The 85,000-mile relay that will culminate with the lighting of the Olympic torch got underway March 24. The torch will pass through five continents and 20 countries on its way to the Beijing 2008 Olympic Games. But the flame isn’t just leading athletes and spectators to the games, it’s also lighting the way to profit.
Beijing is spending at least $40 billion on venues and related infrastructure, all with the goal of showing to the world a modern country that has grown into a political and economic powerhouse.
In addition to the government’s own investment, an estimated 3.5 million visitors will be bringing their wallets to the games. More than 60 sponsors, some of which spent $100 million each just to be associated with the Beijing Olympics, also have opened up their checkbooks.
There’s going to be a lot of money flowing through Beijing as consumers, advertisers, and investors alike swarm the city.
Here are a few of the leading candidates to win big come August…
Overnight Profits
The number of international visitors to China rose 9.6% in 2007, with close to 55 million arrivals, the World Tourism Organization reported. In that same time, Chinese domestic travel skyrocketed with 1.6 billion domestic trips.
Hotel managers in China saw an increase in revenue per available room (revPAR) of 3.2% in 2007, according to HotelBenchmark Survey by Deloitte & Touche LLC.
The Beijing Tourism Authority predicts the city will be flooded with 3.5 million visitors, both domestic and international, during the games. Hotels and houses for rent are going quickly, and insiders say that rental rates during the Olympics will be 10 times the usual amount. Conscious of the investment opportunity, Beijing residents have been grabbing up as much real estate as possible to prepare.
The average cost of a hotel room in Beijing was $127 a night in 2007. The city’s occupancy rate was 70.8%. And it’s a safe bet that both occupancy, and the cost of accommodations, will be significantly higher in 2008.
A leading economy hotel chain such as Home Inns & Hotel Management Inc. (HMIN) stands to reap a tidy profit from the increased traffic that will be pouring through China. Home Inns reported revenue of $135.7 million (989.5 million yuan) last year, an annual increase of 68.1%. The profit margin of the Nasdaq-listed company jumped 43% year over year to $15.2 million (106.7 million yuan) in 2007, its unaudited financial report said.
"While we delivered strong overall financial results for 2007, we did experience increased costs as well as some negative margin pressure during the fourth quarter due to our acquisition of Top Star and our expansion into lower tier cities," Chief Financial Officer May Wu said in the report. "We will continue to make efforts to more effectively manage costs as this effort continues."
The company expects its revenue in the first quarter of 2008 to be in the range of $47 million to $50 million, with full-year revenue growing 70% to 80% over 2007.
The Other Baidu
For 40 years - dating back to 1969, when civilian Internet emerged from a Defense Department project - the United States has had the biggest population of Internet users. But that mantle - like so many others - has been passed along to China.
China has some 225 million Internet users, according to the China Internet Network Information Center. BDA China, a Beijing-based consulting and research firm, thinks that figure is closer to 228 million. Either way, the United States has relinquished its web-surfing crown. And in the next year, another 60 million China consumers are expected to join the online world.
Web portals will be busy as billions of frenzied fans sign on for updates on their favorite events. Baidu.com Inc. (BIDU) , China’s leading search engine, will do well, no doubt, but Sohu.com Inc. (SOHU) might be a more unconventional play.
Sohu is a popular provider of online entertainment, information and communication. And it’s the official Chinese portal for the Beijing Olympic Games. Sohu’s fourth-quarter revenue shot up 90% to $65.3 million. Earnings soared 144% to 43 cents a share. Those results easily eclipsed Wall Street’s projected results of 39 cents a share on $55.4 million in revenue.
Advertisers will continue to ratchet up their spending as the Games draw nearer, and Sohu expects advertising revenue to soar by 40% in the first quarter of 2008. Analysts also think Sohu is well positioned to build on its momentum in the next year.
In a note to clients, Goldman Sachs Group Inc. (GS) analyst Leah Hao raised her first-quarter game revenue estimate by $4 million, increasing her total revenue estimate for the quarter to $72.8 million from $68.7 million. She also raised her first-quarter earnings estimate to 42 cents per share, from an earlier estimate of 34 cents per share.
The World’s Largest Clean-up Effort
In addition to beating out the United States to become the world’s biggest Internet user, China has also supplanted the United States as the world’s biggest polluter.
Half of China’s population - 600 million to 700 million people - drinks water contaminated by human and animal waste. In fact, one billion tons of untreated sewage is dumped into the Yangtze River each year.
Just as alarming, both the World Bank and the Chinese Academy on Environmental Planning believe air pollution to be responsible for no less than 411,000 premature deaths a year.
Indeed, China’s pollution is so bad that some Olympic athletes will be taking the last possible flights to Beijing to delay breathing in the city’s smog for as long as possible. U.S. Olympians will be bringing their own food out of concern for safety.
Most of the air pollution comes from the China’s coal-fired power plants, which supply 80% of the nation’s energy. The country is home to more than 2,000 coal-fired power plants, and a new one goes into operation every week.
Between 2003 and 2006, worldwide coal consumption increased as much as it did in the 23 years beforehand. China was responsible for 90% of that increase. China used 2.5 billion tons of coal in 2006, more than the next three highest-consuming nations combined.
With its climate-change program, China is working to reduce greenhouse gas emissions by 950 million tons over the next two years. To accomplish that goal, China’s going to have to find a new source of power, and so far nuclear energy seems to be Beijing’s best option.
In addition to the 11 nuclear reactors already operating in China, the government is looking to build 30 more nuclear power plants. This is the largest nuclear power initiative ever undertaken, and it’s entirely likely that the price tag will exceed $50 billion. For its money, the Republic of China would end up with 11% of the world’s nuclear energy capability.
What does this add up to? Possibly a big run-up in the price of uranium. At the end of 2003, when China first announced its plan, uranium was valued at $15.50 a pound. By June 2007, the price had climbed to $133, a 758% increase. The price has retreated from its peak to a current price of $73.00 a pound. But once China’s newest power plants come on line, and other emerging markets such as India increase their consumption, the price will likely bounce back.
According to the market’s leading journal, The Uranium Market Outlook, the amount of available above-ground uranium is at an all-time low. The journal attributes the sudden dearth to 30 years of underinvestment, increasingly stringent regulations and an overall lack of exploration of uranium deposits. It takes eight years for a mine to be brought up to standards and to start producing uranium of a high-enough grade for use in nuclear reactors.
Cameco Corp. (CCJ) has been called the "Saudi Arabia of Uranium" because it is the world’s largest producer, accounting for 20% of global supply. It’s also straight downstream from a glut of cash contained in a new energy bill that offers $18.5 billion in loans to cover the construction costs of new nuclear plants.
The stock has been beaten down by uranium’s price drop - and a sagging global economy - but was raised to "Buy" from "Neutral" by Merrill Lynch & Co. Inc. (MER) Canada analyst Alka Singh, who wrote in a note that the stock "looks attractive" and may be poised for a rebound.
Monday, March 31, 2008
Sunday, March 30, 2008
Learning from George Soros' Books
One trap you can fall into in life is not learning from those that you disagree with, for one reason or another. George Soros would be an example of that. His politics are very different from mine, as well as his religious views. He’s a far more aggressive investor than I am as well. I aim to hit singles with high frequency over the intermediate term. He played themes to hit home runs.
The Alchemy of Finance made a big impression on me 15 years ago. Perhaps it was a book that was in the right place at the right time. It helped to crystallize a number of questions that I had about economics as it is commonly taught in the universities of the U.S.
First, a little about me and economics. I passed my PhD oral exams, but did not receive a PhD, because my dissertation fell apart. Two of my three committee members left, and the one that was left didn’t understand my dissertation. What was worse, I had moral qualms with my dissertation, because I knew it would not get approved.
My dissertation did not prove anything. Most responses would simply point to my work and say, “We’re sorry, but we don’t know anything more as a result of your work here.” I have commented before that the social sciences would be better off if we did publish results that said: Don’t look here, Nothing going on here. But that's not the case. So many grad students in a similar situation choose to falsify their data and publish. I couldn’t do that. I also couldn’t restart, because I had put off the wedding long enough, so for my wife’s sake, I punted, and became an actuary.
That said, I was a skeptical graduate student, and not very happy with much of the common theories. I wondered whether cultural influences played a larger role in many of the matters that we studied. I thought that people satisfied rather than maximized, because maximization takes work, and work is a bad.
I saw how macroeconomics had a pretty poor track record in explaining the past, much less the present or future. In development economics, the countries that ignored the foreign experts tended to do the best. Even in finance, which I thought was a little more rigorous, I saw unprovable monstrosities like the CAPM and its cousins, concepts of risk that existed only to make risk uniform, so professors could publish, and option pricing models that relied on lognormal price movement.
Beyond that there was the sterility of economic models that never got contaminated by data. I was a practical guy; I did not want to spend my days defending ideas that didn’t work in the real world. And, I felt from my studies of philosophy that economists were among the unexamined on methodology issues. They would just use techniques and turn the crank, not asking whether the method, together with data collection issues made sense or not. The one place where I felt that was not true was in econometrics, when we dealt with data integrity and model identification issues.
Wait. This is supposed to be a book review. Um, after getting my Fellowship in the Society of Actuaries, I was still looking for unifying ideas to aid me in understanding economics and finance. I had already read a lot on value investing, but I needed something more.
On a vacation to visit my in-laws, I ended up reading The Alchemy of Finance. A number of things started to click with me, which got confirmed when I read Soros on Soros, and later, when I began to bump into the work of the Santa Fe Institute.
I was already familiar with nonlinear dynamics from a brief meeting with a visiting professor back in my grad student days, so when I ran into Soros’ concept of reflexivity, I said “Of course.” You had to give up the concept of rationality of financial actors in the classical sense, and replace them with actors that are limitedly rational, and are prone to fear and greed. Now, that’s closer to the world that I live in!
Reflexivity, as I see it, is that many financial phenomena become temporarily self-reinforcing. We saw that in the housing bubble. So long as housing prices kept rising, speculators (and people who did not know that they were speculators) showed up to buy homes. That persisted until the effective cashflow yield of owning a home was less than the financing costs, even with the funky financing methods used.
Now we are in a temporarily self-reinforcing cycle down. Where will it end? When people with excess equity capital look at housing and say that they can tuck it away for a rainy day with little borrowing. The cash on cash yields will be compelling. We’re not there yet.
Along with that, a whole cast of characters get greedy and then fearful, with the timing closely correlated. Regulators, appraisers, investment bankers, loan underwriters, etc., all were subject to the boom-bust cycle.
Expectations are the key here. We have to measure the expectations of all parties, and ask how that affects the system as a whole.
In The Alchemy of Finance, Soros goes through how reflexivity applied to the Lesser Developed Country lending, currency trading, equities, including the crash in 1987, and credit cycles generally. He gives a detailed description of how his theories worked in 1985-6. He also gives you some of his political theorizing, but that’s just a small price to pay for the overall wisdom there.
Now, Soros on Soros is a series of edited interviews. The advantage is that the interviewers structure the questioning, and forces more clarity than in The Alchemy of Finance. The drawback (or benefit) is that the book is more basic, and ventures off into non-economic areas even more than The Alchemy of Finance. That said, he shows some prescience on derivatives (though it took a long time to get to the promised troubles), though he missed on the possibility of European disintegration.
On the whole, Soros on Soros is the simpler read, and it reveals more of the man; The Alchemy of Finance is a little harder, but focuses more on the rationality within boom/bust cycles, and how one can profit from them.
The Alchemy of Finance made a big impression on me 15 years ago. Perhaps it was a book that was in the right place at the right time. It helped to crystallize a number of questions that I had about economics as it is commonly taught in the universities of the U.S.
First, a little about me and economics. I passed my PhD oral exams, but did not receive a PhD, because my dissertation fell apart. Two of my three committee members left, and the one that was left didn’t understand my dissertation. What was worse, I had moral qualms with my dissertation, because I knew it would not get approved.
My dissertation did not prove anything. Most responses would simply point to my work and say, “We’re sorry, but we don’t know anything more as a result of your work here.” I have commented before that the social sciences would be better off if we did publish results that said: Don’t look here, Nothing going on here. But that's not the case. So many grad students in a similar situation choose to falsify their data and publish. I couldn’t do that. I also couldn’t restart, because I had put off the wedding long enough, so for my wife’s sake, I punted, and became an actuary.
That said, I was a skeptical graduate student, and not very happy with much of the common theories. I wondered whether cultural influences played a larger role in many of the matters that we studied. I thought that people satisfied rather than maximized, because maximization takes work, and work is a bad.
I saw how macroeconomics had a pretty poor track record in explaining the past, much less the present or future. In development economics, the countries that ignored the foreign experts tended to do the best. Even in finance, which I thought was a little more rigorous, I saw unprovable monstrosities like the CAPM and its cousins, concepts of risk that existed only to make risk uniform, so professors could publish, and option pricing models that relied on lognormal price movement.
Beyond that there was the sterility of economic models that never got contaminated by data. I was a practical guy; I did not want to spend my days defending ideas that didn’t work in the real world. And, I felt from my studies of philosophy that economists were among the unexamined on methodology issues. They would just use techniques and turn the crank, not asking whether the method, together with data collection issues made sense or not. The one place where I felt that was not true was in econometrics, when we dealt with data integrity and model identification issues.
Wait. This is supposed to be a book review. Um, after getting my Fellowship in the Society of Actuaries, I was still looking for unifying ideas to aid me in understanding economics and finance. I had already read a lot on value investing, but I needed something more.
On a vacation to visit my in-laws, I ended up reading The Alchemy of Finance. A number of things started to click with me, which got confirmed when I read Soros on Soros, and later, when I began to bump into the work of the Santa Fe Institute.
I was already familiar with nonlinear dynamics from a brief meeting with a visiting professor back in my grad student days, so when I ran into Soros’ concept of reflexivity, I said “Of course.” You had to give up the concept of rationality of financial actors in the classical sense, and replace them with actors that are limitedly rational, and are prone to fear and greed. Now, that’s closer to the world that I live in!
Reflexivity, as I see it, is that many financial phenomena become temporarily self-reinforcing. We saw that in the housing bubble. So long as housing prices kept rising, speculators (and people who did not know that they were speculators) showed up to buy homes. That persisted until the effective cashflow yield of owning a home was less than the financing costs, even with the funky financing methods used.
Now we are in a temporarily self-reinforcing cycle down. Where will it end? When people with excess equity capital look at housing and say that they can tuck it away for a rainy day with little borrowing. The cash on cash yields will be compelling. We’re not there yet.
Along with that, a whole cast of characters get greedy and then fearful, with the timing closely correlated. Regulators, appraisers, investment bankers, loan underwriters, etc., all were subject to the boom-bust cycle.
Expectations are the key here. We have to measure the expectations of all parties, and ask how that affects the system as a whole.
In The Alchemy of Finance, Soros goes through how reflexivity applied to the Lesser Developed Country lending, currency trading, equities, including the crash in 1987, and credit cycles generally. He gives a detailed description of how his theories worked in 1985-6. He also gives you some of his political theorizing, but that’s just a small price to pay for the overall wisdom there.
Now, Soros on Soros is a series of edited interviews. The advantage is that the interviewers structure the questioning, and forces more clarity than in The Alchemy of Finance. The drawback (or benefit) is that the book is more basic, and ventures off into non-economic areas even more than The Alchemy of Finance. That said, he shows some prescience on derivatives (though it took a long time to get to the promised troubles), though he missed on the possibility of European disintegration.
On the whole, Soros on Soros is the simpler read, and it reveals more of the man; The Alchemy of Finance is a little harder, but focuses more on the rationality within boom/bust cycles, and how one can profit from them.
Saturday, March 29, 2008
False Gestures
My experience with "false gestures" reached its climax at its inception as I accompanied Jim Lorie when he showed prospective University of Chicago professors to the Hyde Park neighborhood. He'd stop at The Unique Deli and conspicuously leave the keys in the car. The prospect would say "I thought it would be very dangerous here" and Jim would say "it's so safe here that I don't even have to worry about the car."
A highlight of my observation of false gestures came when I saw a distinguished Objectivist scholar, always dressed in formal suit and tie, stoop to play with a child at a lecture he gave where all the questions had to be submitted in writing in advance and I couldn't even ask him about the identical twins. The gesture was so false, so contrived, he was so obviously uncomfortable with kids that it was a laugh.
A third experience was watching a Japanese movie where the blond American proprietress of a Japanese wine shop spoke in Japanese to all the Japanese customers. It was so hilarious, so out of whack, that you understood immediately why Japanese think that any American who tries to speak their language, no matter how good his accent and grammar, is an utter charlatan.
A recent experience came when I asked an attorney whether it is good to look at the jury when testifying or look directly at the questioner. He said " the juries hate it when you look at them because they know you're treating them like sheep" and they really don't believe you're that much more sagacious and truthful and a man of the people than they.
I wonder what the significance of false gestures in the market is. It's almost a Googlewhack with just nine out of context, unrelated conjunctions of "stock market" and "false gestures." The move on Monday that's reversed on Tuesday comes to mind, or the move from 2:30 to 3:00, like today, up 1% on the Bear Stearns increase rumour immediately followed by down 2% on the Oracle shortfall of 1/3 of 1% on revenues. Yes, but the real ones are part of the "I'm the greatest" bag. They come when companies fudge the real reasons for their shortfall of earnings or insiders fudge their real reason for selling out – "it was just estate and family matters."
The whole subject calls for quantification and further examples in all fields related to investments.
A highlight of my observation of false gestures came when I saw a distinguished Objectivist scholar, always dressed in formal suit and tie, stoop to play with a child at a lecture he gave where all the questions had to be submitted in writing in advance and I couldn't even ask him about the identical twins. The gesture was so false, so contrived, he was so obviously uncomfortable with kids that it was a laugh.
A third experience was watching a Japanese movie where the blond American proprietress of a Japanese wine shop spoke in Japanese to all the Japanese customers. It was so hilarious, so out of whack, that you understood immediately why Japanese think that any American who tries to speak their language, no matter how good his accent and grammar, is an utter charlatan.
