied to $1008 (02/20/09).  The government has flooded the economy with dollars and future inflation is evitable (Obama’s pledge to cut the federal deficit in half by the end of his first term is laughable).  Everyone knew gold should go higher and it did – a 48% rally trough to peak.  Gold has also been bid up as it is also a flight-to-safety trade given the highly uncertain and tepid equities market.  However, gold is still off its all-time high of $1034 (March 17, 2008, Bear Stearns collapse).

Five years from now, I believe, gold and other precious metals will be trading at much higher levels, but recently, the gold trade has become very crowded.  That is, everyone (and I mean everyone), is buying gold or on CNBC saying you should buy gold.  Gold has since pulled-back to $930. 

Here's the rule to follow: Do not chase what everyone else is buying (or saying to buy).  Just because other people are buying does not mean you have to buy.  The thesis may be correct, but the price may not be correct.  When people say to buy something, it is probably too late.  Wait for the pullback and the pounding-the-table "buys" to subside to get a good entry point.

Financial folly: A (meager) defense of the nationalization of banks.

The famous John Bogle, founder of Vanguard Mutual Fund group, reminds his readers in Enough of an epigram from 18^th century Britain:

Some men wrest a living from nature and with their hands; this is called work.

Some men wrest a living from those who rest a living from nature and with their hands; this is called trade.

Some men wrest a living from those who wrest a living from those who rest a living from nature and with their hands; this is called finance.

Of course some people have always been skeptical of the real value finance holds. Tim O’Reilly, who, while being a very smart guy, is certainly not a finance guy, and about a month ago put out an essay on his blog likening our global economy to a Ponzi scheme in itself. Tim cites former World Bank economist Herman Daly, who was griping about the global crisis back in October last year.

As Daly puts it “Real wealth is concrete; financial assets are abstractions—existing real wealth carries a lien on it in the amount of future debt.” And while Daly made this statement to set up an obvious argument about how debt works, this point is illustrative for a different reason – why are financial assets abstractions?

Gao Xiqing, the president of China Investment corporation, a SWF that manages $200billion of China’s foreign assets, and makes the most newsworthy of China’s foreign investments (Blackstone, Morgan Stanley, etc), described financial assets in a recent Atlantic article this way:

First of all, you have this book to sell. [He picks up a leather-bound book.] This is worth something, because of all the labor and so on you put in it. But then someone says, “I don’t have to sell the book itself! I have a mirror, and I can sell the mirror image of the book!” Okay. That’s a stock certificate. And then someone else says, “I have another mirror—I can sell a mirror image of that mirror.” Derivatives. That’s fine too, for a while. Then you have 10,000 mirrors, and the image is almost perfect. People start to believe that these mirrors are almost the real thing. But at some point, the image is interrupted. And all the rest will go.

These assets are nothing more than contracts, and are conceived in acts of financial wizardry as quickly as they can be sold. Daly addresses this point head on:

Can the economy grow fast enough in real terms to redeem the massive increase in debt? In a word, no. As Frederick Soddy (1926 Nobel Laureate chemist and underground economist) pointed out long ago, “you cannot permanently pit an absurd human convention, such as the spontaneous increment of debt [compound interest] against the natural law of the spontaneous decrement of wealth [entropy]”. The population of “negative pigs” (debt) can grow without limit since it is merely a number; the population of “positive pigs” (real wealth) faces severe physical constraints.

Fine. We get it. These things can be dangerous. Dividends in particular are financial weapons of mass destruction, as Buffet put it like a million years ago. But our economy creates a lot of really valuable stuff that only exists as an idea, as bits of information, not in any warehouse. Through an accountant’s eyes, how are derivatives fundamentally different from software, or insurance, or a new drug? Leverage is a complex and value-adding technology; one must know how much of it, of what type, and how and when to re-position it. Our problem with leverage was not that we had too much, but that we didn’t understand it. As entities de-lever, they are returning to positions where they won’t be in as much hot water the next time they get it wrong. This is akin to releasing a drug too soon, and finding out that it has a chance of killing people.

