Wednesday, April 30, 2008

Fedspeak for the Common Man

As expected, the Fed lowered the fed funds rate another 25 bps today (1/4%). I thought I'd take a few minutes to help interpret their accompanying press release.

"Recent information indicates that economic activity remains weak. Household and business spending has been subdued and labor markets have softened further."

translation: The economy is in the crapper. No one feels like spending money in this environment which makes sense since you're about to lose your job.

"Financial markets remain under considerable stress, and tight credit conditions and the deepening housing contraction are likely to weigh on economic growth over the next few quarters."
translation: We know better than anyone what shape the financial markets are in, and we can't believe you clowns are bidding up the stock market and financial sector! We're actually making side bets as to which of you hedge funds disappears next. Anyways, enjoy last quarter's snappy .60% GDP growth!
"Although readings on core inflation have improved somewhat, energy and other commodity prices have increased, and some indicators of inflation expectations have risen in recent months."

translation: Stagflation! I never should've left my teaching job at Princeton.

"The Committee expects inflation to moderate in coming quarters, reflecting a projected leveling-out of energy and other commodity prices and an easing of pressures on resource utilization."

translation: Well, by The Committee I really mean all of us except the two dissenters who actually understand the role of the Federal Reserve, but they don't really count. Ignoring that, we've basically taken to good intentioning when it comes to slowing down inflation despite the fact that we keep lowering interest rates (tee hee). But don't forget the good news! With the economy slowing down that should help reduce demand for commodities! Hmmmmm....but that would mean the economy would have to be weaker....which would mean another rate cut....and a higher money supply....which has been pushing up commodity prices..... Frig'n Greenspan.

"Still, uncertainty about the inflation outlook remains high. It will be necessary to continue to monitor inflation developments carefully."

translation: Let me be perfectly clear. Inflation is a problem, but it isn't a problem, but it might slow down, but it might not. We feel very strongly that inflation will either be a problem or it won't.

"The substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help to promote moderate growth over time and to mitigate risks to economic activity. The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability."

translation: Hey, Plosser! Push on my back. I can't reach my ankles.


First quarter GDP came out today and showed the economy grew at a whopping .60% rate, the same as last quarter and the slowest pace since the fourth quarter of 2002. It's difficult to know what to do with these releases since they come from the biased government and are often significantly revised well after the fact. However, the market pays attention to it, so we have to pay attention to it. It's a silly game. We all know the figures are manipulated and heavily revised, but since we think others are trading on the data, we'd better too! Game theory run amok.

The bulls will take some solace in the "fact" that we haven't seen the two consecutive quarters of negative GDP growth that some still look for to define a recession. Either way, it's clear that the economy has at least stalled out over the past 6 months.

Keep in mind that real GDP takes out the effect of inflation, so the lower the government's estimate of inflation, the better the real GDP looks. For the first quarter, inflation was estimated to be running at a 3.5% pace. Had that estimate come in a little higher, real GDP would have been negative. Given the government's use of hedonic pricing and rent-equivalency for estimating housing inflation/deflation, they can pretty much manufacture whatever number they want.

More striking is the fact that all of the GDP growth last quarter can be attributed to an increase in inventory. GDP measures the value of that inventory even though an increase in inventory means more product is sitting on shelves and may prove to be a drag in future quarters. If you take out the change in inventory, you're left with what's called final sales. This is a purer measure of what actually happened in the quarter. This figure fell .20% last quarter. This is only the fourth time this decade that this figure fell below zero.

As for other contributors, it's no surprise that net exports helped boost GDP for the fourth straight quarter as the dollar has been declining. Personal consumption registered its slowest growth rate since the second quarter of 2001. Residential investment once again took a good chunk (-1.23%) out of GDP.

All in all, this isn't a particularly cheery report. For the balance of the year, consumption and investment are likely to remain weak while net exports and government spending add some support. I imagine the bulls and the press will make a fuss over the fact that GDP came in positive, but I doubt this report will have much of an impact on the Fed's interest rate decision this afternoon.

Tuesday, April 29, 2008

Britain's Coming Real Estate Bust

The real estate troubles we've been experiencing here in the U.S. aren't at all unique to us. Many a European flat, chateau, and villa experienced a similar or greater bubble during this decade, and they're now starting to retrench as well. Home prices are falling and mortgages are more difficult to come by as many banks are (rationally) requiring higher credit standards and larger down payments, if they're willing to lend at all.