A recent experience came when I asked an attorney whether it is good to look at the jury when testifying or look directly at the questioner. He said " the juries hate it when you look at them because they know you're treating them like sheep" and they really don't believe you're that much more sagacious and truthful and a man of the people than they.
I wonder what the significance of false gestures in the market is. It's almost a Googlewhack with just nine out of context, unrelated conjunctions of "stock market" and "false gestures." The move on Monday that's reversed on Tuesday comes to mind, or the move from 2:30 to 3:00, like today, up 1% on the Bear Stearns increase rumour immediately followed by down 2% on the Oracle shortfall of 1/3 of 1% on revenues. Yes, but the real ones are part of the "I'm the greatest" bag. They come when companies fudge the real reasons for their shortfall of earnings or insiders fudge their real reason for selling out – "it was just estate and family matters."
The whole subject calls for quantification and further examples in all fields related to investments.
the market mistress
On many occasions the market has been referred to as “the market mistress.” I find this to be an apt moniker because she shares many qualities with women. She’s complex, mysterious, seductive, and just when you think you’ve got her figured out, she surprises you. With that in mind I thought some observations from last night’s carousing with a friend (in celebration of a birthday) might shed some light.
One only need sit in a singles bar for an hour or two to observe hundreds of false gestures. Looking back on the mating rituals from an anthropological standpoint, it seems to me that the market (women) falls for, then identifies, and finally renders obsolete false gestures. Pick up lines are useless. Sending a drink across the bar is passé. “Do you come here often?” usually elicits a mocking laugh. Fortunately for market participants (men) there seems to be an unending supply of original false gestures due to everchanging cycles. Pick up lines are now a contest to see who can come up with the most outrageous and are obviously a joke. I have sent a drink across the bar, but it was a glass of water. The response was a playful tossing of ice back across the bar and a subsequent invitation for a conversation. When it comes to these false gestures, the key to success seems to be originality and timing. An original and unexpected false gesture can move the market drastically.
My final observation is that even the successful false gesture is merely a crutch. If there is no substance to back it up, the market reverses. It is useful for getting a date (trading), but not for getting a girlfriend/wife (investing).
One only need sit in a singles bar for an hour or two to observe hundreds of false gestures. Looking back on the mating rituals from an anthropological standpoint, it seems to me that the market (women) falls for, then identifies, and finally renders obsolete false gestures. Pick up lines are useless. Sending a drink across the bar is passé. “Do you come here often?” usually elicits a mocking laugh. Fortunately for market participants (men) there seems to be an unending supply of original false gestures due to everchanging cycles. Pick up lines are now a contest to see who can come up with the most outrageous and are obviously a joke. I have sent a drink across the bar, but it was a glass of water. The response was a playful tossing of ice back across the bar and a subsequent invitation for a conversation. When it comes to these false gestures, the key to success seems to be originality and timing. An original and unexpected false gesture can move the market drastically.
My final observation is that even the successful false gesture is merely a crutch. If there is no substance to back it up, the market reverses. It is useful for getting a date (trading), but not for getting a girlfriend/wife (investing).
Friday, March 28, 2008
The Fed is Deflating: 10 Reasons Why
The collapse of U.S. housing is an effect that far outweighs the rise in oil prices. It's $1-2 trillion in final losses, and probably $2-3 trillion in credit contraction over the next 3-5 years as old loans fail, cannot be refinanced, and only a fraction succeed. Total spending (dollars x volume) has fallen and is falling. The results have not yet been fully felt, though the final result does depend on the size of the bailout package.
The basic speculative sequence has also been missed, as many analysts assume that the short-term price effects of a deflationary policy is actually an acceleration of inflationary pressure. But that is unlikely because the sequence will probably play out differently. For example:
Interest rates too low in 2003-2004
Higher supply of dollars and higher imports
Dollar continues depreciating
Fed raises interest rates
Real estate market tops in mid 2005
Domestic credit crisis in real estate financing starting in August of 2007
Dollar continues to fall
Fed cannot extinguish excess dollars (it would make the crisis worse) and cannot expand dollars (to offset deflation) as it may severely impact the market for U.S. treasuries ... so it essentially freezes the monetary base and "follows the market down" (we're here now)
Lower interest rates and rising prices spur inflationists to declare victory (perhaps they are right, but isn't it premature?)
Deflationary effects begin to overcome the initial inflationary effects perhaps late in 2008 or in 2009, although oil and other goods remain buoyant (supply / demand).
1 trillion in losses and 2-3 trillion in credit disappears, the net effect being several hundred billion subtracted out of GDP (about 2%-4% lost). The knock-on effects are larger than any correction since the great depression. Interest rates remain stubbornly high as risk aversion continues. Supply/Demand issues dominate in mortgage banking with "too many banks" being propped up for fear of a cascade of losses (like Countrywide).
The near future coincides with extremes in Euro valuation against the dollar ... which will likely reverse, until both currencies see themselves in trouble against the Yuan.
The Euro is given second thought as China will roughly equal U.S. GDP in 2011 (or near there) and their growth prospects, with some corrections, looks huge with the size of their population and available capital outbuild. Per capita GDP won't hit the U.S. level until an estimated 2040. Imagine the size...
The last few were speculation of course.
Fallacy 1 - There are different ways to measure money.
Not true. There are different ways to measure credit ... but not money. Credit is confused with money so frequently it is useful to point out the distinction. Money is the enforceable legal convention used for ultimate settlement - paper dollars or electronic cash reserves at the Fed. Only those items are ultimately used to clear settlements.
Fallacy 2 - Deposits are money.
Not true. They are credit offered to the bank. Credit is any transaction where one economic actor is obligated to pay another economic actor money at a later time. Credit is not money, but substitutes for money during good times. U.S. treasuries are not money, but they are turned into money when the Fed buys them or allows them to be discounted at their window.
Fallacy 2.5 - Banks create money.
Not true. Banks create credit. Even in history, banks could not create the means of final settlement as the market regarded only one or two goods as ultimate settlement. Ultimate settlement could be invoked at any time "on demand" by insisting on payment in gold or silver. Today, money - the means of settlement - is created only by the Federal Reserve. The U.S. Treasury creates physical cash and sends it to the Fed. The Fed replaces old currency and monetizes U.S. treasuries into new cash depending on it's policy.
Fallacy 3 - Oil and food items rising in price demonstrate a policy of price inflation.
Not true. If gas goes up, an economic actor will have to spend less on something else. An economic actor can only spend more on both if they have more income or more credit. There is no such thing as inflation without an increase in spending power - money or credit - to go with it. A drop in the demand to hold money is reflected in rising incomes with the same amount of spending power (money plus credit), which the central bank should offset with higher interest rates.
Fallacy 4 - Rising prices indicate inflationary policy and falling prices indicate deflationary policy.
Not true. Rising prices or falling prices do not indicate policy by themselves but indicate changes in relative demand for a good. Only when total spending (dollars x volume) expands beyond the ability of future supply does the process of price inflation begin. Without showing that total credit or money is rising faster than overall supply, no price increase can be argued to occur from monetary expansion, hence policy cannot be argued to be "inflationary" unless all factors are considered.
Fallacy 4.5 - Indexes show inflation or deflation.
Not True. Indexes tend to underestimate (frequently) and overestimate (rare) price inflation depending on the particular circumstance and indexes lag the events that cause price inflation or deflation confusing a lot of analysts. Indexes didn't include housing price inflation and don't include the housing price deflation, but they are including the rise in rental costs as many former homeowners become renters.
Fallacy 5 - The Fed can (or will or must) "bail us out".
Not true. The Fed has diminished their ability to "inflate" because they operate on a base of roughly 900 billion in base money - and that's after nearly 100 years in operation (and 95% drop in the value of the dollar despite major growth). There is no practical way to monetize a trillion-dollar mortgage-banking accident into cash without completely destroying the currency, ruining the market for U.S. treasuries, and effectively shutting down the Federal Reserve. The only option is to "borrow" our way out. Under current circumstances, to do so without price inflation will require extinguishing a multiple of that purchasing power in the private market to offset the public debt.
If investors sense hyperinflation, they will front-run the Fed even if the Fed isn't yet inflating - which appears to be happening to some degree now. The Fed might need to go far into deflationary territory before a scared market is satisfied with the soundness of the dollar. Rather than analysts arguing for a persisent policy of excess monetary expansion, it is far more likely the Fed will oscillate policy from fast to slow, as then they have a more sustainable market for treasuries by pushing participants to extremes on in the market, effectively forcing a "bust" and creating demand for currency.
Is the Fed deflating now?
Most likely. Total credit is and will continue (without intervention) to fall strongly while the Fed holds base money expansion nearly flat. If those circumstances hold, policy is deflationary no matter what certain classes of prices do.
Ironically, if the Fed reverses soon enough, price deflation may not be evident across broad groups of goods that are now rising and the inflationists would appear right even though they are currently incorrect.
For now, the current credit contraction may be the worst since the great depression. The near collapse of U.S. housing is an effect that far outweighs the rise in oil prices (the banking system will probably register between 1 and 2 trillion in final losses, and probably 2-3 trillion in credit contraction over the next 3-5 years as old loans fail, cannot be refinanced, and only a fraction succeed). Already, defaulted loans are near 650 billion. Price deflation - should it occur - will be baked in when average goods (those that are not busted like housing or going up fast like oil) register price declines.
Only in the case where the losses are not taken (a bailout leaving a large part of the spending power in existence) AND the Fed complies by running looser money will that solidify the past monetary expansion and lead to future (very high) price inflation.
Fallacy 6 - "Sensitive" prices (gold, commodities) indicate the Fed is inflating.
Not true. Prices are rising from past policy, not current policy ... Gold is a good indicator of expected future price inflation or deflation, but the price of gold is only partly dependent on current monetary policy because gold also responds to changes in the supply of goods and the demand for currency for settlement.
For example: If the central bank for 10 years provided the basis for credit expansion which was used to build hundreds of skyscrapers neglecting the production of an essential good like oil - then oil prices are going way up. Credit has functioned to expand the economic outbuild only to emerge with severe supply constraints. Gold begins to rise in anticipation of price inflation.
But a problem created by 10 years of neglect isn't likely to be solved by 1 year of tight money. So the Fed must collapse demand across the board (all sorts of businesses unrelated to the booming industry of skyscrapers) to bring oil prices in line. The LAST prices to give will be oil and oil substitutes - whose production has been neglected.
Since the last prices to respond are those that are rising the strongest, to immediately halt those prices from rising would take a deflationary policy with it's own set of costs after the economy had to bear the costs of inflation. The best course of action would be to stop monetary expansion which means - to the extent capable - slow the expansion of money and credit by watching the balance sheets of the banks carefully, and let the economy adjust. Over time price increases will moderate, but will remain at a higher overall level.
The Fed will need to follow the sequence: tighten (break the bubble), loosen (offset the deflationary contraction), then tighten (maintain tighter money during recovery to stop residual inflationary pressure).
It is not enough to collapse a specific industry (like mortgage banking).
Many related prices (because of supply constraints from prior inflation) can rise in a deflation.
Which is what is happening to mortgage banking (formerly inflated and now busted) and oil, commodities, and energy.
The fiscal authorities could help by reducing government spending (which consumes and uses up precious resources for little benefit) and cutting taxes allowing the market to restructure: not by continuing government spending while reducing taxes.
Fallacy 7 - The Fed does not have a good reason to deflate.
Not true. The Fed is the world's largest market maker. Their #1 no-holds-barred, essential-to-survival task is to make a market in U.S. treasuries using the supply of dollar money and dollar credit to the world. Until that reality changes, they will do whatever it takes to keep the game running as long as they can. That doesn't mean the Fed won't figure some other way to get markets to take treasuries, just that under certain conditions, deflationary policy is a risk (note the early '80s).
It might prove useful to consider the global economic situation as "currency wars" where international finance either wants the U.S. dollar to remain dominant or plan to shift to another currency at some time in the future. Large players push markets to extremes so they can put on and unload positions. The central banks are market makers and are also influenced or controlled by the largest market makers in the world of finance.
Fallacy 8 - The Fed is printing money hand over fist.
Not True. The Fed **IS** deflating.
Don't believe me? Check out the stats on the base money here... it is rising glacially during the worst credit implosion since the Great Depression (note the much higher numbers in prior years). Note the latest graph for ABX HE AAA 07 indexes. And M1 going flat (note also how it went flat at almost precisely the breakdown in the housing market ...and ditto for the year 2000 stock market break).
In a nutshell:
Money is not credit
Inflation is not rising prices. Deflation is not falling prices. Both are complex and a distinction between monetary expansion, price inflation, monetary contraction, and price deflation needs to be made.
Inflation and deflation are from an increase or decrease in total spending (dollars x volume) compared to future supply of goods and services (a good reason we should have private money as entrepreneurs are motivated to correctly determine the future).
Deflation and inflation are tied to how credit substitutes for money. This complex relationship has to be analyzed carefully for conclusions to be correct.
PRICE inflation is influenced by former policy which also affected the restricted supply of the goods that are now rising.
It takes time for equilibrium to be reached even when policy freezes.
During a significant contraction, holding base money flat is a policy of deflation.
Fallacy 9 - The Fed will pursue a continuous policy of inflation or deflation.
Probably not true. The Fed will OSCILLATE policy because they make errors, and because that provides greater ability to push credit into the system. Credit stimulates trade, which increases deposits, which provides the purchasing power for the private markets to buy U.S. treasuries as collateral and as protection against the bust. Investment policy: It is prudent to hold inflation hedges and hold deflation hedges. Be aware of the monetary factors which will affect your personal ability to generate income.
Fallacy 10 - There is a sure-fire inflation or deflation argument.
Not true. The situation is more complex. The examples given by inflationists or deflationists can be reversed. For example: If the government runs a deficit to prop up real estate it's not necessarily inflationary because the Fed has to make a market for more government bonds. If they can do so only by increasing treasury rates higher than they otherwise would have been, that may cause deflationary effects. Catch 22. Inversely, if people don't pay their debts and a large part of the banking system goes down, existing dollar positions may be sold in a panic against real goods, causing a re-evaluation of the position of the dollar as a reserve currency, which feeds on itself, resetting the dollar at a far lower value. With such a large change in the demand for dollars, a deflationary (credit) "inflation" (prices) occurs. The results are ambiguous because it depends on what an economic actor believes other people will do ... and then the market promptly does the reverse because too many economic actors are on the same side of the market. Whether we have inflation or deflation depends very much on market psychology in regards to the dollar in the future - a very difficult issue to pin down. There is one argument you should consider: if the interbank settlement system goes down (like would happen in a derivatives crisis) the Fed cannot operate and no one will take dollars for trade for fear of the Fed providing excess money. The dollar becomes worthless and all assets are lost. Is that inflation or deflation? Depends on your point of view.
Hopefully that never happens and we get better policy in the future - perhaps a private market in money. Until then, policy has, and most likely will, continue to oscillate.
The basic speculative sequence has also been missed, as many analysts assume that the short-term price effects of a deflationary policy is actually an acceleration of inflationary pressure. But that is unlikely because the sequence will probably play out differently. For example:
Interest rates too low in 2003-2004
Higher supply of dollars and higher imports
Dollar continues depreciating
Fed raises interest rates
Real estate market tops in mid 2005
Domestic credit crisis in real estate financing starting in August of 2007
Dollar continues to fall
Fed cannot extinguish excess dollars (it would make the crisis worse) and cannot expand dollars (to offset deflation) as it may severely impact the market for U.S. treasuries ... so it essentially freezes the monetary base and "follows the market down" (we're here now)
Lower interest rates and rising prices spur inflationists to declare victory (perhaps they are right, but isn't it premature?)
Deflationary effects begin to overcome the initial inflationary effects perhaps late in 2008 or in 2009, although oil and other goods remain buoyant (supply / demand).
1 trillion in losses and 2-3 trillion in credit disappears, the net effect being several hundred billion subtracted out of GDP (about 2%-4% lost). The knock-on effects are larger than any correction since the great depression. Interest rates remain stubbornly high as risk aversion continues. Supply/Demand issues dominate in mortgage banking with "too many banks" being propped up for fear of a cascade of losses (like Countrywide).
The near future coincides with extremes in Euro valuation against the dollar ... which will likely reverse, until both currencies see themselves in trouble against the Yuan.
The Euro is given second thought as China will roughly equal U.S. GDP in 2011 (or near there) and their growth prospects, with some corrections, looks huge with the size of their population and available capital outbuild. Per capita GDP won't hit the U.S. level until an estimated 2040. Imagine the size...
The last few were speculation of course.
Fallacy 1 - There are different ways to measure money.
Not true. There are different ways to measure credit ... but not money. Credit is confused with money so frequently it is useful to point out the distinction. Money is the enforceable legal convention used for ultimate settlement - paper dollars or electronic cash reserves at the Fed. Only those items are ultimately used to clear settlements.
Fallacy 2 - Deposits are money.
Not true. They are credit offered to the bank. Credit is any transaction where one economic actor is obligated to pay another economic actor money at a later time. Credit is not money, but substitutes for money during good times. U.S. treasuries are not money, but they are turned into money when the Fed buys them or allows them to be discounted at their window.
Fallacy 2.5 - Banks create money.
Not true. Banks create credit. Even in history, banks could not create the means of final settlement as the market regarded only one or two goods as ultimate settlement. Ultimate settlement could be invoked at any time "on demand" by insisting on payment in gold or silver. Today, money - the means of settlement - is created only by the Federal Reserve. The U.S. Treasury creates physical cash and sends it to the Fed. The Fed replaces old currency and monetizes U.S. treasuries into new cash depending on it's policy.
Fallacy 3 - Oil and food items rising in price demonstrate a policy of price inflation.
Not true. If gas goes up, an economic actor will have to spend less on something else. An economic actor can only spend more on both if they have more income or more credit. There is no such thing as inflation without an increase in spending power - money or credit - to go with it. A drop in the demand to hold money is reflected in rising incomes with the same amount of spending power (money plus credit), which the central bank should offset with higher interest rates.
Fallacy 4 - Rising prices indicate inflationary policy and falling prices indicate deflationary policy.