What’s the solution? Well, we can start with improving our financial regulation, which has proven pretty soundly that it is less than useless – it’s dangerous. I don’t have the time in this article to discuss the many things we should probably be doing to fix regulators and rating agencies, but I do want to address one concern: complexity. The GAO (Government Accountability Office) had this to say in a recent report entitled A Framework for Crafting and Assessing Proposals to Modernize the Outdated U.S. Financial Regulatory System:

As new and increasingly complex financial products have become more common, FASB and SEC have also faced challenges in trying to ensure that accounting and financial reporting requirements appropriately meet the needs of investors and other financial market participants. The development and widespread use of increasingly complex financial products has heightened the importance of having effective accounting and financial reporting requirements that provide interested parties with information that can help them identify and assess risk. As the pace of financial innovation increased in the last 30 years, accounting and financial reporting requirements have also had to keep pace, with 72 percent of the current 163 standards having been issued since 1980—some of which were revisions and amendments to recently established standards, which evidences the challenge of establishing accounting and financial reporting requirements that respond to needs created by financial innovation.

CFO Blog mentioned this report two weeks back (it’s where I found that quote), and elaborated:

Accounting rulemakers have struggled to keep pace with financial innovation… But missing from this statement of the bleeding obvious is the fact that many of the 'financial innovations' in question were innovative because they were slick end-runs around accounting rules. Structured finance, by definition, is some form of leverage whose structure is complex enough that the letter of accounting rules does not apply. Ditto for hybrid securities, intended to win preferential accounting and tax treatment.

What does this issue have to do with nationalizing our banks? Nassim Taleb, recently stated on Charlie Rose that banks should be treated as utilities. The entities that take the real risks, the sophisticated investment vehicles like hedge funds, will still have role, albeit significantly smaller, and under the explicit understanding that they will never be bailed out again. Could this stronger control restrain us from making big bets on complexity that we do not yet understand? Could government oversight allow for economists to have a greater sense of how finance works, and allow for us to design better models for control? Perhaps, although we can probably be just as certain of the inefficiencies and restrained growth that comes with bureaucracies and government oversight.

Should we nationalize banks? Should bank holding companies just be plain-vanilla utilities? I have no idea, but I do know that we don’t seem to understand how the modern capital markets really function. And even if we do, we definitely don’t have the transparency and the appropriate control systems in place to organize this system to our predictions and analysis will be relevant. Would having our government oversee these capital markets help our economists develop the appropriate theories to understand our world? If so, it sure sounds a lot like communism. Not that we’re not pushing that envelope anyway.

Bringing it all back to Tim O’Reilly and Daly’s arguments, they promote a “steady state” economy. With the arguments I have made in this post, I will continue this week to discuss the merits and the issues with a steady state model as I see them.

Market Summary: Mon. Jan. 26, 2009

Something I noticed today that was not talked about too much in the news was the significant amount of job cuts announced.

1)      Home Depot will lay off about 7,000 workers (2% of workforce), and it will exit its EXPO business.

2)      Caterpillar will eliminate 20,000 jobs (almost 18% of workforce).  The company also reported earnings that missed expectations.  Q4 net income was $1.08 per share (compared to $1.50 per share a year earlier) while analysts were expecting $1.30 per share.   

3)      Sprint Nextel will cut 8,000 jobs (about 15% of workforce).  The job cuts will save the company about $1.2 billion each year.

4)      GM will cut 2,000 jobs (3% of 64,000 employees) at plants in Ohio and Michigan.  The last time GM made a profit was in 2004 when the company employed 111,000 workers.

5)      Deere will cut about 700 jobs (just over 1% of workforce) at factories in Brazil and Iowa.

6)      ING, a Dutch financial company, will lay off 7,000 workers (about 5.5% of workforce).

7)      IBM reported that it eliminated 1,400 sales jobs (about 3.5% of workforce) last week.

Companies are going to great lengths to lower costs and the easiest and fastest way is to reduce the number of employees.  Obviously, these companies are behind the curve, but I look at it as a positive sign. 