Britain seems to be just a bit behind us on this credit/housing unwind. Discretionary spending is likely to at least moderate as credit availability suffers and inflation continues to rise. We should expect to see a slowing in European real economic growth. The most interesting question just may be how our recession and a slowing in Europe would affect Asia. I'll address this in another post.

The Europeans do have one big advantage over us. If things get really bad for them they can take advantage of the weak dollar, move to the States, and buy a mansion in Cleveland for what it costs them to fill an SUV back home. Of course, they'd have have the distasteful choice of working as either as debt collector or a political strategist since these are about the only jobs available here.

From the TimesOnline:

House prices fell for the second consecutive month in March, according to official figures released today.

The Land Registry figures, which show that the average cost of a home in England and Wales dropped by 0.4 per cent in March to stand at £184,798, will add to growing fears that the UK is about to suffer a significant slump in the housing market.

The Land Registry also revealed that housing market transactions averaged 81,926 a month between October 2007 and January 2008, which was down 25.5 per cent year-on-year. Sales volumes were also weakening more markedly at the end of this period, as they were down 39.2 per cent year-on-year in January at 53,221.

Howard Archer, chief UK economist at Global Insight said: "We now expect house prices to fall by 7 per cent in 2008 and 9 per cent in 2009. Furthermore, the longer the credit crunch goes on and the deeper and longer the UK economic slowdown is, the greater the danger will be that an even sharper housing market correction will occur.

"Current rapidly deteriorating sentiment over the housing market also heightens the risk that house prices could fall more sharply over the next couple of years. Consequently, it is very possible that a drop of more than 20 per cent in house prices could occur over the next couple of years.

The official figures came as a leading estate agent suggested that house prices could fall by as much as 25 per cent if the credit crunch persists, with the market declining by 10 per cent this year and by a further 15 percentage points in 2009.

From the BBC:

The slowdown in the UK mortgage market continued in March, according to figures from the Bank of England.

It said the number of new mortgages approved for house purchases in March fell to a record low of 64,000, down from 72,000 the previous month.

This was the lowest level since the bank started collecting the data in April 2003, and was down 44% on the figure for the same month in 2007.

However, credit card and other lending increased in March from February.

A global credit crunch has caused lenders to put up prices on mortgages and withdraw mortgage deals, especially for those unable to put down a significant deposit, in recent months.

The credit crunch, when banks are less willing to lend to each other and consumers, was caused by problems in the US housing market, which saw a surge in mortgage defaults and a drop in property values.

In the UK, property prices have also started to dip during 2008, according to various housing surveys.

"The news that mortgage approvals dropped to a record low of 64,000 is hardly surprising given that lenders have been aggressively scaling back on the provision of finance to homebuyers," said Simon Rubinsohn, chief economist at the Royal Institution of Chartered Surveyors (Rics).

The Bank also reported a drop in loans approved for remortgaging, down 11,000 in March from the previous month at 98,000, and for other purposes such as buy-to-let, down 6,000 at 57,000.

Sunday, April 27, 2008

Ricing Frustrations: Follow-Up

The pace of the increase in the price of rice has gone from a wok to a run since last fall. Brazil, Egypt, Vietnam, Cambodia, and Egypt have placed restrictions on rice exports. Other countries such as China are imposing punitive tariffs, and still others have begun stockpiling. Even Sam's Club and Costco have started limiting rice purchases. If the cost of water wasn't so expensive in my town, I'd be turning my yard into a paddy field.

It's difficult to really know the extent of the rice shortage because of the stockpiling and hoarding that is occurring at the country and individual level. These actions serve to drive up the near-term demand for rice which leads to higher prices which leads to more hoarding.....

As I wrote in the original "
Ricing Frustrations" post:

Clearly, demand has been outstripping supply (as with many commodities). The key will be to look for the inflection point. There's a huge incentive these days (where prices are not constrained) to put even marginal land back into farm service. Pests, disease, and weather are always wild-cards, but the incentive to plant is there.