Not true. Rising prices or falling prices do not indicate policy by themselves but indicate changes in relative demand for a good. Only when total spending (dollars x volume) expands beyond the ability of future supply does the process of price inflation begin. Without showing that total credit or money is rising faster than overall supply, no price increase can be argued to occur from monetary expansion, hence policy cannot be argued to be "inflationary" unless all factors are considered.
Fallacy 4.5 - Indexes show inflation or deflation.
Not True. Indexes tend to underestimate (frequently) and overestimate (rare) price inflation depending on the particular circumstance and indexes lag the events that cause price inflation or deflation confusing a lot of analysts. Indexes didn't include housing price inflation and don't include the housing price deflation, but they are including the rise in rental costs as many former homeowners become renters.
Fallacy 5 - The Fed can (or will or must) "bail us out".
Not true. The Fed has diminished their ability to "inflate" because they operate on a base of roughly 900 billion in base money - and that's after nearly 100 years in operation (and 95% drop in the value of the dollar despite major growth). There is no practical way to monetize a trillion-dollar mortgage-banking accident into cash without completely destroying the currency, ruining the market for U.S. treasuries, and effectively shutting down the Federal Reserve. The only option is to "borrow" our way out. Under current circumstances, to do so without price inflation will require extinguishing a multiple of that purchasing power in the private market to offset the public debt.
If investors sense hyperinflation, they will front-run the Fed even if the Fed isn't yet inflating - which appears to be happening to some degree now. The Fed might need to go far into deflationary territory before a scared market is satisfied with the soundness of the dollar. Rather than analysts arguing for a persisent policy of excess monetary expansion, it is far more likely the Fed will oscillate policy from fast to slow, as then they have a more sustainable market for treasuries by pushing participants to extremes on in the market, effectively forcing a "bust" and creating demand for currency.
Is the Fed deflating now?
Most likely. Total credit is and will continue (without intervention) to fall strongly while the Fed holds base money expansion nearly flat. If those circumstances hold, policy is deflationary no matter what certain classes of prices do.
Ironically, if the Fed reverses soon enough, price deflation may not be evident across broad groups of goods that are now rising and the inflationists would appear right even though they are currently incorrect.
For now, the current credit contraction may be the worst since the great depression. The near collapse of U.S. housing is an effect that far outweighs the rise in oil prices (the banking system will probably register between 1 and 2 trillion in final losses, and probably 2-3 trillion in credit contraction over the next 3-5 years as old loans fail, cannot be refinanced, and only a fraction succeed). Already, defaulted loans are near 650 billion. Price deflation - should it occur - will be baked in when average goods (those that are not busted like housing or going up fast like oil) register price declines.
Only in the case where the losses are not taken (a bailout leaving a large part of the spending power in existence) AND the Fed complies by running looser money will that solidify the past monetary expansion and lead to future (very high) price inflation.
Fallacy 6 - "Sensitive" prices (gold, commodities) indicate the Fed is inflating.
Not true. Prices are rising from past policy, not current policy ... Gold is a good indicator of expected future price inflation or deflation, but the price of gold is only partly dependent on current monetary policy because gold also responds to changes in the supply of goods and the demand for currency for settlement.
For example: If the central bank for 10 years provided the basis for credit expansion which was used to build hundreds of skyscrapers neglecting the production of an essential good like oil - then oil prices are going way up. Credit has functioned to expand the economic outbuild only to emerge with severe supply constraints. Gold begins to rise in anticipation of price inflation.
But a problem created by 10 years of neglect isn't likely to be solved by 1 year of tight money. So the Fed must collapse demand across the board (all sorts of businesses unrelated to the booming industry of skyscrapers) to bring oil prices in line. The LAST prices to give will be oil and oil substitutes - whose production has been neglected.
Since the last prices to respond are those that are rising the strongest, to immediately halt those prices from rising would take a deflationary policy with it's own set of costs after the economy had to bear the costs of inflation. The best course of action would be to stop monetary expansion which means - to the extent capable - slow the expansion of money and credit by watching the balance sheets of the banks carefully, and let the economy adjust. Over time price increases will moderate, but will remain at a higher overall level.
The Fed will need to follow the sequence: tighten (break the bubble), loosen (offset the deflationary contraction), then tighten (maintain tighter money during recovery to stop residual inflationary pressure).
It is not enough to collapse a specific industry (like mortgage banking).
Many related prices (because of supply constraints from prior inflation) can rise in a deflation.
Which is what is happening to mortgage banking (formerly inflated and now busted) and oil, commodities, and energy.
The fiscal authorities could help by reducing government spending (which consumes and uses up precious resources for little benefit) and cutting taxes allowing the market to restructure: not by continuing government spending while reducing taxes.
Fallacy 7 - The Fed does not have a good reason to deflate.
Not true. The Fed is the world's largest market maker. Their #1 no-holds-barred, essential-to-survival task is to make a market in U.S. treasuries using the supply of dollar money and dollar credit to the world. Until that reality changes, they will do whatever it takes to keep the game running as long as they can. That doesn't mean the Fed won't figure some other way to get markets to take treasuries, just that under certain conditions, deflationary policy is a risk (note the early '80s).
It might prove useful to consider the global economic situation as "currency wars" where international finance either wants the U.S. dollar to remain dominant or plan to shift to another currency at some time in the future. Large players push markets to extremes so they can put on and unload positions. The central banks are market makers and are also influenced or controlled by the largest market makers in the world of finance.
Fallacy 8 - The Fed is printing money hand over fist.
Not True. The Fed **IS** deflating.
Don't believe me? Check out the stats on the base money here... it is rising glacially during the worst credit implosion since the Great Depression (note the much higher numbers in prior years). Note the latest graph for ABX HE AAA 07 indexes. And M1 going flat (note also how it went flat at almost precisely the breakdown in the housing market ...and ditto for the year 2000 stock market break).
In a nutshell:
Money is not credit
Inflation is not rising prices. Deflation is not falling prices. Both are complex and a distinction between monetary expansion, price inflation, monetary contraction, and price deflation needs to be made.
Inflation and deflation are from an increase or decrease in total spending (dollars x volume) compared to future supply of goods and services (a good reason we should have private money as entrepreneurs are motivated to correctly determine the future).
Deflation and inflation are tied to how credit substitutes for money. This complex relationship has to be analyzed carefully for conclusions to be correct.
PRICE inflation is influenced by former policy which also affected the restricted supply of the goods that are now rising.
It takes time for equilibrium to be reached even when policy freezes.
During a significant contraction, holding base money flat is a policy of deflation.
Fallacy 9 - The Fed will pursue a continuous policy of inflation or deflation.
Probably not true. The Fed will OSCILLATE policy because they make errors, and because that provides greater ability to push credit into the system. Credit stimulates trade, which increases deposits, which provides the purchasing power for the private markets to buy U.S. treasuries as collateral and as protection against the bust. Investment policy: It is prudent to hold inflation hedges and hold deflation hedges. Be aware of the monetary factors which will affect your personal ability to generate income.
Fallacy 10 - There is a sure-fire inflation or deflation argument.
Not true. The situation is more complex. The examples given by inflationists or deflationists can be reversed. For example: If the government runs a deficit to prop up real estate it's not necessarily inflationary because the Fed has to make a market for more government bonds. If they can do so only by increasing treasury rates higher than they otherwise would have been, that may cause deflationary effects. Catch 22. Inversely, if people don't pay their debts and a large part of the banking system goes down, existing dollar positions may be sold in a panic against real goods, causing a re-evaluation of the position of the dollar as a reserve currency, which feeds on itself, resetting the dollar at a far lower value. With such a large change in the demand for dollars, a deflationary (credit) "inflation" (prices) occurs. The results are ambiguous because it depends on what an economic actor believes other people will do ... and then the market promptly does the reverse because too many economic actors are on the same side of the market. Whether we have inflation or deflation depends very much on market psychology in regards to the dollar in the future - a very difficult issue to pin down. There is one argument you should consider: if the interbank settlement system goes down (like would happen in a derivatives crisis) the Fed cannot operate and no one will take dollars for trade for fear of the Fed providing excess money. The dollar becomes worthless and all assets are lost. Is that inflation or deflation? Depends on your point of view.
Hopefully that never happens and we get better policy in the future - perhaps a private market in money. Until then, policy has, and most likely will, continue to oscillate.
Thursday, March 27, 2008
In the Wake of Bear: I-Bank Regulation Now in Fed's Hands
Yesterday morning in the New York Times, Andrew Ross Sorkin drew attention to the fact that the Fed was calling the shots behind the Bear Stearns (BSC) "bailout." This point was obvious last week. Just because the price moved from $2 to $10 and there is speculation about whether or not the Fed set the offer prices does not make this any more or less of a "bailout."
It was pretty obvious the Fed was pulling the strings from the beginning. Just take a look at the original $30bn backstop (now $29bn with JPMorgan (JPM) on the hook for first losses of $1bn on risk derived from illiquid BS assets). By meddling in the Bear Stearns mess again, the Fed has entered a quagmire of competing interests. The parties it must politically handle are Bear Stearns’ shareholders, JPMorgan, Wall Street, neo-liberal economists who want the Fed to stay out of this mess, those that want to give relief to homeowners, and congressman trying to figure this out.
To wit, the consequences of Bear going bankrupt would have been catastrophic for economies and markets around the world. However, The Prince doubts chapter 11 was ever an option for a Bear Stearns, which was careening towards insolvency (he is not alone and BSC could only seek Chapter 7 with the trustee being SIPC). Were the actions the Fed took in the "national economic interest" of the U.S.? It does not matter much to The Prince—what is done is done, and its implications are enormous.
After reading Mr. Sorkin’s column, The Prince is convinced that by focusing on the intrigues of how the Fed called the shots on the offer, he is missing the long term implications of the Federal Reserve’s actions in the Bear Stearns debacle. It is interesting that the Fed did not inform Bear of its plans to open the discount window the night it signed JPMorgan’s bid. These actions clearly favor the argument that the Fed preferred the first bid, as Mr. Sorkin points out. The Prince couldn’t agree more with Sorkin when he states the fact that, "The Fed is officially in the deal-making business." But why is this problematic?
Most of the stories about this mess have spoken vaguely about "moral hazard" and setting a precedent which will increase risk taking in the future etc. Very few columnists, journalists, or bloggers have looked at what the actions of the Fed forebode for Investment Bank regulation going forward. The Prince does not care what happens with the Bear Stearns takeover because the long-term implications of the actions taken by the Fed in this debacle are far more ominous and important. Please allow The Prince to illustrate some of the most problematic implications.
First, the Fed has now become the lender of last resort to the entire financial system, not just the bank holding companies that it normally regulates. This is a landmark event in American monetary and economic policy. The Fed as the lender of last resort has fundamentally altered the on-the-ground reality of counterparty risk, and this will forever change the environment in which investment banks operate.
The Prince does not know when the current credit crisis will end or when the Bear Stearns will be put down, but one thing is beyond clear. At the end of this mess the regulatory environment governing the financial sector will be dramatically different from what we have now. While many on Wall Street may like the safety that the Fed provides as a lender of last resort, many on Wall Street will not like the changes that are coming.
Let’s analyze the situation more closely. The Fed has rescued an entity with almost $30bn in credit and the entity is not regulated by the Fed. Remember BSC is regulated by the SEC. The SEC’s required capital levels are roughly a third of what the Fed requires of the commercial banks it regulates. The Fed has taken these steps because of its concerns over counterparty risk. That is the worry: that Bear Stearns liquidating would impose enormous burdens on its counterparties and throw the financial system into a frenzy. This is the second time The Fed has done this (the first time being LTCM where it helped to orchestrate a Wall Street bailout of the hedge fund).
We will soon learn that the Fed has learned its lesson when it comes to counterparty risk. Such risk will have to be managed much better by banking regulators around the globe. This will bring an end to the free-wheeling days of fixed income derivatives. The Prince predicts that most of these derivatives are pretty much over and will be the whipping objects of many analysts of what went wrong at the investment banks. More robust (regulated) settlement and clearing processes are coming and the Fed/Treasury will be driving these changes not the ISDA, the SEC, or the broker-dealers themselves. Fixed income derivatives are likely to go the way of other securities markets. This means they will be non-levered hedging and speculation tools. Leveraging through derivatives will probably end with an order from the regulators against such actions.
Second, the Fed has crossed the Rubicon in regards to the type of financing it is providing for the transaction. The financing of $29bn is almost equity-type financing. It is a $29bn non-recourse line to finance toxic parts of the balance sheet of Bear Stearns only protected by a $1bn cushion of first loss collateral from JPMorgan. What would happen if a broker-dealer is going down and there is no other broker-dealer to buy the company like JPM? This BSC deal better work, or we are may be seeing the Fed explicitly recapping financial institutions by directly injecting equity or taking over the institution.
Third, the days are gone when an independent investment bank could have a large trading book. The Fed will ensure that if it is required to bail out such institutions, not having regulatory control of capital jurisdiction over such entities would be wholly unacceptable. The Prince also sees no real way for the investment banks to opt out of the protection that the Fed has now extended because any investment bank is subject to counterparty risk in the financial marketplace. Investment banks will turn into banks, through consolidation driven by non-stressed, distressed, or regulatory realities.
Under this new regulatory system Goldman Sachs (GS), with its large trading book, is no longer the model investment banker and JPMorgan now assumes that title. JPMorgan is the correct model to the Fed in an "everybody is too big to fail" regulatory regime. As a result of this new regulatory regime, a big round of consolidation among financial services is coming in the U.S. and probably globally.
To conclude this argument, The Prince must say that the credit risk of any modestly sized financial institution that is a player in the capital markets is a good buy now that we are living in an era free of moral hazard. If a company is big enough, there is no credit risk with the Fed waiting there with a bailout. So go forth and sell protection on LEH, GS, and MS CDS at these levels. Also go out and buy Agency credit risk. It may be some of the last good money to be made before the regulators begin to burn and pillage the investment banking community. If BSC is too big to fail and the Fed has to provide $30bn in effective equity in a bailout, then what large financial institution is a legitimate credit or a counterparty risk? That is all my loyal subjects.
It was pretty obvious the Fed was pulling the strings from the beginning. Just take a look at the original $30bn backstop (now $29bn with JPMorgan (JPM) on the hook for first losses of $1bn on risk derived from illiquid BS assets). By meddling in the Bear Stearns mess again, the Fed has entered a quagmire of competing interests. The parties it must politically handle are Bear Stearns’ shareholders, JPMorgan, Wall Street, neo-liberal economists who want the Fed to stay out of this mess, those that want to give relief to homeowners, and congressman trying to figure this out.
To wit, the consequences of Bear going bankrupt would have been catastrophic for economies and markets around the world. However, The Prince doubts chapter 11 was ever an option for a Bear Stearns, which was careening towards insolvency (he is not alone and BSC could only seek Chapter 7 with the trustee being SIPC). Were the actions the Fed took in the "national economic interest" of the U.S.? It does not matter much to The Prince—what is done is done, and its implications are enormous.
After reading Mr. Sorkin’s column, The Prince is convinced that by focusing on the intrigues of how the Fed called the shots on the offer, he is missing the long term implications of the Federal Reserve’s actions in the Bear Stearns debacle. It is interesting that the Fed did not inform Bear of its plans to open the discount window the night it signed JPMorgan’s bid. These actions clearly favor the argument that the Fed preferred the first bid, as Mr. Sorkin points out. The Prince couldn’t agree more with Sorkin when he states the fact that, "The Fed is officially in the deal-making business." But why is this problematic?
Most of the stories about this mess have spoken vaguely about "moral hazard" and setting a precedent which will increase risk taking in the future etc. Very few columnists, journalists, or bloggers have looked at what the actions of the Fed forebode for Investment Bank regulation going forward. The Prince does not care what happens with the Bear Stearns takeover because the long-term implications of the actions taken by the Fed in this debacle are far more ominous and important. Please allow The Prince to illustrate some of the most problematic implications.
First, the Fed has now become the lender of last resort to the entire financial system, not just the bank holding companies that it normally regulates. This is a landmark event in American monetary and economic policy. The Fed as the lender of last resort has fundamentally altered the on-the-ground reality of counterparty risk, and this will forever change the environment in which investment banks operate.
The Prince does not know when the current credit crisis will end or when the Bear Stearns will be put down, but one thing is beyond clear. At the end of this mess the regulatory environment governing the financial sector will be dramatically different from what we have now. While many on Wall Street may like the safety that the Fed provides as a lender of last resort, many on Wall Street will not like the changes that are coming.
Let’s analyze the situation more closely. The Fed has rescued an entity with almost $30bn in credit and the entity is not regulated by the Fed. Remember BSC is regulated by the SEC. The SEC’s required capital levels are roughly a third of what the Fed requires of the commercial banks it regulates. The Fed has taken these steps because of its concerns over counterparty risk. That is the worry: that Bear Stearns liquidating would impose enormous burdens on its counterparties and throw the financial system into a frenzy. This is the second time The Fed has done this (the first time being LTCM where it helped to orchestrate a Wall Street bailout of the hedge fund).
We will soon learn that the Fed has learned its lesson when it comes to counterparty risk. Such risk will have to be managed much better by banking regulators around the globe. This will bring an end to the free-wheeling days of fixed income derivatives. The Prince predicts that most of these derivatives are pretty much over and will be the whipping objects of many analysts of what went wrong at the investment banks. More robust (regulated) settlement and clearing processes are coming and the Fed/Treasury will be driving these changes not the ISDA, the SEC, or the broker-dealers themselves. Fixed income derivatives are likely to go the way of other securities markets. This means they will be non-levered hedging and speculation tools. Leveraging through derivatives will probably end with an order from the regulators against such actions.
Second, the Fed has crossed the Rubicon in regards to the type of financing it is providing for the transaction. The financing of $29bn is almost equity-type financing. It is a $29bn non-recourse line to finance toxic parts of the balance sheet of Bear Stearns only protected by a $1bn cushion of first loss collateral from JPMorgan. What would happen if a broker-dealer is going down and there is no other broker-dealer to buy the company like JPM? This BSC deal better work, or we are may be seeing the Fed explicitly recapping financial institutions by directly injecting equity or taking over the institution.