I became much less bearish on my outlook for the economy and the stock market after I attended University of Illinois’ town hall meeting where the school’s budget and plan to cut cost and over the next few years was discussed.  It takes a great deal of time for large institutions to make changes (especially financial ones), and when these big institutions finally realize they need to make changes the worst is already behind them.  In no way am I saying that the economy will bounce back and the stock market will zoom higher, but for now, people know things are bad and they are finally making the appropriate decisions to deal with the stagnant economy.   

Re-inventing economics: Part 1

One of my favorite bloggers, Fred Wilson, recently questioned the relevance of economists, especially after their inability to predict, as well as (arguably) correct this current global economic crisis. Fred cites Umair Haque, who griped that “We can't fix today's problems unless we change yesterday's rules. But economists -- and the models they rely on -- are bounded by yesterday's rules.”

Now I’ve got no patience for people who try to ignore the past because they of sensationalism or some naive idea that this time it’s all different. However, we can always improve on the past, so in this post is the first of two very potent ideas I’ve read about recently pertaining to a shifting opinion in modern economics.

Nobel Laureate Joseph Stiglitz (well, Economics isn’t one of the REAL Nobel Prizes, but everyone treats it that way) has put out a paper with a handful of other clever clogs describing a fresh look at economics based on modern networks theory. They developed their paper using data pulled from banks and certain firms in the 2004 Japanese credit market.

The paper basically argues that the old way of looking at markets through “the average, or most probable, behavior of the constituent” does not best describe the true “dynamics of the system,” when that system is made up of autocatalytic processes.  Autocatalytic processes are simply processes that grow on their own (self-perpetuating), and in this case, they become very important when they grow faster than the average, or most probable process. This type of growth can be “scale-free” or “scale-invariant,” which means the bits and pieces that make up the whole all grow at different rates, so after time some processes become more important than others.

So to put it simply, Stiglitz & co basically said that we should use a theory that doesn’t ignore the rare (i.e. not average or most probable) processes, when those processes can grow at astonishing rates, and become very important (e.g. processes that caused this crisis). “The real world is controlled as much by the tails of distributions as by means or averages” (page 2).

And not that this is new: apparently “the relevance of scale free distributions in economics (e.g. of firm size, wealth, income, etc.) is now extensively recognized, and has been the subject of thorough investigation in the econophysics literature” (page 2). I don’t even want to imagine what econophysics is. Regardless, people apparently haven’t given much consideration to how this type of thinking relates to credit markets, UNTIL NOW! The authors purport “…Japanese credit market shows that the credit relations between banks and firms are scale-free, and the standard representative agent plus normal distribution framework is badly equipped for dealing with it” (page 2).

I could be wrong, but I’m pretty sure this is basically chaos theory (which has been around for decades) meets the credit market.

An example the authors give is “the failure of a firm heavily indebted with a bank may produce important consequences on the balance sheet, or the financial status, of the bank itself. If a bank’s supply of credit is depleted, total supply of loans is negatively affected and/or the rate of interest increases, thus transferring the adverse shock to the other firms. Therefore the study of structure of the links and their weights allows to gain some insights in the financial stability of the economic system and to develop new economic policy tools” (page 2). This all looks to be pretty obvious – surely anyone with a passing interest in economics or finance recognizes the interrelatedness of these processes. Joe and Co just look like they’re one of the first guys to decide to map out and measure those links and their weights, this time in a controlled experiment (2004 Japan).

Network theory is an analysis of the interrelationship between nodes and links. In the case of this paper, nodes are banks and firms, while links are debt/credit contracts those banks and firms hold.

I don’t have the patience (or probably the intelligence) to wade through the actual research, but the conclusion offers some interesting opinions on how lessons learned from this data can maybe produce useful tools to stem future crises.