From an article in today's The Times of India:

Thailand's Prime Minister Samak Sundaravej promised Sunday that the kingdom would not cut rice exports, as soaring prices of Asia's staple grain continued to fuel concerns of a shortage.
Samak said in his weekly television address to the nation that there was plenty of rice in Thailand, the world's biggest exporter.
"Thailand will not announce a ban on rice exports. It would destroy our reputation," he said.
He explained that farmers were now planting five crops in two years -- up from the traditional two crops per year -- to ensure they met demand.

This is precisely the type of action we should expect to see with rice prices hitting record levels. More land will be put to agricultural use, and crops will be planted more frequently (which could have longer-term soil productivity implications).

Rice is a staple of nearly 3 billion people. Governments may tinker with education, health care, business incentives, and tax policy, but food is the most basic human need. If you can't feed your people you won't remain in power, so there's a strong incentive for governments to try and address this issue. We can expect to see more and continued export limits, price caps, farming incentives, rationing, tariffs, land conversion programs, etc. Some of these policies (such as price caps and higher export taxes) will impede the development of new supply but others (such as land conversion and farming incentives) will encourage development. Some countries will get it wrong, and others will get it right.

the natural forces of supply and demand will correct this rice crisis. We'll see new supply coming from countries which aren't limiting exports or prices. Hoarding will diminish. People will substitute Smores for Rice Krispy treats. We'll see more bubble blowing than rice throwing at weddings.

From an investment perspective, no one knows how high rice prices will ultimately go, but you can be sure that market forces are currently unfolding and sowing the seeds of a future sharp correction in the price of rice.

Saturday, April 26, 2008

Is the Coast Clear - Again?

Over the past month, we've seen the S&P 500 (first chart) rebound by about 11%, and we've seen the volatility index (second chart - measures expected market volatility over the next 30 days) decline markedly from last month's high. It's no surprise that over this same period the "experts" have once again been coming out of the woodwork to proclaim that the worst is behind us and that this is a great buying opportunity. Of course, many of these gurus never noticed this huge credit bubble building or foresaw its demise. Regardless, CNBC doesn't hesitate to reserve plenty of air time for their endless droning.

For the sake of fairness, there's always a chance that we have seen the worst, and there's a chance that the stock market could rally to new highs and beyond this year. There's also a chance that professional lawn bowling will take our country by storm or that a global tone deafness virus will sufficiently affect the population to allow me to become the next American Idol.

In my humble and increasingly out-of-favor view, what we are witnessing is standard bear market activity. As discussed in an earlier post, just as bull markets are marked by the occasional 10%+ retrenchment, bear markets experience the occasional 10%+ rally. Sentiment swings violently and on a dime. One minute, everyone is fearing Armageddon and the next everyone is shoving Granny out of the way to get in "at the bottom".

Why my continued pessimism? Here is a brief summary of a few concerns:

  • Economic growth in recent years was fueled largely by an ever-increasing amount of debt rather than through savings. This was never sustainable long-term and is finally reversing.
  • Consumers became increasingly reliant on extracting equity from their homes this decade in order to fund their lifestyle. With home prices off sharply and mortgage availability far more limited, this source of "income" is largely gone.
  • Higher oil prices are likely here to stay. Though they could dip somewhat in the face of a global economic slowdown, the longer-term trend is likely to be higher as high depletion rates and limited significant exploration success fail to keep up with growing demand.
  • Roughly 70% of GDP comes from consumer spending. The consumer is stretched to the max as evidenced by soaring foreclosure rates and credit card defaults. In addition, wage growth has been anemic. It's time for the consumer to start saving and rebuild his/her balance sheet.
  • The housing market is likely to be weak for much longer than most expect. Sales are plummeting and inventory continues to grow. In the hot markets that experienced the most overheating, asking prices still bear no relation to rents - as they should. Ultimately, prices will need to fall to levels that make houses more affordable for homeowners or to levels at which investors can rent them out for a positive cash flow.
  • We haven't even begun to see the impact of Option ARM defaults. These will be rolling to higher interest rates in the next couple of years, and it's likely that the loss experience of these homeowners won't be terribly different than that of the subprime lot.
  • State and local budgets are going to become a big issue. With tax receipts falling and expenditures remaining high, many states will be faced with some hard choices given their balanced budget mandates. Taxes will need to be raised and/or spending cut.
  • Banks remain very hesitant to lend. Liquidity is king. There is plenty of corporate debt coming due in the next couple of years, and it will be crucial for companies to roll this debt over at reasonable rates. Otherwise, interest expense will increase and/or shareholders will experience dilution as more companies are forced to sell stock to redeem their debt.
  • The losses banks have taken thus far have been largely mark-to-market accounting related losses. Once the slowing economy begins to impact the general economy, we will see increasing corporate defaults.
  • More and more companies are lowering their capital expenditure plans and announcing layoffs. Clearly, the financial industry is currently experiencing a net outflow of jobs. This will likely start to trickle through much of the rest of the economy this year.
  • Inflation continues to surge, regardless of what the corrupt government statistics indicate. We all know what we're paying for gas, food, utilities, education, health care, etc.
  • With the dollar weakening and inflation rising, it wouldn't be surprising if our lenders (China, Japan) soon started demanding a higher interest rate on their government security purchases. This would help the dollar but wreak havoc on an already weak economy.
Even with all of these issues, stocks could be a buy for those with a longer-term outlook if valuation were attractive enough. If I believed that stock prices more than adequately discounted all of the above concerns, I would be bullish. Unfortunately, that just isn't the case. As with most investments, you make your money when you buy. History has clearly shown that the initial valuation of stocks is a terrific guide to future returns. The lower the initial valuation the better the future returns - in general. Currently, we're still at the high end of the historical range of valuation. The P/E for 2009 is up in the mid-teens. Given all of the problems cited above, this hardly strikes me as a compelling entry point for the market as a whole. History has shown that future returns tend to be anemic when starting from these levels (just look at the last 10 years).