Third, the days are gone when an independent investment bank could have a large trading book. The Fed will ensure that if it is required to bail out such institutions, not having regulatory control of capital jurisdiction over such entities would be wholly unacceptable. The Prince also sees no real way for the investment banks to opt out of the protection that the Fed has now extended because any investment bank is subject to counterparty risk in the financial marketplace. Investment banks will turn into banks, through consolidation driven by non-stressed, distressed, or regulatory realities.
Under this new regulatory system Goldman Sachs (GS), with its large trading book, is no longer the model investment banker and JPMorgan now assumes that title. JPMorgan is the correct model to the Fed in an "everybody is too big to fail" regulatory regime. As a result of this new regulatory regime, a big round of consolidation among financial services is coming in the U.S. and probably globally.
To conclude this argument, The Prince must say that the credit risk of any modestly sized financial institution that is a player in the capital markets is a good buy now that we are living in an era free of moral hazard. If a company is big enough, there is no credit risk with the Fed waiting there with a bailout. So go forth and sell protection on LEH, GS, and MS CDS at these levels. Also go out and buy Agency credit risk. It may be some of the last good money to be made before the regulators begin to burn and pillage the investment banking community. If BSC is too big to fail and the Fed has to provide $30bn in effective equity in a bailout, then what large financial institution is a legitimate credit or a counterparty risk? That is all my loyal subjects.
Wednesday, March 26, 2008
Bear Markets: A Necessary Evil
The smallness of the army renders the natural strength of the community an overmatch for it; and the citizens, not habituated to look up to the military power for protection, or to submit to its oppressions, neither love nor fear the soldiery; they view them with a spirit of jealous acquiescence in a necessary evil, and stand ready to resist a power which they suppose may be exerted to the prejudice of their rights. (Federalist Papers, Alexander Hamilton)
A necessary evil can be defined as an unpleasant necessity; something that is unpleasant or undesirable but is needed to achieve a result. An example of a necessary evil might be taxes. Investors should also view bear markets as a necessary evil. Let’s explore why.
Perhaps the most basic principle of modern financial theory is that risk and expected return are related. We know that stocks are riskier than one-month Treasury bills (which is considered the benchmark riskless instrument). Since they are riskier, the only logical explanation for investing in stocks is that they must provide a higher expected return. However, if stocks always provided higher returns than one-month Treasury bills (the expected always occurred) investing in stocks would not entail any risk—and there would be no risk premium. In fact, in twenty-three of the eighty-two years from 1926 through 2007, or close to 30 percent of the time, the S&P 500 Index produced negative returns. In addition, there have been periods when the S&P 500 Index produced severe losses:
January 1929–December 1932 it lost 64 percent.
January 1973–September 1974 it lost 43 percent.
April 2000–September 2002 it lost 44 percent.
The very fact that investors have experienced such large losses leads them to price stocks with a large risk premium. From 1927 through 2007 the S&P has provided an annual risk premium over one-month Treasury bills of just over 8 percent. If the losses that investors experienced had been smaller, the risk premium would also have been smaller. And the smaller the losses experienced, the smaller the premium would have been. In other words, the less risk that investors perceive, the higher the price are willing to pay for stocks. And the higher the price-to-earnings ratio of the market, the lower the future returns.
The bottom line is that bear markets are necessary to the creation of the large equity risk premium we have experienced. Thus, if investors want stocks to provide high expected returns, bear markets, while painful to endure, should be considered a necessary evil. We can extend this logic to the risks of investing in small and value stocks.
Small-cap and Value Stocks
We know that small companies are riskier than large companies. Therefore, the market prices small-cap stocks to provide higher returns than large-cap stocks. From 1927 through 2007, small-cap stocks have provided an annual risk premium of 3 percent. However, small-cap stocks have not always outperformed large-cap stocks. If they always outperformed, there would be no risk of investing in them relative to investing in large-cap stocks—and there would be no risk premium. For example:
January 1969–December 1974, small-cap stocks underperformed large-cap stocks by a total of 47 percent.
January 1986–December 1990, small-cap stocks underperformed large-cap stocks by a total of 33 percent.
January 1994–December 1998, small-cap stocks underperformed large-cap stocks by a total of 30 percent.
Further evidence of the risk of investing in small-cap stocks is that while the small-cap risk premium has been 3 percent, the annual standard deviation of the premium, at over 13 percent, has been more than four times the premium.
We also know that value companies are riskier than growth companies. Therefore, the market prices value stocks to provide higher returns than growth stocks. From 1927 through 2007, value stocks have provided an annual risk premium of 5 percent. However, value stocks have not always outperformed. If they always outperformed, there would be no risk of investing in them relative to investing in growth stocks—and there would be no risk premium. For example:
March 1934–March 1935, value stocks underperformed growth stocks by a total of 43 percent.
June 1998–February 2000, value stocks underperformed growth stocks by a total 44 percent.
And, as was the case with the small-cap premium, the value premium is volatile. The annual standard deviation of the value premium, at just under 13 percent, has been more than 2.5 times the premium.
Risk Premiums and Investment Discipline
The bottom line is that the outperformance of stocks relative to Treasury bills, small-cap stocks relative to large-cap stocks and value stocks relative to growth stocks is not what economists call a free lunch—there are risks involved. And it is a virtual certainty that the risks will show up from time to time. Unfortunately, we cannot know when, or for how long, the periods of underperformance will last, nor how severe they will be.
It is during the periods of underperformance when investor discipline is tested. Unfortunately, the evidence suggests that most investors significantly underperform both the stock market and the very mutual funds in which they invest. Consider the results of a study by Morningstar. Morningstar found that in all seventeen fund categories they examined the returns earned by individuals were below the returns of the very funds in which they had invested. For example, among large growth funds the ten-year annualized dollar-weighted return was 3.4 percent less than the time-weighted return (the return reported by the fund). For mid-cap growth and small-cap growth funds the underperformance was 2.5 and 3.0 percent. Investors in sectors funds fared worse, with tech investors producing particularly disastrous results, underperforming by 14 percent per annum.[1] The reason for the underperformance is that investors act like generals fighting the last war. They observe yesterday’s winners and jump on the bandwagon— buying high—and they observe yesterday’s losers and abandon ship—selling low. It is almost as if investors believe that they can buy yesterday’s returns, when they can only buy tomorrow’s.
There are several explanations for this outcome. The first is that investors allow their emotions to impact their investment decisions. In bull markets, greed and envy take over and risk is overlooked. In bear markets, fear and panic take over, and even the well-thought-out plans can end up in the trash heap of emotions.
The second explanation is that investors are overconfident of their ability to deal with risk when it inevitably shows up. They believe that they can stomach losses of 20, 30, 40 or even 50 percent and still stay the course, adhering to their plan. However, the evidence demonstrates that investors are as overconfident of their investment abilities as they are of their driving skills (studies have found that the vast majority of people believe they are better than average drivers).
The third explanation is that investors often treat the likely (stocks will outperform Treasury bills) as certain and the unlikely (a severe bear market) as impossible. The result is that they take more risk than is appropriate—and when the risks show up they are “forced” to sell.
The Keys to Successful Investing
There is an old adage that “those who fail to plan, plan to fail.” Therefore, the first key to successful investing is to have a well-thought-out plan. That plan includes an understanding of the nature of the risks of investing. That means accepting that bear markets are inevitable and must be built into the plan. And that means having the discipline to stay the course just when it will be most difficult to do so (partly because the media will be filled with stories of economic doom and gloom). What is particularly difficult is that staying the course does not just mean buy and hold. Adhering to a plan requires that investors rebalance the portfolio, maintaining their desired asset allocation. That means that investors must buy stocks during bear markets and sell them in bull markets. That brings us to the second key to success.
While academic research has determined that almost all of the risk and return of a portfolio is determined by the portfolio’s asset allocation, the actual returns earned by investors are determined more by the ability to adhere to whatever the allocation they chose than by the allocation itself. Thus, the second key to successful investing it to be sure that investors do not take more risk than they have ability (determined by their investment horizon and stability of income), willingness (risk tolerance) and need (the rate of return needed to achieve their objectives) to take. Those investors that avoid excessive risk taking are the ones most likely to be able to stay the course and avoid the buy high/sell low pattern that bedevils most investors.
The third key to success is to understand that trying to time the market is a loser’s game. A loser’s game is one that while it is possible to win, the odds of doing so are so low that it is not prudent to try. Consider the evidence from two studies on market timing. Tactical Asset Allocation [TAA] is just a fancy name for market timing. For the twelve years ending 1997, while the S&P 500 Index on a total return basis rose 734 percent the average return for 186 TAA mutual funds was a mere 384 percent.[2] Just as impressive is the results of a study on the performance of 100 pension plans that engaged in TAA: Not one single plan benefited from their efforts.[3] If the results of these studies are not enough to convince you, perhaps the following from legendary investor Warren Buffett will. Listen carefully to his statements regarding efforts to time the market:
“Inactivity strikes us as intelligent behavior.”[4]
“The only value of stock forecasters is to make fortune-tellers look good.”[5]
“We continue to make more money when snoring than when active.”[6]
“Our stay-put behavior reflects our view that the stock market serves as a relocation center at which money is moved from the active to the patient.”[7]
Buffett also observed: [8]
Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. But Sir Isaac's talents didn't extend to investing: He lost a bundle in the South Sea Bubble, explaining later, ‘I can calculate the movement of the stars, but not the madness of men.’ If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases.
Perhaps Buffett’s views on market-timing efforts are best summed up by the following from the 2004 Annual Shareholder Letter of Berkshire Hathaway:
Over the 35 years, American business has delivered terrific results. It should therefore have been easy for investors to earn juicy returns: All they had to do was piggyback Corporate America in a diversified, low-expense way. An index fund that they never touched would have done the job. Instead many investors have had experiences ranging from mediocre to disastrous. There have been three primary causes: first, high costs, usually because investors traded excessively or spent far too much on investment management; second, portfolio decisions based on tips and fads rather than on thoughtful, quantified evaluation of businesses; and third, a start-and-stop approach to the market marked by untimely entries (after an advance has been long underway) and exits (after periods of stagnation or decline). Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful.
The above observation is perhaps why Buffett has stated that investing is simple, but not easy.[9] The simple part is that the winning strategy is to act like the lowly postage stamp that adheres to its letter until it reaches its destination. Investors should stick to their asset allocation until they reach their financial goals. The reason it is not easy is that it is difficult for most individuals to control their emotions—emotions of greed and envy in bull markets and fear and panic in bear markets. In fact, bear markets are the mechanism that serves to transfer assets from those with weak stomachs and without investment plans to those with well-thought-out plans—with the anticipation of bear markets built into the plans—and the discipline to adhere to those plans.
Summary
Bear markets are a necessary evil in that their existence is the very reason that the stock market has provided the large risk premium and the high return that investors have had the opportunity to earn. But there is another important point that investors need to understand about bear markets. Investors in the accumulation phase of their investment careers should actually view bear markets not just as a necessary evil, but also as a good thing. The reason is that bear markets provide those investors (at least those that have the discipline to adhere to their plan) with the opportunity to buy stocks at lower prices, increasing expected returns. It is only those that are in the withdrawal phase (e.g., retirees) that should fear bear markets. The reason is that withdrawals make it more difficult to maintain the portfolio’s value over the long term. Thus, investors in the withdrawal phase have a lesser ability to take risk and should build that into their plan.
The bottom line for investors is this: If you don’t have a plan, immediately sit down and develop one. Make sure the plan anticipates bear markets and outlines what actions you will take when they occur (doing so when you are not under the stress that bear markets create). Put the plan in writing in the form of an investment policy statement and an asset allocation table and sign it. That will increase the odds of your adhering to it when you are tested by the emotions caused by both bull and bear markets. And then be sure to stay the course, altering your plan only if your assumptions about your ability, willingness or need to take risk have changed.
Morningstar FundInvestor (July 2005).
David Dreman, Contrarian Investment Strategies, p.57.
Charles Ellis, Investment Policy (Irwin Professional Pub 2nd edition 1992).
1996 Annual Report of Berkshire Hathaway.
1992 Annual Report of Berkshire Hathaway.
1996 Annual Report of Berkshire Hathaway.
1991 Annual Report of Berkshire Hathaway.
2006 Annual Report of Berkshire Hathaway.
Financial Analysts Journal, November/December 2005, p. 51.
A necessary evil can be defined as an unpleasant necessity; something that is unpleasant or undesirable but is needed to achieve a result. An example of a necessary evil might be taxes. Investors should also view bear markets as a necessary evil. Let’s explore why.
Perhaps the most basic principle of modern financial theory is that risk and expected return are related. We know that stocks are riskier than one-month Treasury bills (which is considered the benchmark riskless instrument). Since they are riskier, the only logical explanation for investing in stocks is that they must provide a higher expected return. However, if stocks always provided higher returns than one-month Treasury bills (the expected always occurred) investing in stocks would not entail any risk—and there would be no risk premium. In fact, in twenty-three of the eighty-two years from 1926 through 2007, or close to 30 percent of the time, the S&P 500 Index produced negative returns. In addition, there have been periods when the S&P 500 Index produced severe losses:
January 1929–December 1932 it lost 64 percent.
January 1973–September 1974 it lost 43 percent.
April 2000–September 2002 it lost 44 percent.
The very fact that investors have experienced such large losses leads them to price stocks with a large risk premium. From 1927 through 2007 the S&P has provided an annual risk premium over one-month Treasury bills of just over 8 percent. If the losses that investors experienced had been smaller, the risk premium would also have been smaller. And the smaller the losses experienced, the smaller the premium would have been. In other words, the less risk that investors perceive, the higher the price are willing to pay for stocks. And the higher the price-to-earnings ratio of the market, the lower the future returns.
The bottom line is that bear markets are necessary to the creation of the large equity risk premium we have experienced. Thus, if investors want stocks to provide high expected returns, bear markets, while painful to endure, should be considered a necessary evil. We can extend this logic to the risks of investing in small and value stocks.
Small-cap and Value Stocks
We know that small companies are riskier than large companies. Therefore, the market prices small-cap stocks to provide higher returns than large-cap stocks. From 1927 through 2007, small-cap stocks have provided an annual risk premium of 3 percent. However, small-cap stocks have not always outperformed large-cap stocks. If they always outperformed, there would be no risk of investing in them relative to investing in large-cap stocks—and there would be no risk premium. For example:
January 1969–December 1974, small-cap stocks underperformed large-cap stocks by a total of 47 percent.
January 1986–December 1990, small-cap stocks underperformed large-cap stocks by a total of 33 percent.
January 1994–December 1998, small-cap stocks underperformed large-cap stocks by a total of 30 percent.
Further evidence of the risk of investing in small-cap stocks is that while the small-cap risk premium has been 3 percent, the annual standard deviation of the premium, at over 13 percent, has been more than four times the premium.
We also know that value companies are riskier than growth companies. Therefore, the market prices value stocks to provide higher returns than growth stocks. From 1927 through 2007, value stocks have provided an annual risk premium of 5 percent. However, value stocks have not always outperformed. If they always outperformed, there would be no risk of investing in them relative to investing in growth stocks—and there would be no risk premium. For example:
March 1934–March 1935, value stocks underperformed growth stocks by a total of 43 percent.
June 1998–February 2000, value stocks underperformed growth stocks by a total 44 percent.
And, as was the case with the small-cap premium, the value premium is volatile. The annual standard deviation of the value premium, at just under 13 percent, has been more than 2.5 times the premium.
Risk Premiums and Investment Discipline
The bottom line is that the outperformance of stocks relative to Treasury bills, small-cap stocks relative to large-cap stocks and value stocks relative to growth stocks is not what economists call a free lunch—there are risks involved. And it is a virtual certainty that the risks will show up from time to time. Unfortunately, we cannot know when, or for how long, the periods of underperformance will last, nor how severe they will be.
It is during the periods of underperformance when investor discipline is tested. Unfortunately, the evidence suggests that most investors significantly underperform both the stock market and the very mutual funds in which they invest. Consider the results of a study by Morningstar. Morningstar found that in all seventeen fund categories they examined the returns earned by individuals were below the returns of the very funds in which they had invested. For example, among large growth funds the ten-year annualized dollar-weighted return was 3.4 percent less than the time-weighted return (the return reported by the fund). For mid-cap growth and small-cap growth funds the underperformance was 2.5 and 3.0 percent. Investors in sectors funds fared worse, with tech investors producing particularly disastrous results, underperforming by 14 percent per annum.[1] The reason for the underperformance is that investors act like generals fighting the last war. They observe yesterday’s winners and jump on the bandwagon— buying high—and they observe yesterday’s losers and abandon ship—selling low. It is almost as if investors believe that they can buy yesterday’s returns, when they can only buy tomorrow’s.
There are several explanations for this outcome. The first is that investors allow their emotions to impact their investment decisions. In bull markets, greed and envy take over and risk is overlooked. In bear markets, fear and panic take over, and even the well-thought-out plans can end up in the trash heap of emotions.
The second explanation is that investors are overconfident of their ability to deal with risk when it inevitably shows up. They believe that they can stomach losses of 20, 30, 40 or even 50 percent and still stay the course, adhering to their plan. However, the evidence demonstrates that investors are as overconfident of their investment abilities as they are of their driving skills (studies have found that the vast majority of people believe they are better than average drivers).
The third explanation is that investors often treat the likely (stocks will outperform Treasury bills) as certain and the unlikely (a severe bear market) as impossible. The result is that they take more risk than is appropriate—and when the risks show up they are “forced” to sell.
The Keys to Successful Investing
There is an old adage that “those who fail to plan, plan to fail.” Therefore, the first key to successful investing is to have a well-thought-out plan. That plan includes an understanding of the nature of the risks of investing. That means accepting that bear markets are inevitable and must be built into the plan. And that means having the discipline to stay the course just when it will be most difficult to do so (partly because the media will be filled with stories of economic doom and gloom). What is particularly difficult is that staying the course does not just mean buy and hold. Adhering to a plan requires that investors rebalance the portfolio, maintaining their desired asset allocation. That means that investors must buy stocks during bear markets and sell them in bull markets. That brings us to the second key to success.