Basically Joe & Co think that “instead of a helicopter drop of liquidity, one can make “targeted” interventions to a given agent or sector of activity.” Presumably, if you use network theory to understand how problems of, say, liquidity arise, then you can surgically fix the problem at its source. Of course, in order to put this into practice, economists would both need to satisfy a tall list of demands:

1. 1.      Have at hand all of the relevant data (this probably means every balance sheet for every relevant institution as well as every debt contract [both of which of course must include homeowners’ personal finances and their mortgages]
   
2. 2.      Intimately understand all of these autocatalytic processes (of which in a modern economy there must be potentially millions)
   
3. 3.      Be able to act quickly enough to solve the problem before it gets out of hand
   

Sounds like the job for a totalitarian, dystopian, and super-intelligent government. But let’s be honest, wouldn’t access to that degree of information be every economist’s dream? Or perhaps this will all be possible, now that we are building petaflop computers that can probably manage the work, and we own all of the banks anyway…

 

Market Summary: Fri. Jan. 23, 2009

Capital One (COF), a credit card company, reported poor fourth quarter earnings and gave a very negative outlook.  For the quarter, COF lost $3.74 per share while analysts were expecting a profit of $0.33.  The company set aside $1 billion for bad loans, and expects unemployment to rise to 8.7% and home prices to decline another 10%.  The company’s CFO said that “the really big risk to our outlook isn’t 2009, but it is what 2010 might look like.”  The company also said that 7.08% of its credit card and auto loans were in default.  During the third quarter, this figure was only 5.85% (Source: WSJ).      

Based on what Capital One said, we should not expect a quick recovery anytime soon.  2009 just began and COF is already preparing for a bad 2010.  Many analysts are expecting credit cards and auto loans to be the next shoe to fall.

Citigroup tapped the government’s Temporary Liquidity Guarantee Program for $12 billion.  This money is guaranteed by the Federal Deposit Insurance Corp. (FDIC) making it the highest rated debt.  This is the largest debt offering under this program since its inception on November 25, 2008.  When will the government just cut its losses and let Citigroup go under?

Freddie Mac also announced it will need $35 billion of government TARP money. 

Market Summary: Thurs. Jan. 22, 2009

Negativity returned to the market today, but stocks managed to finish well off their lows.  Stocks were down more than 3% this morning, but only finished down 1.5%.  Even though stocks lost ground, there was no flight-to-quality trade as investors actually sold Treasurys today (yields up).  When investors are willing to take on more risk – financials, growth names (infrastructure, energy, and materials), and emerging markets – the market will turn higher.

Down-beat news from Microsoft set the tone for the markets today.  The company announced that it “will cut as many as 5,000 jobs, the first companywide firings in its 34-year history.”  Net income for the fourth quarter was $0.47 per share, but analysts were looking for about $0.50.  Revenue also fell short of expectations by about $500 million.  The stock finished down 12% and did not rally when the market turned higher in the afternoon.  It actually closed near its lows.   

Recently, there has been a clear divide between the tech winners and losers.  Winners: Apple, IBM, Google, Hewlett-Packard, and Research In Motion.  Losers: Microsoft, Intel, Dell, and Yahoo. 

Worse-than-expected economic data also weighed on the markets.  Initial jobless claims were 589,000 last week – 46,000 more than expected.  Also, continuing claims increased to 4.61 million.  December housing starts and building permits were both below expectations.  Crude oil inventories increased 6.1 million barrels last week – 4.7 million more than expected (Source: Briefing.com).      

The most surprising news story of the day was John Thain, the former Merrill Lynch CEO, getting fired from Bank of America.  Much controversy has surrounded the Bank of America acquisition of Merrill Lynch because Merrill reported a $15.4 billion fourth quarter loss.  What problems did Merrill Lynch have that Bank of America did not know about?  Was Merrill hiding something?  On top of his firing, it was reported that Thain spent over $1.2 million to redecorate his office when he became CEO.  He spent $87,000 on area rugs and $25,000 for a table.  Ridiculous!  He deserves to get fired.     

After hours Google reported stellar earnings that handily beat expectations.  

Market Summary: Wed. Jan. 21, 2009

We saw a relief rally from yesterday’s massive sell-off, although stocks are still down over the two-day period.  Stocks got a little over-sold yesterday (especially the financials), and investors went bargain hunting today to buy the stocks of good companies on the cheap.

Here’s the news: 

1)      FDIC Chairman Sheila Bair commented that “banks are solvent” and “well-capitalized overwhelmingly.”  Either she is lying to assuage Americans’ concerns or she does not know what she is talking about.  Banks are in desperate need of capital, especially the large institutions with lots of mortgage-related securities, as they are rapidly burning through the TARP funding that was just distributed.