I do believe that, although the bulls are back in control for the moment, we will look back at this rally and see that it was another dead-cat bounce (bear market rally). Near-term, I intend to add to select short positions. The stock market has held up well so far during this earnings season, but this is more a function of expectations having been set unreasonably low going into the earnings reports. When you expect Armageddon but end up with purgatory that looks like good news. I expect a fairly ugly pre-announcement season for next quarter and will increase my shorts leading into it should the market continue to move higher and sentiment remain bullish.

Thursday, April 24, 2008

Agriculture Stocks - Pulling Back as Expected

It looks like we're getting the pullback I was expecting in the agriculture/fertilizer companies (see last week's post "This Sector is Full of Sh*t"). In the past couple of days, Potash (POT), Agrium (AGU), and Monsanto (MON) have pulled back about 10%, and Mosaic has pulled back about 15%. As suggested, I did modestly reduce exposure to these names and was lucky enough to do so pretty close to their recent highs.

Today, Potash reported outstanding results. The fundamentals of this industry remain terrific with companies enjoying strong pricing power and cash generation. Given the pullback in the sector, today I started adding back the position I just sold a few days ago with purchases of POT and MOS. Should the group continue to retrace (certainly possible), I'll likely continue to add to these names opportunistically.

New Home Sales Stats = U - G - L - Y

New home sales came in at a seasonably adjusted pace of 526,000, continuing their fall from an all time peak of 1,389,000 in July of 2005. The median sale price for new homes fell to $227,600 in March, continuing its decline from a record level of $262,600 just last year in March of 2007. That makes for a 13% decline - so far. At the current sales rate, the 468,000 new homes currently for sale works out to an 11-month inventory. The all-time high of 11.6 months was reached back in April 1980.

The bad news? We're clearly not seeing any sign of a bottom in the new home market. Worst of all, despite dramatically falling sales and prices, inventory continues to move higher. For this overhang to be worked down, we'll need to see fewer new builds and lower prices.

The good news? It's still early, but sales and prices are headed in the right direction to ultimately clean out the inventory glut. Lower housing starts will ultimately help on the supply side and lower prices will help with demand. One of the wild cards with the existing home sales inventory data is how many properties are not being listed by homeowners who would like to move but aren't even bothering to list their property due to the poor housing market.

This housing problem will be with us longer than most expect.

An Economic Bright Spot, But...........

I'm fairly pessimistic about this year's economic prospects given our economy's dependence on the overstretched, debt-laden, house-poor, inflation-wracked consumer and a corporate sector beginning to curtail investment. However, there is one segment of GDP which should lend some support - net exports. The weakening of the U.S. dollar has helped make our goods more cost competitive globally, and that has recently begun to spur exports. For many of the multinational companies that have reported earnings so far this quarter, international growth has been one of, if not the only, bright spots in their reports.