While academic research has determined that almost all of the risk and return of a portfolio is determined by the portfolio’s asset allocation, the actual returns earned by investors are determined more by the ability to adhere to whatever the allocation they chose than by the allocation itself. Thus, the second key to successful investing it to be sure that investors do not take more risk than they have ability (determined by their investment horizon and stability of income), willingness (risk tolerance) and need (the rate of return needed to achieve their objectives) to take. Those investors that avoid excessive risk taking are the ones most likely to be able to stay the course and avoid the buy high/sell low pattern that bedevils most investors.
The third key to success is to understand that trying to time the market is a loser’s game. A loser’s game is one that while it is possible to win, the odds of doing so are so low that it is not prudent to try. Consider the evidence from two studies on market timing. Tactical Asset Allocation [TAA] is just a fancy name for market timing. For the twelve years ending 1997, while the S&P 500 Index on a total return basis rose 734 percent the average return for 186 TAA mutual funds was a mere 384 percent.[2] Just as impressive is the results of a study on the performance of 100 pension plans that engaged in TAA: Not one single plan benefited from their efforts.[3] If the results of these studies are not enough to convince you, perhaps the following from legendary investor Warren Buffett will. Listen carefully to his statements regarding efforts to time the market:
“Inactivity strikes us as intelligent behavior.”[4]
“The only value of stock forecasters is to make fortune-tellers look good.”[5]
“We continue to make more money when snoring than when active.”[6]
“Our stay-put behavior reflects our view that the stock market serves as a relocation center at which money is moved from the active to the patient.”[7]
Buffett also observed: [8]
Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. But Sir Isaac's talents didn't extend to investing: He lost a bundle in the South Sea Bubble, explaining later, ‘I can calculate the movement of the stars, but not the madness of men.’ If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases.
Perhaps Buffett’s views on market-timing efforts are best summed up by the following from the 2004 Annual Shareholder Letter of Berkshire Hathaway:
Over the 35 years, American business has delivered terrific results. It should therefore have been easy for investors to earn juicy returns: All they had to do was piggyback Corporate America in a diversified, low-expense way. An index fund that they never touched would have done the job. Instead many investors have had experiences ranging from mediocre to disastrous. There have been three primary causes: first, high costs, usually because investors traded excessively or spent far too much on investment management; second, portfolio decisions based on tips and fads rather than on thoughtful, quantified evaluation of businesses; and third, a start-and-stop approach to the market marked by untimely entries (after an advance has been long underway) and exits (after periods of stagnation or decline). Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful.
The above observation is perhaps why Buffett has stated that investing is simple, but not easy.[9] The simple part is that the winning strategy is to act like the lowly postage stamp that adheres to its letter until it reaches its destination. Investors should stick to their asset allocation until they reach their financial goals. The reason it is not easy is that it is difficult for most individuals to control their emotions—emotions of greed and envy in bull markets and fear and panic in bear markets. In fact, bear markets are the mechanism that serves to transfer assets from those with weak stomachs and without investment plans to those with well-thought-out plans—with the anticipation of bear markets built into the plans—and the discipline to adhere to those plans.
Summary
Bear markets are a necessary evil in that their existence is the very reason that the stock market has provided the large risk premium and the high return that investors have had the opportunity to earn. But there is another important point that investors need to understand about bear markets. Investors in the accumulation phase of their investment careers should actually view bear markets not just as a necessary evil, but also as a good thing. The reason is that bear markets provide those investors (at least those that have the discipline to adhere to their plan) with the opportunity to buy stocks at lower prices, increasing expected returns. It is only those that are in the withdrawal phase (e.g., retirees) that should fear bear markets. The reason is that withdrawals make it more difficult to maintain the portfolio’s value over the long term. Thus, investors in the withdrawal phase have a lesser ability to take risk and should build that into their plan.
The bottom line for investors is this: If you don’t have a plan, immediately sit down and develop one. Make sure the plan anticipates bear markets and outlines what actions you will take when they occur (doing so when you are not under the stress that bear markets create). Put the plan in writing in the form of an investment policy statement and an asset allocation table and sign it. That will increase the odds of your adhering to it when you are tested by the emotions caused by both bull and bear markets. And then be sure to stay the course, altering your plan only if your assumptions about your ability, willingness or need to take risk have changed.
Morningstar FundInvestor (July 2005).
David Dreman, Contrarian Investment Strategies, p.57.
Charles Ellis, Investment Policy (Irwin Professional Pub 2nd edition 1992).
1996 Annual Report of Berkshire Hathaway.
1992 Annual Report of Berkshire Hathaway.
1996 Annual Report of Berkshire Hathaway.
1991 Annual Report of Berkshire Hathaway.
2006 Annual Report of Berkshire Hathaway.
Financial Analysts Journal, November/December 2005, p. 51.
Tuesday, March 25, 2008
A Historic Nine Days for the Federal Reserve
I've been writing for a couple of weeks that that these are some of the most incredible moves we have seen by the Federal Reserve. Even though we've discussed two weeks ago [Mar 11: Fed Rides to the Rescue], at the end of that week, [Mar 14: Bear Stearns Getting Secured Financing from JP Morgan and NY Fed], the next Sunday evening [Mar 16: More Fed Actions!], and even Friday when the Fed put a cherry on top [Mar 20: What the Banks Want the Banks Get - Fed Expanding Junk It Will Take In] - it is worth putting them all in one story and for those newer to the market realize the historic level of "free market" interference that is happening.
While Wall Street equity traders cheer (as they get their tax payer backstop), a US citizen must ask what is the Federal Reserve finally seeing that is scaring them into such historical action? Probably the same things the Roubinis of the world have been warning [Scary Stat of the Day: Roubini Calling for $1 Trillion-$3 Trillion in Losses] .... that should scare people, but instead it emboldens them to take more risk. This is the true meaning of "moral hazard".
Moral Hazard? Will this change Wall Street's ways? hahah - you made me laugh. Not in this compensation system in America where in CEO roulette - heads you win, tails you still win. Especially not in the financial system where heads you win, tails you win, and if it lands on its side the taxpayer pays the bill! [Wall Street Culture Not Likely to Change] And the Federal Reserve is helping it all along - such nice people.
See, this is the irony in it all, there is no way for these people to lose. None. Never. The banking system is the US. It cannot be allowed to falter - it is now intertwined to such a degree (and levered!) nothing like the early 90s S&L bailout (when 1000+ S&Ls failed) could be allowed to happen. To do so, risks global collapse. So keep taking risk, keep rewarding yourselves with tons of bonuses and pay outs, and then when a few go under the underlings/peons will lose their jobs and 401ks, but the taxpayer will make sure the system keeps on ticking? And don't forget those retention bonuses to keep those excellent risk managers in their CEO/CFO/CIO posts. Excellent.
And so analysts believe the sale of Bear Stearns to JPMorgan Chase & Co. for a stunning $2 per share ultimately won't have that much of an impact on how Wall Street conducts business.
In fact, bankers and traders are under even more pressure to reap big returns because of the ongoing credit crisis, and risk is just part of the game.
Indeed, the past decade has seen a number of investing fiascoes that Wall Street doesn't appear to have learned much from. Krosby noted the go-go Internet days -- when untested high-tech companies reaped piles of cash in public offerings. The lesson then was, don't put a lot of money into a venture that isn't on fairly solid ground -- but mortgages granted to people with poor credit are quite akin to high-tech firms that had never turned a profit. In both cases, investors gleefully looked past the risk.
The biggest risk now is if these moves truly don't put a backstop under the situation - I've been saying for a while now the implicit trust that the Federal Reserve can fix everything is really all that buffets this market from a much larger fall. I have no idea if the Federal Reserve is big enough and can print enough or it's actions are enough to support a multi trillion global shadow banking system. But they are trying and the actions truly are unprecedented in scope. For now they seem to have restored the feeling that everything will be ok. But the story is not over yet - we'll see how things continue to play out.
The Federal Reserve has taken its boldest action since the Great Depression, invoking rarely used powers in an effort to contain a panic threatening to undermine the economy. The central bank acted with speed the White House and Congress only could envy.
The Fed is largely free from many constraints that bog down other policymakers. Also, it is the only U.S. institution with the authority and ability to create money out of thin air.
For now, the steps orchestrated by Chairman Ben Bernanke, in the first critical test of his leadership since succeeding Alan Greenspan in early 2006, are earning praise from the Bush administration, Congress and presidential contenders Barack Obama, Hillary Rodham Clinton and John McCain. (of course they are, bailout nation - we do NOT care who pays the bills, the grandchildren and their grandchildren can worry about it - all we care about is political polls in the here and now)
But the Fed's moves are raising questions about whether its regulatory powers, established in the early 20th century, need overhauling and whether it took on some responsibilities that Congress and the administration should have shouldered.
"I spent 35 years on Wall Street, have been a Fed watcher for a long time and I have never seen the potential for a more severe credit crisis than this one," said David Jones, chief economist at DMJ Advisors and a former Wall Street economist. "It looks like we turned the corner precisely because of what the Fed did."
Congress created the Fed in 1913 to prevent financial panics such as runs on banks and set it up as an independent entity. Its powers grew in 1933 and 1935. Although the Fed is subject to congressional oversight, its decisions do not have to be ratified by the president or Congress. Fed officials are not paid with money appropriated by Congress.
The system includes 12 Reserve Banks in major cities. These banks have their own boards of directors, two-thirds of whom are elected by commercial banks in the region and one-third by the Fed board in Washington.
In a remarkable week, the Fed: (1) engineered the fire sale of bankruptcy-headed Bear Stearns Cos. to J.P. Morgan Chase & Co. with a $30 billion loan. (2) offered emergency loans to other securities dealers under terms normally reserved for regulated banks. (3) slashed a key short-term interest rate by three quarters of a percentage point, to 2.25 percent. The cut was sixth since September. (and you forgot about the late Thursday actions of increasing the type of junk they will now allow the financial institutions to offload into the Fed balance sheet; and don't forget last week's $200 Billion action)
An interesting "opinion" (or fact?) piece on CBSMarketwatch.com
In a financial crisis, the Federal Reserve has an obligation to become the lender of last resort, making cash available for banks that need it right away to prevent a systemwide meltdown. But for this crisis, the Fed has become the lender of first resort to a whole new group of financial institutions that are relying on the central bank to boost their profits.
Instead of lending only to firms that cannot find money elsewhere, the Fed apparently is lending to firms that can get the money elsewhere, yet at a higher cost than borrowing from the Fed. I say "apparently" because almost everything about the Fed's new primary dealer-lending facility is secret.
The New York Federal Reserve Bank, which runs the program, would not comment about who is borrowing or under what conditions they are borrowing. The only information that was from the Fed came Thursday in the weekly report on reserve balances, showing that the 20 primary dealers borrowed $28.8 billion on Wednesday and about $19 billion on Monday and Tuesday.
What executives have said, however, indicates that these firms are violating the spirit, if not the letter of the law. A spokesman for Goldman Sachs for instance, told MarketWatch's Alistair Barr that the firm has borrowed from the Fed and intends to do so again "if doing so makes sense from an economic and funding-diversification point of view." He said that the Fed was a good "alternative." In other words, the Fed is just another source of money for Goldman, and not the only one. Because the Fed's only charging 2.5% interest, it's a very "attractive" source of money
The Federal Reserve Act, the legal authority that makes the Fed a more honorable institution than the Mafia, states clearly that the central bank may lend money to companies that are not "depository institutions" (in other words, that are not commercial banks) only if that firm proves to the Fed that it is "unable to secure adequate credit accommodations from other banking institutions" and only "in unusual and exigent circumstances." On Sunday, the Fed board voted unanimously to declare these to be "unusual and exigent circumstances."
It's a judgment call by the New York Fed as to whether these firms can find credit elsewhere. In the middle of the worst liquidity crisis since the Great Depression, the New York Fed is understandably bending over backwards to supply credit now and ask questions later.
Being the lender of first resort could make the Fed's goal of stabilizing financial markets harder to achieve, because the Fed could be crowding out private-sector lending. How can anyone compete with the central bank? Any firm that doesn't have access to the Fed's cheap money is at a serious disadvantage.
Another article: after reading this it looks like this man is going to be the next Fed Chief .... he is doing the dirty work behind the scenes and already he appears to be the best friend of NYC banks so who better to fill their pockets to the brim in the future?
While Wall Street equity traders cheer (as they get their tax payer backstop), a US citizen must ask what is the Federal Reserve finally seeing that is scaring them into such historical action? Probably the same things the Roubinis of the world have been warning [Scary Stat of the Day: Roubini Calling for $1 Trillion-$3 Trillion in Losses] .... that should scare people, but instead it emboldens them to take more risk. This is the true meaning of "moral hazard".
Moral Hazard? Will this change Wall Street's ways? hahah - you made me laugh. Not in this compensation system in America where in CEO roulette - heads you win, tails you still win. Especially not in the financial system where heads you win, tails you win, and if it lands on its side the taxpayer pays the bill! [Wall Street Culture Not Likely to Change] And the Federal Reserve is helping it all along - such nice people.
See, this is the irony in it all, there is no way for these people to lose. None. Never. The banking system is the US. It cannot be allowed to falter - it is now intertwined to such a degree (and levered!) nothing like the early 90s S&L bailout (when 1000+ S&Ls failed) could be allowed to happen. To do so, risks global collapse. So keep taking risk, keep rewarding yourselves with tons of bonuses and pay outs, and then when a few go under the underlings/peons will lose their jobs and 401ks, but the taxpayer will make sure the system keeps on ticking? And don't forget those retention bonuses to keep those excellent risk managers in their CEO/CFO/CIO posts. Excellent.
And so analysts believe the sale of Bear Stearns to JPMorgan Chase & Co. for a stunning $2 per share ultimately won't have that much of an impact on how Wall Street conducts business.
In fact, bankers and traders are under even more pressure to reap big returns because of the ongoing credit crisis, and risk is just part of the game.
Indeed, the past decade has seen a number of investing fiascoes that Wall Street doesn't appear to have learned much from. Krosby noted the go-go Internet days -- when untested high-tech companies reaped piles of cash in public offerings. The lesson then was, don't put a lot of money into a venture that isn't on fairly solid ground -- but mortgages granted to people with poor credit are quite akin to high-tech firms that had never turned a profit. In both cases, investors gleefully looked past the risk.
The biggest risk now is if these moves truly don't put a backstop under the situation - I've been saying for a while now the implicit trust that the Federal Reserve can fix everything is really all that buffets this market from a much larger fall. I have no idea if the Federal Reserve is big enough and can print enough or it's actions are enough to support a multi trillion global shadow banking system. But they are trying and the actions truly are unprecedented in scope. For now they seem to have restored the feeling that everything will be ok. But the story is not over yet - we'll see how things continue to play out.
The Federal Reserve has taken its boldest action since the Great Depression, invoking rarely used powers in an effort to contain a panic threatening to undermine the economy. The central bank acted with speed the White House and Congress only could envy.
The Fed is largely free from many constraints that bog down other policymakers. Also, it is the only U.S. institution with the authority and ability to create money out of thin air.
For now, the steps orchestrated by Chairman Ben Bernanke, in the first critical test of his leadership since succeeding Alan Greenspan in early 2006, are earning praise from the Bush administration, Congress and presidential contenders Barack Obama, Hillary Rodham Clinton and John McCain. (of course they are, bailout nation - we do NOT care who pays the bills, the grandchildren and their grandchildren can worry about it - all we care about is political polls in the here and now)
But the Fed's moves are raising questions about whether its regulatory powers, established in the early 20th century, need overhauling and whether it took on some responsibilities that Congress and the administration should have shouldered.
"I spent 35 years on Wall Street, have been a Fed watcher for a long time and I have never seen the potential for a more severe credit crisis than this one," said David Jones, chief economist at DMJ Advisors and a former Wall Street economist. "It looks like we turned the corner precisely because of what the Fed did."
Congress created the Fed in 1913 to prevent financial panics such as runs on banks and set it up as an independent entity. Its powers grew in 1933 and 1935. Although the Fed is subject to congressional oversight, its decisions do not have to be ratified by the president or Congress. Fed officials are not paid with money appropriated by Congress.
The system includes 12 Reserve Banks in major cities. These banks have their own boards of directors, two-thirds of whom are elected by commercial banks in the region and one-third by the Fed board in Washington.
In a remarkable week, the Fed: (1) engineered the fire sale of bankruptcy-headed Bear Stearns Cos. to J.P. Morgan Chase & Co. with a $30 billion loan. (2) offered emergency loans to other securities dealers under terms normally reserved for regulated banks. (3) slashed a key short-term interest rate by three quarters of a percentage point, to 2.25 percent. The cut was sixth since September. (and you forgot about the late Thursday actions of increasing the type of junk they will now allow the financial institutions to offload into the Fed balance sheet; and don't forget last week's $200 Billion action)
An interesting "opinion" (or fact?) piece on CBSMarketwatch.com
In a financial crisis, the Federal Reserve has an obligation to become the lender of last resort, making cash available for banks that need it right away to prevent a systemwide meltdown. But for this crisis, the Fed has become the lender of first resort to a whole new group of financial institutions that are relying on the central bank to boost their profits.
Instead of lending only to firms that cannot find money elsewhere, the Fed apparently is lending to firms that can get the money elsewhere, yet at a higher cost than borrowing from the Fed. I say "apparently" because almost everything about the Fed's new primary dealer-lending facility is secret.
The New York Federal Reserve Bank, which runs the program, would not comment about who is borrowing or under what conditions they are borrowing. The only information that was from the Fed came Thursday in the weekly report on reserve balances, showing that the 20 primary dealers borrowed $28.8 billion on Wednesday and about $19 billion on Monday and Tuesday.