2)      Talks of forced nationalization of UK banks continue to scare investors.  Barclays was down 19% and Lloyds was down 12.5%.  The UK government owns a 70% stake in Royal Bank of Scotland and a 43% stake in Lloyds.

3)      Financials led the market higher after news broke that several bank insiders purchased shares.  JPMorgan’s Jamie Dimon bought $11.5 million of stock, and Bank of America executives purchased about $3 million of stock.  Insider buying is considered a bullish sign for a stock.   

4)      Shares of Wal-Mart were downgraded because “the incremental benefit it realized from consumer trade-down in 2008 might not repeat itself in 2009.”  I agree with this analyst.  Wal-Mart has rallied significantly from its September 2007 lows even though its earning have not kept pace.  When the market turns Wal-Mart will be left behind along with many of the defensive stocks.

5)      Warren Buffett purchased another $272.2 million of Burlington Northern (BNI) shares.  Buffett’s 21.75% ownership in BNI makes him the company’s largest shareholder.

6)      US Bancorp reported quarterly profit of $0.15 per share, which fell short of the $0.18 estimate.  During the quarter the bank quintupled the amount set aside for loan losses.  Shares were down 20% in the morning, but actually finished the day in the green.  This is one financial company that actually made money in the fourth quarter.  Pretty impressive!

7)      Apple reported quarterly results after the bell that handily beat estimates.  Despite Steve Jobs’ illness, the company is still performing and remains a “buy.”  The company reported earnings of $1.78 per share.  Analysts were expecting $1.40.  Revenue also beat expectations and rose 5.8% year-over-year.  Quite impressive numbers given the state of the consumer and economy.

8)      Intel announced it may cut up to 6,000 jobs. 

9)      Hedge fund investors withdrew a record $152 billion in the fourth quarter of 2008.  

Market Summary: Tues. Jan. 20, 2009

As I said in my last post, as the financials go so does the market.  Stocks finished the day down 5.3% and the financials (XLF) were down 16.5% (when I say stocks I am referring to the S&P 500).  Today’s news simply reiterated the fact that all financial institutions are in trouble (at home and abroad) and remain a “sell.”  They are simply not investable.  How are they going to make money in the future?  Will they even be public companies?

 The big losers:

-         State Street Corp  -59.04%

-         Barclays  -42.62%

-         PNC Financial Services  -41.40%

-         Bank of America  -28.97%

-         Regions Financial  -24.22%

-         Wells Fargo  -23.82%

-         JPMorgan  -20.73%

-         Citigroup  -20.00%

-         Goldman Sachs  -18.96%

European banks have been under pressure too.  Concerns are mounting that Royal Bank of Scotland may be nationalized by the British government.  The company lost $41 billion in 2008 and the British government is exchanging its preferred shares of common shares that could give it 70% ownership in the bank.  Because of this news the British Pound was crushed today.  It trades at its lowest level versus the Dollar in almost eight years. 

The U.S. government is way ahead of European governments in terms of financial aid and bailouts.  Look for weakness in Europe, specifically Britain, to continue.  

-         Fiat is in talks to acquire a 35% stake in Chrysler.  There is no cash involved with this transaction, and it is not a merger.  The companies would get access to each other’s plants and technology. 

-         Meredith Whitney explained what is going wrong at Citigroup.  Its “core problem is that it simply doesn’t make money in any of its businesses except Smith Barney, which it is in the process of selling.”  After the bell, Citigroup announced it is cutting its dividend to $0.01 from $0.16.  

-         Here is a good article that discusses the oil market.  There is an estimated 80 million barrels of oil being held on offshore tankers in order to take advantage of the steep crude curve.  That is, buying cheap crude today (spot market), storing it on these tankers, and then selling it in the future at a higher price. 

-         After hours, IBM reported earnings that beat estimates.  Shares are up 4% in after hours trading.

-         Obama took office today.  But guess what?  Nothing changed about our economy.  It still stinks!

-         The government has given Citigroup $45 billion in loans, but the company’s market cap is only $15.3 billion.  The government should just buy the company outright, do what it wants with the good and bad assets, and avoid all the added uncertainty and fear that is plaguing the financial markets.