What executives have said, however, indicates that these firms are violating the spirit, if not the letter of the law. A spokesman for Goldman Sachs for instance, told MarketWatch's Alistair Barr that the firm has borrowed from the Fed and intends to do so again "if doing so makes sense from an economic and funding-diversification point of view." He said that the Fed was a good "alternative." In other words, the Fed is just another source of money for Goldman, and not the only one. Because the Fed's only charging 2.5% interest, it's a very "attractive" source of money
The Federal Reserve Act, the legal authority that makes the Fed a more honorable institution than the Mafia, states clearly that the central bank may lend money to companies that are not "depository institutions" (in other words, that are not commercial banks) only if that firm proves to the Fed that it is "unable to secure adequate credit accommodations from other banking institutions" and only "in unusual and exigent circumstances." On Sunday, the Fed board voted unanimously to declare these to be "unusual and exigent circumstances."
It's a judgment call by the New York Fed as to whether these firms can find credit elsewhere. In the middle of the worst liquidity crisis since the Great Depression, the New York Fed is understandably bending over backwards to supply credit now and ask questions later.
Being the lender of first resort could make the Fed's goal of stabilizing financial markets harder to achieve, because the Fed could be crowding out private-sector lending. How can anyone compete with the central bank? Any firm that doesn't have access to the Fed's cheap money is at a serious disadvantage.
Another article: after reading this it looks like this man is going to be the next Fed Chief .... he is doing the dirty work behind the scenes and already he appears to be the best friend of NYC banks so who better to fill their pockets to the brim in the future?
Monday, March 24, 2008
Market Outlook: Watch Out, the Signs Can Be Deceiving
For the bulls, the events of the past several days have marked a major turning point for the U.S. equity market.
Share prices staged their first weekly gain in a month. The Federal Reserve pulled out all stops to save the banking system. Financial shares bounced hard, and inflation fears eased as commodity prices fell back to earth.
In other words, the ducks are all lined up: it’s time to buy.
Upon closer inspection, however, recent developments are less than reassuring. History suggests, for example, that major upside reversals are rarely anticipated before the fact - or at the time. Often, they are not even acknowledged for days or months after a rally has begun.
Yet there was plenty of talk this week about "bottom-fishing," "buying opportunities," and the likelihood of a "bear market bounce" in share prices. Analyst Richard Bove proclaimed that “the financial crisis was over.” A Merrill Lynch survey revealed that money managers were itching to buy “undervalued” equities.
These are not exactly signs of excessive pessimism.
There hasn’t been much “capitulation” by weak hands, either. Apart from the quick downdraft that occurred in mid-January, apparently spurred by hedge fund selling, the decline from the October record peak has been fairly orderly.
Yet the absence of a washout doesn’t seem to phase the bulls. One pundit even went so far as to say that a lack of panic-type selling like we saw last Monday was “another sign that we could be near a bottom.” That takes the cake as far as bullish rationalizations go.
What about the fact that financials were at the head of the pack during this past week’s recovery? Was it because investors were taking advantage of what Bove characterized as a “once in a generation opportunity to buy,” or did it have everything to do with the fact that the most heavily-shorted shares were being squeezed the hardest?
Otherwise, is it actually good news that Fannie Mae (FNM) and Freddie Mac (FRE) can now operate with even smaller capital cushions than they had before? Or that curious financial footwork helped some brokers to beat Street estimates, even though their outlooks remained dicey? Or that the Bear Stearns (BSC) “rescue” could only be solved with the help of $30 billion in non-recourse Federal Reserve loans?
Many bulls also took comfort from the sharp decline in commodity prices, which was seen as a sign that inflation was no longer a concern. Reports indicate, however, that “de-leveraging” by hedge funds and proprietary trading desks played a major role in the unwinding. Instead of being good news, the slump probably means that bursting-credit-bubble deflation is gathering force, which is bad news for share prices.
Of course, what really got the bullish juices flowing recently are the actions of the Fed. From helping to orchestrate a Bear Stearns bailout, to cutting the discount and federal funds rates, to opening up new sources of liquidity for an ever-widening array of institutions, Bernanke & Co. are doing anything and everything they can to try and save the day.
Unfortunately, there’s just one thing missing: good results.
Former Fed vice chairman Alan Blinder, a Princeton University professor, said the following in a Bloomberg report:
He has taken extraordinary measures, things that we haven't seen since the Great Depression. He's working overtime, literally and figuratively, to get this panic under control. But so far, it's not under control.
Arguably, the Federal Reserve is actually making things worse. For instance, rather than bolstering confidence, the central bank’s seemingly reactive and seat-of-the-pants, secretive, and unusually forceful response suggests that policymakers are desperate and behind the curve.
In addition, new liquidity facilities that allow a broad range of unnamed counterparties to swap unknown amounts of mis-rated and overpriced mortgage-backed securities for U.S. government bonds only adds to uncertainty about valuations and the extent of the problems that like ahead.
Finally, people are being led to believe that things are under control, so instead of doing whatever is necessary to prepare for the worst, they are setting themselves up for an even bigger blindsiding than before.
In sum, while bulls believe that share prices are poised to reverse and move sharply higher, the facts suggest otherwise. In reality, what they are seeing is the set-up for the next leg down. Some might call that a continuation point.
Share prices staged their first weekly gain in a month. The Federal Reserve pulled out all stops to save the banking system. Financial shares bounced hard, and inflation fears eased as commodity prices fell back to earth.
In other words, the ducks are all lined up: it’s time to buy.
Upon closer inspection, however, recent developments are less than reassuring. History suggests, for example, that major upside reversals are rarely anticipated before the fact - or at the time. Often, they are not even acknowledged for days or months after a rally has begun.
Yet there was plenty of talk this week about "bottom-fishing," "buying opportunities," and the likelihood of a "bear market bounce" in share prices. Analyst Richard Bove proclaimed that “the financial crisis was over.” A Merrill Lynch survey revealed that money managers were itching to buy “undervalued” equities.
These are not exactly signs of excessive pessimism.
There hasn’t been much “capitulation” by weak hands, either. Apart from the quick downdraft that occurred in mid-January, apparently spurred by hedge fund selling, the decline from the October record peak has been fairly orderly.
Yet the absence of a washout doesn’t seem to phase the bulls. One pundit even went so far as to say that a lack of panic-type selling like we saw last Monday was “another sign that we could be near a bottom.” That takes the cake as far as bullish rationalizations go.
What about the fact that financials were at the head of the pack during this past week’s recovery? Was it because investors were taking advantage of what Bove characterized as a “once in a generation opportunity to buy,” or did it have everything to do with the fact that the most heavily-shorted shares were being squeezed the hardest?
Otherwise, is it actually good news that Fannie Mae (FNM) and Freddie Mac (FRE) can now operate with even smaller capital cushions than they had before? Or that curious financial footwork helped some brokers to beat Street estimates, even though their outlooks remained dicey? Or that the Bear Stearns (BSC) “rescue” could only be solved with the help of $30 billion in non-recourse Federal Reserve loans?
Many bulls also took comfort from the sharp decline in commodity prices, which was seen as a sign that inflation was no longer a concern. Reports indicate, however, that “de-leveraging” by hedge funds and proprietary trading desks played a major role in the unwinding. Instead of being good news, the slump probably means that bursting-credit-bubble deflation is gathering force, which is bad news for share prices.
Of course, what really got the bullish juices flowing recently are the actions of the Fed. From helping to orchestrate a Bear Stearns bailout, to cutting the discount and federal funds rates, to opening up new sources of liquidity for an ever-widening array of institutions, Bernanke & Co. are doing anything and everything they can to try and save the day.
Unfortunately, there’s just one thing missing: good results.
Former Fed vice chairman Alan Blinder, a Princeton University professor, said the following in a Bloomberg report:
He has taken extraordinary measures, things that we haven't seen since the Great Depression. He's working overtime, literally and figuratively, to get this panic under control. But so far, it's not under control.
Arguably, the Federal Reserve is actually making things worse. For instance, rather than bolstering confidence, the central bank’s seemingly reactive and seat-of-the-pants, secretive, and unusually forceful response suggests that policymakers are desperate and behind the curve.
In addition, new liquidity facilities that allow a broad range of unnamed counterparties to swap unknown amounts of mis-rated and overpriced mortgage-backed securities for U.S. government bonds only adds to uncertainty about valuations and the extent of the problems that like ahead.
Finally, people are being led to believe that things are under control, so instead of doing whatever is necessary to prepare for the worst, they are setting themselves up for an even bigger blindsiding than before.
In sum, while bulls believe that share prices are poised to reverse and move sharply higher, the facts suggest otherwise. In reality, what they are seeing is the set-up for the next leg down. Some might call that a continuation point.
Sunday, March 23, 2008
Character to Adopt Simple Rules Some Market Statistics
Our model is designed for the next 6 to 24 months and after the last two days, nothing haschanged. Every single indicator we have in Psychology, Monetary and Valuation, which use history as a guide, say the odds are way in our favor. Every single indicator we follow is bullish.
We strongly believe this downturn is short-term in nature, and once any good news breaksthrough, the pent-up demand of tremendous fear, combined with huge amounts of cash on the sidelines, combined with amazing valuation levels will springboard this stock market to much higher levels.
Ben Graham once said that, “People don’t need extraordinary insight or intelligence. What they need most is the character to adopt simple rules and stick to them.” Our rules, developed since 1969, have never let us down in the past, and we firmly believe they will not let us down again. We could use our emotion, but think using our model will get you much further down the road.
Some Statistics that we have shared again and again:
AAII: Reached 200%, average gain of 21.75% with NO INSTANCES OF DECLINE.
Gambill Ratio: Reached 25%, the stock market was up 22% over the next 12 months.
ISEE: With readings under 120, the market was up 21.5% over the next 12 months.
Equity Put/Call: Reached 80%, stock market was up 18% over the next 12 months.
VIX: Since 1990, when the VIX has been between 30 and 40, the market is up an average 10.9% over the next six months and 16.2% over the next 12 months.
ARMS Index: When ARMS climbs above 1.8, market advanced 11.2% over six months and 16.38% over next 12 months.
T-Bill Yields: Yields under 1.5%, stocks advance 23.3% over next 12 months.
Fed rate cuts: Dow has average 18.8% gain 12 months later. When cash outperforms: When cash has outperformed all of the Fidelity Select funds, the market was up 23% on average, with no instances of decline.
Rule of 20 – With current readings, the market is up 17% over the next 12 months.
IBES Valuation: In 2002, market was up more than 30% over the next 12 months.
Jaspon Goepfert of SentimenTrader.com tells us after 4 consecutive monthly losses like we have seen the last four months, the market has had some great returns:
• Goepfert also looked back over the past 65 years at times that the market was oversold then enjoyed two 3% or greater up days within a 10-day window as we just experienced. Only five instances popped up: 05/28/70, 09/05/74, 10/21/87, 09/08/98 and 07/29/02. All of those were times the market was hammering out the end of bear markets.
• March 11thand again this Tuesday had more than nine times the up volume as down volume. David Aronson, author of a book titled, "Evidence-Based Technical Analysis", tested the statistical significance of "Double Nine-to-One" signals. He looked at what happens in the stock market in the 60-trading-day period following a “Double Nine-to-One” signal. In those 60-trading-day windows, the S&P 500 index produced an average annualized return of over 22%.
• So much fear produces so much cash doing nothing. That equates to a huge amount of buying power ready to go. Another Great Mark Dodson chart:
• Fidelity recently published a report stating that this year through February 29th, 2008 is the worst calendar-year start in 75 years since 1933 (-17%), and the second worst 2-month start in history. The best 3-year performance in history began in March 1933 – up 195% - immediately after the worst 2-month start. We believe that is the type of opportunity that exists in this stock market.
Ed Yardeni tells us the S&P 500 P/E down to 12.9 this week. On Tuesday, the stock market enjoyed its biggest point gain since July 29, 2002. That was a good entry point back then, after the DJIA closed at 8624.39 on July 26, 2002, and subsequently rose 64.2% to a record high of 14164.53 on October 9, 2007. Over our history since our inception January 1999, Hays Advisory has annualized 10.46% while the S&P 500 has annualized 3.70% on a gross basis. But every top money manager experiences ups and downs of the market. Here are a few of ours:
6 Months
-14.30% 9/30/2000 to 3/31/2001
-27.62% 3/31/2002 to 9/30/2002
1 Year
-19.67% 9/30/2000 to 9/30/2001
2 Years
-34.39% 9/30/2000 to 9/30/2002
…and that is from a manager who has a downside capture of just 62.3% of the market’s downturns. It pays to stay calm, think with your head, and consider what history is telling you. We believe that will lead you to the big upside gains we all love to enjoy.
We strongly believe this downturn is short-term in nature, and once any good news breaksthrough, the pent-up demand of tremendous fear, combined with huge amounts of cash on the sidelines, combined with amazing valuation levels will springboard this stock market to much higher levels.
Ben Graham once said that, “People don’t need extraordinary insight or intelligence. What they need most is the character to adopt simple rules and stick to them.” Our rules, developed since 1969, have never let us down in the past, and we firmly believe they will not let us down again. We could use our emotion, but think using our model will get you much further down the road.
Some Statistics that we have shared again and again:
AAII: Reached 200%, average gain of 21.75% with NO INSTANCES OF DECLINE.
Gambill Ratio: Reached 25%, the stock market was up 22% over the next 12 months.
ISEE: With readings under 120, the market was up 21.5% over the next 12 months.
Equity Put/Call: Reached 80%, stock market was up 18% over the next 12 months.
VIX: Since 1990, when the VIX has been between 30 and 40, the market is up an average 10.9% over the next six months and 16.2% over the next 12 months.
ARMS Index: When ARMS climbs above 1.8, market advanced 11.2% over six months and 16.38% over next 12 months.
T-Bill Yields: Yields under 1.5%, stocks advance 23.3% over next 12 months.
Fed rate cuts: Dow has average 18.8% gain 12 months later. When cash outperforms: When cash has outperformed all of the Fidelity Select funds, the market was up 23% on average, with no instances of decline.
Rule of 20 – With current readings, the market is up 17% over the next 12 months.
IBES Valuation: In 2002, market was up more than 30% over the next 12 months.
Jaspon Goepfert of SentimenTrader.com tells us after 4 consecutive monthly losses like we have seen the last four months, the market has had some great returns:
• Goepfert also looked back over the past 65 years at times that the market was oversold then enjoyed two 3% or greater up days within a 10-day window as we just experienced. Only five instances popped up: 05/28/70, 09/05/74, 10/21/87, 09/08/98 and 07/29/02. All of those were times the market was hammering out the end of bear markets.
• March 11thand again this Tuesday had more than nine times the up volume as down volume. David Aronson, author of a book titled, "Evidence-Based Technical Analysis", tested the statistical significance of "Double Nine-to-One" signals. He looked at what happens in the stock market in the 60-trading-day period following a “Double Nine-to-One” signal. In those 60-trading-day windows, the S&P 500 index produced an average annualized return of over 22%.
• So much fear produces so much cash doing nothing. That equates to a huge amount of buying power ready to go. Another Great Mark Dodson chart:
• Fidelity recently published a report stating that this year through February 29th, 2008 is the worst calendar-year start in 75 years since 1933 (-17%), and the second worst 2-month start in history. The best 3-year performance in history began in March 1933 – up 195% - immediately after the worst 2-month start. We believe that is the type of opportunity that exists in this stock market.
Ed Yardeni tells us the S&P 500 P/E down to 12.9 this week. On Tuesday, the stock market enjoyed its biggest point gain since July 29, 2002. That was a good entry point back then, after the DJIA closed at 8624.39 on July 26, 2002, and subsequently rose 64.2% to a record high of 14164.53 on October 9, 2007. Over our history since our inception January 1999, Hays Advisory has annualized 10.46% while the S&P 500 has annualized 3.70% on a gross basis. But every top money manager experiences ups and downs of the market. Here are a few of ours:
6 Months
-14.30% 9/30/2000 to 3/31/2001
-27.62% 3/31/2002 to 9/30/2002
1 Year
-19.67% 9/30/2000 to 9/30/2001
2 Years
-34.39% 9/30/2000 to 9/30/2002
…and that is from a manager who has a downside capture of just 62.3% of the market’s downturns. It pays to stay calm, think with your head, and consider what history is telling you. We believe that will lead you to the big upside gains we all love to enjoy.
Saturday, March 22, 2008
Best Private High Schools
America's Top10 Day Schools 2008
Rank School Name______(%) SAT Scores AP Courses
1 Roxbury Latin School, MA___45%____2230________11
2 Collegiate School, NY______44%____1460________19
2 Brearley School, NY_____%____1430________11
4 Winsor School, MA__________42%____1400_________7
5 Trinity School, NY_________41%________________11
6 Chapin School, NY__________38%________________11
7 Spence School, NY__________36%____2065_________2
8 St. Anne's School, NY______34%__________________
8 National Cathedral Sch, DC_34%____2130________17
10 Harvard-Westlake , CA____32%____1370________19
10 Dalton School, NY_________32%____2060________11
(%): % Placement to Ivy+MIT+Standford
*
*
America's Top10 Boarding Schools 2008
Rank School Name________________(%) SAT Scores AP Courses
1 St. Paul’s School, NH_____34%____1344________19
2 Deerfield Academy, MA______32%____1370________19
2 Milton Academy, MA_________32%____1360________11
4 Groton School, MA__________31%____1320________13
5 Middlesex School, MA_______30%____1350________19
6 Phillips Andover Ac, MA____29%____1388________14
6 Phillips Exeter Ac, NH_____29%____2073________19
8 Noble and Greenough S, MA__28%____1355________16
9 St. Alban’s School, DC____25%________________14
10 Lawrenceville School, NJ__22%____1360________11
Rank School Name______(%) SAT Scores AP Courses
1 Roxbury Latin School, MA___45%____2230________11
2 Collegiate School, NY______44%____1460________19
2 Brearley School, NY_____%____1430________11
4 Winsor School, MA__________42%____1400_________7
5 Trinity School, NY_________41%________________11
6 Chapin School, NY__________38%________________11
7 Spence School, NY__________36%____2065_________2
8 St. Anne's School, NY______34%__________________
8 National Cathedral Sch, DC_34%____2130________17
10 Harvard-Westlake , CA____32%____1370________19
10 Dalton School, NY_________32%____2060________11
(%): % Placement to Ivy+MIT+Standford
*
*
America's Top10 Boarding Schools 2008
Rank School Name________________(%) SAT Scores AP Courses
1 St. Paul’s School, NH_____34%____1344________19
2 Deerfield Academy, MA______32%____1370________19
2 Milton Academy, MA_________32%____1360________11
4 Groton School, MA__________31%____1320________13
5 Middlesex School, MA_______30%____1350________19
6 Phillips Andover Ac, MA____29%____1388________14
6 Phillips Exeter Ac, NH_____29%____2073________19
8 Noble and Greenough S, MA__28%____1355________16
9 St. Alban’s School, DC____25%________________14
10 Lawrenceville School, NJ__22%____1360________11
Thursday, March 20, 2008
Don't Wait for the Official End of the Recession
In his latest annual report to shareholders, Guru Charles Royce published some interesting statistics:
All the figures reflect cumulative total returns from the official start of the recession [a date only known after the fact] and through the last month of the recession as determined by the resumption of GDP growth. That date, by definition, is also known only after the fact.
There was no consistent over or under performance as related to cap size. What was glaring, though, was that 7 of the 8 measured total returns DURING the recessions were nicely positive numbers. Even the one negative was very minor.
Also noteworthy was the average duration of the most recent four recessions - an average of 9.5 months start to finish. Three of the four were eight months or less.
If the US entered a recession late last year [as is likely based on empirical data that has come in since year-end 2007], then we may very well be close to halfway through this latest one.
Since stock markets are leading indicators, we could be set for a pick-up in the averages pretty soon if this recession lasts the typical 6-9 months from inception.
Moral: Don't wait for the official end of the recession to load up on bargains. Share prices typically start rising about 6 months before the proclamation that "The Recession is Over" hits the airwaves.
All the figures reflect cumulative total returns from the official start of the recession [a date only known after the fact] and through the last month of the recession as determined by the resumption of GDP growth. That date, by definition, is also known only after the fact.
There was no consistent over or under performance as related to cap size. What was glaring, though, was that 7 of the 8 measured total returns DURING the recessions were nicely positive numbers. Even the one negative was very minor.
Also noteworthy was the average duration of the most recent four recessions - an average of 9.5 months start to finish. Three of the four were eight months or less.
If the US entered a recession late last year [as is likely based on empirical data that has come in since year-end 2007], then we may very well be close to halfway through this latest one.
Since stock markets are leading indicators, we could be set for a pick-up in the averages pretty soon if this recession lasts the typical 6-9 months from inception.
Moral: Don't wait for the official end of the recession to load up on bargains. Share prices typically start rising about 6 months before the proclamation that "The Recession is Over" hits the airwaves.
One Must Read Book
Time to brush up on what happens during a Bear Market, via Anatomy of the Bear.
"How does one spot the bottom of a bear market? What brings a bear to its end? Financial market history is a guide to understanding the future."
Looking at the four occasions when US equities were particularly cheap - 1921, 1932, 1949 and 1982, Russell Napier sets to answers these questions by analyzing every article (70,000!) in the Wall Street Journal of either side of the market bottom.
Can this method help one to understand the features which indicate that a great buying opportunity is emerging?
By looking at how markets really did work in these bear-market bottoms, rather than theorizing how they should work, the author offers a how-to guide.
Source:
Anatomy of the Bear: Lessons From Wall Street's Four Great Bottoms
Russell Napier
December 5, 2005
"How does one spot the bottom of a bear market? What brings a bear to its end? Financial market history is a guide to understanding the future."
Looking at the four occasions when US equities were particularly cheap - 1921, 1932, 1949 and 1982, Russell Napier sets to answers these questions by analyzing every article (70,000!) in the Wall Street Journal of either side of the market bottom.
Can this method help one to understand the features which indicate that a great buying opportunity is emerging?
By looking at how markets really did work in these bear-market bottoms, rather than theorizing how they should work, the author offers a how-to guide.
Source:
Anatomy of the Bear: Lessons From Wall Street's Four Great Bottoms
Russell Napier
December 5, 2005
Wednesday, March 19, 2008
The End of U.S. Investing as We Know It?
There are more than a dozen reasons to throw in the towel. The financial system has descended into complete chaos. The bursting of the housing bubble has left a record 10% of homeowners "upside-down" on their properties. And 50 years of American materialism has come back to bite us on the proverbial rear-end.
(That was just 3 reasons that many are currently citing. I could have mentioned layoffs, recession, inflation, stagflation, gasoline prices, falling U.S. dollar and the contentious U.S. election.)
I mean let's face it. The Great Depression was a walk in the park. Compared to what's coming down the pike... some "thinkers" are declaring the end to everything we've ever known or ever seen.
Personally, I believe the doomsday prognosticators are very sad people. Being right... which is an INfrequent occurrence for the doomsday crowd... is a pursuit that yields them fleeting moments of happiness.
Fear, anxiety, pessimism and anger are the emotions that embolden these folks to say, "See, I told you so." And it all occurs under the guise of a "realistic" point of view.
What is realistic, then? For starters, the S&P 500 SPDR (SPY) is down roughly 19% from its October 2007 highs.
It's bad. It's bearish. But it hardly qualifies as apocalyptic.
Recession-based bear markets are a natural part of investing cycles. More often than not, stock assets begin falling precipitously long before recessions start and they recover dramatically long before recessions finish. (They tend to start climbing at the mid-point of a recession.)
In my humble opinion, stocks could fall from 19%-27% in total. This is the average for recession-based bears... and I have no reason to believe that it'll be worse.
But why exactly should we believe the doom-n-gloomers who believe that stocks will be worth 1/2 what they were at the October 2007 peak? Because this is the worst economy/worst catastrophe/worst country?
Traditional valuation of company stock strongly supports the notion that the asset class is quite cheap. Granted, valuations don't mean much when fear is in the driver's seat. Nevertheless, it is important to distinguish the 2000-2002 stock market bubble (the S&P 500 SPDR (SPY) did fall 50% from its March 2000 highs) from the 2007-2008 recession/credit crunch.
The glass is not completely empty in 2008. In fact, it may actually be half-full.
For example, while the media focus incessantly on the recession, nearly all of the prominent economists polled in the Wall Street Journal concurred that the recession would be mild. That directly contradicts the idea that we're heading for a "depression" to rival the days of our grandparents.
What's more, the Federal Reserve Board is aggressively easing interest rates. While the negative effects it is having on the U.S. dollar are well-documented, the near-term reality of relief to consumers and small businesses can not be ignored. Rate cuts do not work for up to 9 months, but they do get into the system, and they do provide for attractive borrowing prospects.
It doesn't stop there. Federal government fiscal stimulus is coming in tax rebates. Moreover, bailouts of some kind will likely be afforded to some homeowners as well as financial companies. U.S exports are surging because of the weak dollar. Agriculture is expanding rapidly. And while, housing and auto may be contracting, the other 90% of the U.S. economy is still expanding.
What's the famous line from the movies? "What we have here is a failure to communicate." Simply put, troubles are being amplified tenfold, whereas positive news is being disregarded.
Of course, that's the nature of fear. And that's why the markets are struggling as badly as they are. But opportunists from Warren Buffett to institutional money managers do not stay sidelined for long. They know... we all know... that it is hugely rewarding to "get a little greedy when everyone else is fearful."
Wanna know when it's going to get better? Keep an eye on the Dow Jones Transports Fund (IYT). This is the breakout barometer that I will be watching closely.
(That was just 3 reasons that many are currently citing. I could have mentioned layoffs, recession, inflation, stagflation, gasoline prices, falling U.S. dollar and the contentious U.S. election.)
I mean let's face it. The Great Depression was a walk in the park. Compared to what's coming down the pike... some "thinkers" are declaring the end to everything we've ever known or ever seen.
Personally, I believe the doomsday prognosticators are very sad people. Being right... which is an INfrequent occurrence for the doomsday crowd... is a pursuit that yields them fleeting moments of happiness.
Fear, anxiety, pessimism and anger are the emotions that embolden these folks to say, "See, I told you so." And it all occurs under the guise of a "realistic" point of view.
What is realistic, then? For starters, the S&P 500 SPDR (SPY) is down roughly 19% from its October 2007 highs.
It's bad. It's bearish. But it hardly qualifies as apocalyptic.
Recession-based bear markets are a natural part of investing cycles. More often than not, stock assets begin falling precipitously long before recessions start and they recover dramatically long before recessions finish. (They tend to start climbing at the mid-point of a recession.)
In my humble opinion, stocks could fall from 19%-27% in total. This is the average for recession-based bears... and I have no reason to believe that it'll be worse.
But why exactly should we believe the doom-n-gloomers who believe that stocks will be worth 1/2 what they were at the October 2007 peak? Because this is the worst economy/worst catastrophe/worst country?
Traditional valuation of company stock strongly supports the notion that the asset class is quite cheap. Granted, valuations don't mean much when fear is in the driver's seat. Nevertheless, it is important to distinguish the 2000-2002 stock market bubble (the S&P 500 SPDR (SPY) did fall 50% from its March 2000 highs) from the 2007-2008 recession/credit crunch.
The glass is not completely empty in 2008. In fact, it may actually be half-full.
For example, while the media focus incessantly on the recession, nearly all of the prominent economists polled in the Wall Street Journal concurred that the recession would be mild. That directly contradicts the idea that we're heading for a "depression" to rival the days of our grandparents.
What's more, the Federal Reserve Board is aggressively easing interest rates. While the negative effects it is having on the U.S. dollar are well-documented, the near-term reality of relief to consumers and small businesses can not be ignored. Rate cuts do not work for up to 9 months, but they do get into the system, and they do provide for attractive borrowing prospects.
It doesn't stop there. Federal government fiscal stimulus is coming in tax rebates. Moreover, bailouts of some kind will likely be afforded to some homeowners as well as financial companies. U.S exports are surging because of the weak dollar. Agriculture is expanding rapidly. And while, housing and auto may be contracting, the other 90% of the U.S. economy is still expanding.
What's the famous line from the movies? "What we have here is a failure to communicate." Simply put, troubles are being amplified tenfold, whereas positive news is being disregarded.
Of course, that's the nature of fear. And that's why the markets are struggling as badly as they are. But opportunists from Warren Buffett to institutional money managers do not stay sidelined for long. They know... we all know... that it is hugely rewarding to "get a little greedy when everyone else is fearful."
Wanna know when it's going to get better? Keep an eye on the Dow Jones Transports Fund (IYT). This is the breakout barometer that I will be watching closely.
An Abundance of Bottom Calling
Yesterday's gains seem to have been met with plenty of bottom calling. Granted, this is anecdotal evidence from what we've heard on CNBC and other media outlets on Wall Street, but it's important to remember that we're not out of the woods yet.
Below we highlight a chart of the S&P 500 and an index that measures the default risk that investors are placing on high-grade corporate debt. As shown, the S&P 500 (red line) remains in a severe downtrend, and it has a lot of work to do to get out of it. While the credit default risk index had a huge decline yesterday, it barely put a dent in the strong uptrend that it's currently in.
When the market gains 400+ points in one day, it's easy to selectively remember the good and forget the bad. While we hope a bottom has indeed been made, it's still important to tread these waters carefully.
Below we highlight a chart of the S&P 500 and an index that measures the default risk that investors are placing on high-grade corporate debt. As shown, the S&P 500 (red line) remains in a severe downtrend, and it has a lot of work to do to get out of it. While the credit default risk index had a huge decline yesterday, it barely put a dent in the strong uptrend that it's currently in.
When the market gains 400+ points in one day, it's easy to selectively remember the good and forget the bad. While we hope a bottom has indeed been made, it's still important to tread these waters carefully.
Notes for New York Trip
A few tips for the next time.
Hotel, Westin Hotel at Time Square, very stylish, all of us liked it, will book it next time.
Restaurant, good finding this time as well, Thanks to the security guard of Westin Hotel. Carmine is on 44th street, Italian food, big portion. Baru is on 43rd Street, Japanese food, Fish Dish is out of the world.
US Airway shuttle, the service is getting worse, will change to train next time.
Hotel, Westin Hotel at Time Square, very stylish, all of us liked it, will book it next time.
Restaurant, good finding this time as well, Thanks to the security guard of Westin Hotel. Carmine is on 44th street, Italian food, big portion. Baru is on 43rd Street, Japanese food, Fish Dish is out of the world.
US Airway shuttle, the service is getting worse, will change to train next time.
Saturday, March 15, 2008
Commodities and Cash Still King
Jerry Slusiewicz doesn't like cash. But the Newport Beach, Calif.-based advisor and portfolio manager (pictured at right) says he likes current market conditions even less.
"The market is still oversold, which leaves a lot of upside potential," said Slusiewicz. But the founder of Pacific Financial Planners says it's a little early to dive back into stocks.
He considers both technical and fundamental factors before investing. Despite the biggest rise in five years in the Dow Jones Industrial Average index on Tuesday, Slusiewicz is waiting for a confirmation that the current rally has legs.
But prior to that, he notes that the market was down seven out of the last eight days. "So the rally is just starting," Slusiewicz said. "On Wednesday, the major indexes were whipsawed. But on Thursday, we started way down and closed up."
He'd like to see markets show a definite follow. For example, SPDRs (AMEX: SPY) would need to get above $136 per share. It closed at $131.76 on Thursday. "That's the minimum level we'd feel comfortable with before re-applying cash into the markets," Slusiewicz said.
No matter how fast stocks recover, he says taking a disciplined and well-planned approach is important. "We're sitting on 60% cash, so we're going to wade into the market, probably a third at a time," Slusiewicz said.
All-Clear Signal
Based on technical analysis, he pinpoints $140 per share as the next attractive buy point for SPY. The third pricing level would be at $146. "That would signal SPY's all-clear signal," Slusiewicz said. "At that point, it'd be above the downtrend line that started on Oct. 11, 2007, which was basically at the peak of the market."
From the high point in October 2007 of 1576 on the S&P 500, the index fell nearly 20% through the end of last summer. "Everything at this stage revolves around credit and the ongoing financial crisis," Slusiewicz said.
But broad stock indexes remain above their 52-week lows. "The sentiment indicators suggest that stocks remain oversold," Slusiewicz said. "But while it's important to note, those are secondary indicators. So even though we're hopeful that not much downside remains in the market, we're not ready to bet the farm yet."
Besides cash, he's mainly investing in commodities. His biggest holding right now is streetTracks Gold Shares (NYSE: GLD). It hit an all-time high on Thursday and has run up 45% since Sept. 6, 2007. That's when GLD broke out at $68 per share, says Slusiewicz.
"With a gap up today, that's another positive sign," he said. "But I'm concerned that GLD could be poised for a pullback."
The ETF is trading 25% above its 200-day moving average. Gold has also breached the psychologically important $1,000-per-ounce level. "When it hits that level, people might want to take money off the table," Slusiewicz said.
But technically, GLD has minor support at $90 per share and major support at $80 a share, he adds. "So that's where if the rally fizzles, that's where it could fall," Slusiewicz said.
While he still thinks prospects for GLD remain strong long term, he observes that the last time the ETF underwent price consolidation, that pullback lasted 16 months. "So gold's rise hasn't been straight up," Slusiewicz said.
Although he isn't ready to trim his GLD positions, Slusiewicz has put stop-loss orders on GLD at $90.50.
He also owns SPDR S&P Metals & Mining ETF (AMEX: XME). "The global markets are still in a growth phase, and steel and copper haven't slowed either yet," Slusiewicz. "Pretty much anything you pull out of the ground these days is seeing strong demand."
Energy Disconnect
He also holds SPDR S&P Oil & Gas Equipment & Services (AMEX: XES). "It's interesting to see energy prices hitting new highs, but the energy stocks aren't," Slusiewicz said.
But equipment makers should do better long term than diversified oil producers, he added. "At these high prices, looking for alternatives and to dig deeper becomes more affordable," said Slusiewicz. "The money flow's going to continue to create more supply of oil."
He also recently added to his positions in iShares Lehman TIPS Bond (NYSE: TIP). Slusiewicz entered the ETF in October at $101.80 per share. It closed at $110.78 on Thursday. And it's paying about a 4.8% yield.
"We're importing inflation. The falling value of the dollar means it costs us more money to import goods and services," Slusiewicz said. "And I don't see that changing much."
TIP had a breakout on Feb. 28 at $109.40 per share on strong volume. It's up to around $110 now. Slusiewicz says its support is at $105 per share. "So we could see a pullback, but unlike GLD, that could fall to $80; TIP probably isn't positioned technically to fall that much," he said.
With tax rebates coming in May and the Fed likely dropping interest rates on Tuesday, Slusiewicz says a bottom in the broad stock market indexes appears close. "But right now, it pays to be patient," he said. "Very soon, we're expecting to see a rally that could push stocks 16%-20% higher over an extended period."
"The market is still oversold, which leaves a lot of upside potential," said Slusiewicz. But the founder of Pacific Financial Planners says it's a little early to dive back into stocks.
He considers both technical and fundamental factors before investing. Despite the biggest rise in five years in the Dow Jones Industrial Average index on Tuesday, Slusiewicz is waiting for a confirmation that the current rally has legs.
But prior to that, he notes that the market was down seven out of the last eight days. "So the rally is just starting," Slusiewicz said. "On Wednesday, the major indexes were whipsawed. But on Thursday, we started way down and closed up."
He'd like to see markets show a definite follow. For example, SPDRs (AMEX: SPY) would need to get above $136 per share. It closed at $131.76 on Thursday. "That's the minimum level we'd feel comfortable with before re-applying cash into the markets," Slusiewicz said.
No matter how fast stocks recover, he says taking a disciplined and well-planned approach is important. "We're sitting on 60% cash, so we're going to wade into the market, probably a third at a time," Slusiewicz said.
All-Clear Signal
Based on technical analysis, he pinpoints $140 per share as the next attractive buy point for SPY. The third pricing level would be at $146. "That would signal SPY's all-clear signal," Slusiewicz said. "At that point, it'd be above the downtrend line that started on Oct. 11, 2007, which was basically at the peak of the market."
From the high point in October 2007 of 1576 on the S&P 500, the index fell nearly 20% through the end of last summer. "Everything at this stage revolves around credit and the ongoing financial crisis," Slusiewicz said.
But broad stock indexes remain above their 52-week lows. "The sentiment indicators suggest that stocks remain oversold," Slusiewicz said. "But while it's important to note, those are secondary indicators. So even though we're hopeful that not much downside remains in the market, we're not ready to bet the farm yet."
Besides cash, he's mainly investing in commodities. His biggest holding right now is streetTracks Gold Shares (NYSE: GLD). It hit an all-time high on Thursday and has run up 45% since Sept. 6, 2007. That's when GLD broke out at $68 per share, says Slusiewicz.
"With a gap up today, that's another positive sign," he said. "But I'm concerned that GLD could be poised for a pullback."
The ETF is trading 25% above its 200-day moving average. Gold has also breached the psychologically important $1,000-per-ounce level. "When it hits that level, people might want to take money off the table," Slusiewicz said.
But technically, GLD has minor support at $90 per share and major support at $80 a share, he adds. "So that's where if the rally fizzles, that's where it could fall," Slusiewicz said.
While he still thinks prospects for GLD remain strong long term, he observes that the last time the ETF underwent price consolidation, that pullback lasted 16 months. "So gold's rise hasn't been straight up," Slusiewicz said.
Although he isn't ready to trim his GLD positions, Slusiewicz has put stop-loss orders on GLD at $90.50.
He also owns SPDR S&P Metals & Mining ETF (AMEX: XME). "The global markets are still in a growth phase, and steel and copper haven't slowed either yet," Slusiewicz. "Pretty much anything you pull out of the ground these days is seeing strong demand."
Energy Disconnect
He also holds SPDR S&P Oil & Gas Equipment & Services (AMEX: XES). "It's interesting to see energy prices hitting new highs, but the energy stocks aren't," Slusiewicz said.
But equipment makers should do better long term than diversified oil producers, he added. "At these high prices, looking for alternatives and to dig deeper becomes more affordable," said Slusiewicz. "The money flow's going to continue to create more supply of oil."
He also recently added to his positions in iShares Lehman TIPS Bond (NYSE: TIP). Slusiewicz entered the ETF in October at $101.80 per share. It closed at $110.78 on Thursday. And it's paying about a 4.8% yield.
"We're importing inflation. The falling value of the dollar means it costs us more money to import goods and services," Slusiewicz said. "And I don't see that changing much."
TIP had a breakout on Feb. 28 at $109.40 per share on strong volume. It's up to around $110 now. Slusiewicz says its support is at $105 per share. "So we could see a pullback, but unlike GLD, that could fall to $80; TIP probably isn't positioned technically to fall that much," he said.
With tax rebates coming in May and the Fed likely dropping interest rates on Tuesday, Slusiewicz says a bottom in the broad stock market indexes appears close. "But right now, it pays to be patient," he said. "Very soon, we're expecting to see a rally that could push stocks 16%-20% higher over an extended period."
Thursday, March 13, 2008
What Are Brokers' Exposures to Carlyle Capital?
Brokers' trading exposures to Carlyle Capital's soon to be defaulted fund -- rumored to be leveraged at an astonishing 32X! -- has been the big question circulating street desks Thursday.
Here's one set of numbers currently circulating on the potential exposure (analyst unknown):
-Citibank (C) $4.7B
-Lehman (LEH) $3B
-BoA (BAC) $2B
-UBS (UBS) $1.8B
-Bear Stearns (BSC) $1.7B
-ING (ING) $1.5B
-JPMorgan (JPM) $1.4B
-Calyon $1.3B
-Merrill Lynch (MER) $760m
-BN Paribas $600m
-Credit Suisse (CS) $500m
I cannot vouch for the accuracy of these numbers, but this is what is getting pinged around Wall Street trading desks . . .
Here's one set of numbers currently circulating on the potential exposure (analyst unknown):
-Citibank (C) $4.7B
-Lehman (LEH) $3B
-BoA (BAC) $2B
-UBS (UBS) $1.8B
-Bear Stearns (BSC) $1.7B
-ING (ING) $1.5B
-JPMorgan (JPM) $1.4B
-Calyon $1.3B
-Merrill Lynch (MER) $760m
-BN Paribas $600m
-Credit Suisse (CS) $500m
I cannot vouch for the accuracy of these numbers, but this is what is getting pinged around Wall Street trading desks . . .
Wednesday, March 12, 2008
A long term bottom process has started?
There was a dramatic shift in the sentiment readings this week with many of the previous bulls throwing in the towel 'en masse'. Their number fell more that 10% and they are now far outnumbered by the level of the bears.
The bulls crashed all the way to 31.1%, from 41.9% last week. That is their lowest readings since October 2002 when we saw 28.4% on the 11th and 31.0% on the 4th. That was smack at the last bear market bottom which lasted from that July through early March 2003. That period proved to be an excellent entry area as the Dow Jones Industrials wer trading around 7,500 and preparing for a multi-year bull market.
The bears jumped up to 43.3%, from 36.6% last week. Their latest
reading is just above their peak from 12-October-2002 when they
totalled 43.2%.
The market turned up quickly after those readings in 2002 and the
bulls surged to 50.6% just four weeks after their low reading as the
DJIA rallied over 700 points. In that same time frame the bears fell
down to 28.1%.
The remaining 25.6% of the advisors are classified as correction.
There number rose from 21.5% a week ago.
The current sentiment readings are great and very supportive of the
idea that a broad new market bottom is in the process of forming.
The sharp increase in advisor pessimism could be blamed on tumbling
index action and the increased belief that the economy is in a
recession. All three primary stock averages continue to trade below
their declining 200-day moving averages and show penetrations of major support. Last week's acceleration to the downside was enough to cause the latest shifts.
The spread between the bulls and bears is -12.2%, a sharp drop from
+5.3% a week ago. This is also the first negative difference since
October 2002, shown on the chart as the prior move below the 'O' line.
The recent readings remain bullish. There has been and an almost +55% shift in the sentiment spread from the early October 2007 market high. That included a very negative +42.4% difference.
The bulls crashed all the way to 31.1%, from 41.9% last week. That is their lowest readings since October 2002 when we saw 28.4% on the 11th and 31.0% on the 4th. That was smack at the last bear market bottom which lasted from that July through early March 2003. That period proved to be an excellent entry area as the Dow Jones Industrials wer trading around 7,500 and preparing for a multi-year bull market.
The bears jumped up to 43.3%, from 36.6% last week. Their latest
reading is just above their peak from 12-October-2002 when they
totalled 43.2%.
The market turned up quickly after those readings in 2002 and the
bulls surged to 50.6% just four weeks after their low reading as the
DJIA rallied over 700 points. In that same time frame the bears fell
down to 28.1%.
The remaining 25.6% of the advisors are classified as correction.
There number rose from 21.5% a week ago.
The current sentiment readings are great and very supportive of the
idea that a broad new market bottom is in the process of forming.
The sharp increase in advisor pessimism could be blamed on tumbling
index action and the increased belief that the economy is in a
recession. All three primary stock averages continue to trade below
their declining 200-day moving averages and show penetrations of major support. Last week's acceleration to the downside was enough to cause the latest shifts.
The spread between the bulls and bears is -12.2%, a sharp drop from
+5.3% a week ago. This is also the first negative difference since
October 2002, shown on the chart as the prior move below the 'O' line.
The recent readings remain bullish. There has been and an almost +55% shift in the sentiment spread from the early October 2007 market high. That included a very negative +42.4% difference.
Tuesday, March 11, 2008
Jim Rogers says US ‘out of control’
Jim Rogers - who co-founded the now closed Quantum Fund with George Soros - told 750 global fund managers in Tokyo today that, America is “completely out of control”, there will be a 20-year bull market in commodities and that prices will be in turmoil. And he also warned that it “made sense” if global competition for resources ended in armed conflict.
Mr Rogers told delegates to the CLSA investment forum that the prices of all agricultural products would “explode” in coming years and that the price of gold, which hit an all-time high of $964 an ounce yesterday, will continue its surge to as much as $3,500 an ounce.
Gold would continue to rise, the analyst Christopher Wood told fund managers, “because it is the exact opposite of a structured finance product”.
In a blistering attack on US monetary policy and the “helicopter cash drop” responses of the Federal Reserve, Mr Rogers described the American dollar as a “terribly flawed currency”.
He said that the plan by Ben Bernanke, the Fed Chairman, to “crank up the money-printing machines and run them until we run out of trees” had exposed America’s weakest point to her rivals and enemies.
The dollar may have declined recently, he added, “but you ain’t seen nothing yet”.
Talking to a room almost exclusively populated with Japan-focused equity investors, Mr Rogers recommended an immediate language course in Mandarin and a switch into commodities — the second-biggest market in the world behind foreign exchange.
Mr Rogers said that historic drains on wheat, corn and other soft commodity inventories have created market dynamics that could lead to severe food shortages.
The outlook over the next two decades would see prices of everything from cotton and sugar to lead and nickel “going through the roof”.
Heavily playing down the prospects of a big recovery in Japan, Mr Rogers said that the country’s demographics — as the fastest-aging country in the world — would cause it greater problems and an ever-diminishing quality of life for ordinary Japanese.
But he also said that other countries — including Britain, Italy, China and the US — should take note of what their own demographics would look like without the effect of immigration.
“Japan will be the perfect laboratory for the world to watch how a demographic crisis plays out,” he said.
Mr Rogers told delegates to the CLSA investment forum that the prices of all agricultural products would “explode” in coming years and that the price of gold, which hit an all-time high of $964 an ounce yesterday, will continue its surge to as much as $3,500 an ounce.
Gold would continue to rise, the analyst Christopher Wood told fund managers, “because it is the exact opposite of a structured finance product”.
In a blistering attack on US monetary policy and the “helicopter cash drop” responses of the Federal Reserve, Mr Rogers described the American dollar as a “terribly flawed currency”.
He said that the plan by Ben Bernanke, the Fed Chairman, to “crank up the money-printing machines and run them until we run out of trees” had exposed America’s weakest point to her rivals and enemies.
The dollar may have declined recently, he added, “but you ain’t seen nothing yet”.
Talking to a room almost exclusively populated with Japan-focused equity investors, Mr Rogers recommended an immediate language course in Mandarin and a switch into commodities — the second-biggest market in the world behind foreign exchange.
Mr Rogers said that historic drains on wheat, corn and other soft commodity inventories have created market dynamics that could lead to severe food shortages.
The outlook over the next two decades would see prices of everything from cotton and sugar to lead and nickel “going through the roof”.
Heavily playing down the prospects of a big recovery in Japan, Mr Rogers said that the country’s demographics — as the fastest-aging country in the world — would cause it greater problems and an ever-diminishing quality of life for ordinary Japanese.
But he also said that other countries — including Britain, Italy, China and the US — should take note of what their own demographics would look like without the effect of immigration.
“Japan will be the perfect laboratory for the world to watch how a demographic crisis plays out,” he said.
Strategists Continue to Lower Year End Forecasts
Three strategists lowered their price targets on the S&P 500 last week. JP Morgan lowered its price target from 1,590 to 1,450, Strategas lowered its target from 1,640 to 1,480, and Merrill Lynch lowered its target for a second time from 1,475 to 1,425.
So far, nine out of the fifteen equity strategists surveyed by Bloomberg have lowered their 2008 forecasts this year. Merrill now has the lowest price target at 1,425, while Goldman still has the highest target at 1,675. Based on the average of all the forecasts, strategists are looking for gains of 21% from current levels to the end of the year
So far, nine out of the fifteen equity strategists surveyed by Bloomberg have lowered their 2008 forecasts this year. Merrill now has the lowest price target at 1,425, while Goldman still has the highest target at 1,675. Based on the average of all the forecasts, strategists are looking for gains of 21% from current levels to the end of the year
Sunday, March 9, 2008
5 Reasons Why the US Dollar Will Weaken Further
The US dollar has fallen to a record low against the Euro and an 8 year low against the Japanese Yen this past week. Here are 5 reasons why I think the weakness will continue:
1. Non-Farm Payrolls Will Continue to Fall
For 2 months in a row, jobs decreased in the US economy. I expect these numbers to worsen over the next few months because the current state of the labor market is nothing compared to the 15 consecutive months of negative job losses between 2001 and 2002.
2. The Federal Reserve is on High Alert
Not only are Fed Fund futures pricing in a 98 percent chance of a 75bp rate cut on March 18th, but the Federal Reserve is on high alert. For lack of a better description, they are “freaking out.” This morning, they announced moves to pump 200 billion dollars into the banking system to ”address liquidity pressures in the funding markets.” Although they denied that this was related to the weak jobs report, the timing is certainly suspect. The announcement may have been aimed at preventing a non-farm payrolls induced collapse in the stock market, which worked for about an hour before stocks completely reversed all of its gains.
Two year bond yields are also currently yielding slightly more than 1.50 percent while the Fed Funds rate is at 3 percent. That difference of 150bp means that in order for the gap to be neutral, the Fed would need to immediately cut interest rates by 150bp. Since 1990, the average spread between the 2 year treasury rates and Fed funds is approximately +50bp and over the past 10 years, it is +25bp. Therefore it is not rocket science to see that a gap of -150bp is a huge discrepancy and tells us that the Fed could bring rates down to as low as 1.50 percent. Lower interest rates equal a lower US dollar.
3. Retail Sales Could be Negative Next Week
Retail sales could also be negative next week which would lead to another round of dollar selling. 34k jobs were cut from the retail sector and according to the following WSJ chart, sales at most retailers other than discounters have been weak. With gas prices skyrocketing, foreclosures hitting a record high, the labor market weakening and confidence at a record low, discretionary spending may be the last things on the consumer’s mind.
4. Speculators Still Trying to Pick a Top in the EUR/USD
The latest FXCM Speculative Sentiment Index which is a contrarian indicator also calls for further gains in the Euro against the US dollar as speculative short positioning continues to grow. Retail traders are often times caught on the wrong side of the market as they struggle to pick top and bottoms. As indicated by this chart of positioning in the Euro, retail speculators turned net short the EURUSD at 1.25 and have remained short since then.
5. Technicals
According to the technical Elliott Wave formation of the EUR/USD, a spike above 1.56 is very possible before dollar bulls see any relief.
My near term targets is for USD/JPY to fall to 100 and the EUR/USD to rise to 1.55.
However with that in mind, I still think that the US dollar will recover in the second half of the year.
I am a strong believer that we will see a V or at least a U shaped recovery in the US economy that will trigger a dollar recovery and rally in the second half of the year. The Fed’s doing a lot right now and they are being extremely aggressive and this would be especially true if they cut interest rates by another 50 to 75bp this month. Imagine the relief for US consumers and businesses if interest rates came back down towards 1.00 percent. Everyone will be rushing to lock in those rates and use that money for refinancing or capital expenditures. The degree of monetary and fiscal stimulus in the pipeline should lead to a shallow downturn and a swift recovery. Unlike the past, there is still a lot of money to be spent in the Middle East and Asia. When the US recovers, investors in these countries may sweep in with newfound optimism, which will give the dollar a chance to recover as well.
1. Non-Farm Payrolls Will Continue to Fall
For 2 months in a row, jobs decreased in the US economy. I expect these numbers to worsen over the next few months because the current state of the labor market is nothing compared to the 15 consecutive months of negative job losses between 2001 and 2002.
2. The Federal Reserve is on High Alert
Not only are Fed Fund futures pricing in a 98 percent chance of a 75bp rate cut on March 18th, but the Federal Reserve is on high alert. For lack of a better description, they are “freaking out.” This morning, they announced moves to pump 200 billion dollars into the banking system to ”address liquidity pressures in the funding markets.” Although they denied that this was related to the weak jobs report, the timing is certainly suspect. The announcement may have been aimed at preventing a non-farm payrolls induced collapse in the stock market, which worked for about an hour before stocks completely reversed all of its gains.
Two year bond yields are also currently yielding slightly more than 1.50 percent while the Fed Funds rate is at 3 percent. That difference of 150bp means that in order for the gap to be neutral, the Fed would need to immediately cut interest rates by 150bp. Since 1990, the average spread between the 2 year treasury rates and Fed funds is approximately +50bp and over the past 10 years, it is +25bp. Therefore it is not rocket science to see that a gap of -150bp is a huge discrepancy and tells us that the Fed could bring rates down to as low as 1.50 percent. Lower interest rates equal a lower US dollar.
3. Retail Sales Could be Negative Next Week
Retail sales could also be negative next week which would lead to another round of dollar selling. 34k jobs were cut from the retail sector and according to the following WSJ chart, sales at most retailers other than discounters have been weak. With gas prices skyrocketing, foreclosures hitting a record high, the labor market weakening and confidence at a record low, discretionary spending may be the last things on the consumer’s mind.
4. Speculators Still Trying to Pick a Top in the EUR/USD
The latest FXCM Speculative Sentiment Index which is a contrarian indicator also calls for further gains in the Euro against the US dollar as speculative short positioning continues to grow. Retail traders are often times caught on the wrong side of the market as they struggle to pick top and bottoms. As indicated by this chart of positioning in the Euro, retail speculators turned net short the EURUSD at 1.25 and have remained short since then.
5. Technicals
According to the technical Elliott Wave formation of the EUR/USD, a spike above 1.56 is very possible before dollar bulls see any relief.
My near term targets is for USD/JPY to fall to 100 and the EUR/USD to rise to 1.55.
However with that in mind, I still think that the US dollar will recover in the second half of the year.
I am a strong believer that we will see a V or at least a U shaped recovery in the US economy that will trigger a dollar recovery and rally in the second half of the year. The Fed’s doing a lot right now and they are being extremely aggressive and this would be especially true if they cut interest rates by another 50 to 75bp this month. Imagine the relief for US consumers and businesses if interest rates came back down towards 1.00 percent. Everyone will be rushing to lock in those rates and use that money for refinancing or capital expenditures. The degree of monetary and fiscal stimulus in the pipeline should lead to a shallow downturn and a swift recovery. Unlike the past, there is still a lot of money to be spent in the Middle East and Asia. When the US recovers, investors in these countries may sweep in with newfound optimism, which will give the dollar a chance to recover as well.
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