I expect to hear more and more economists praising the weakening dollar and encouraging further devaluation in order to help spur the economy. This would be a disastrous policy to pursue given the number of dollars held abroad and our dependence on other countries (largely China and Japan) to fund our chronic deficits. No country has ever devalued itself to prosperity. We risk a run on the dollar if we're not careful.

Currently, the dollar still offers perceived safety in a volatile financial world, but foreign holders of our debt these days aren't earning much interest. What little interest they are earning is being wiped out by currency losses (the falling dollar). This state isn't likely to persist long-term. At some point, rational foreigners may begin demanding a higher interest rate on our debt to compensate for the purchasing power loss of a falling dollar. Hopefully, this can be forestalled until the economy is strong enough to withstand higher interest rates. If not, this recession could be much more severe and/or prolonged than widely expected.

The following article from yesterday's Wall Street Journal discusses the "high-class" problem of insufficient container supply:

In what may be the only obvious downside to the current U.S. export boom, domestic producers like Reed’s Inc. are finding it harder than ever to get their products onto outbound ships.

federal funds rateSurging foreign trade, fueled largely by the weaker dollar, is filling up ships faster than at any time in recent memory and created a backlog for companies like Reed’s, a Los Angeles-based maker of premium soft drinks, including cream soda and a spicy line of ginger beers.

“I’m working with a couple of companies that are saying May 21st is the earliest date they can get me a container, ANY container,” says Mark Reed, the company’s executive vice president of international sales. “But I need it now.”

The bottleneck is threatening to take the fizz out of Reed’s upcoming product launch in Europe. The company, which sells its premium drinks in natural food stores in the U.S., recently began to push overseas and was gearing up to begin selling in France. “So here I am, I’ve got product specifically labeled for Europe, but I can’t get it over there,” says Mr. Reed, who says this is likely to delay the product launch.

The problem first emerged last year and has been spreading, hindering exports of everything from manufactured goods to farm commodities and scrap metal. –Timothy Aeppel

Wednesday, April 23, 2008

UPS and Downs

UPS is the world's largest package delivery company, so their business results are certainly reflective of economic activity. The company reported first quarter earnings this morning. They met earnings expectations this quarter but lowered guidance for the balance of the year.

The falling dollar is helping their export business, but it's clear from their earnings release and conference call that they see no signs of an economic rebound. Specifically, management commented on how quickly volume fell off in February and the negative impact of rising fuel costs.

Here are a few snippets from the earnings release:

A sharp decline in U.S. economic activity, however, led to a 9.4% drop in diluted earnings per share to $0.87 compared to a prior-year adjusted $0.96.

...consolidated average daily volume remained flat at 15.1 million packages per day.

"U.S. economic activity deteriorated more rapidly than expected during the quarter," said Scott Davis, UPS chairman and CEO.

The slowing U.S. economy not only reduced average daily volume in the U.S. by 0.3% for the quarter but also contributed to a shift away from premium products.Volume declined 3.8% for Next Day Air(R) and 2.9% for Deferred, while increasing 0.3% for Ground.

"We see no signs of economic strengthening in the second quarter," said Kurt Kuehn, UPS's chief financial officer.

Export volume increased approximately 10% in local operating days, which drove a 15.7% revenue increase.

Tuesday, April 22, 2008

Jingle Mail

Below is an article from yesterday's Arizona Republic discussing how some people who owe more than their house is worth are just mailing the keys back to the lenders and walking away.

I particularly like the following quote from REAL ESTATE AGENT Joan Shaffer who bought a house in Phoenix in 2005 that is now worth $200,000 less than what she owes on it. "We paid $585,000. It was the peak of the market, but no one told us."

No one told the real estate agent that the market was peaking!!! Someone forgot to ring the bell and announce to the real estate "professional" that it was a bad time to buy. We'll probably soon be reading about her lawsuit against the seller for having the nerve to sell the house at the top of the market. I'm not a big fan of increasing regulation, but maybe an IQ test should be administered as part of a mortgage application.

Owing more than home is worth, recent buyers walk away

Catherine Reagor
The Arizona Republic
Apr. 21, 2008 12:00 AM

Instead of mailing in their monthly mortgage payment, a growing number of homeowners are sending lenders their keys.

As housing prices fall and rates on some mortgage loans rise, more homeowners are walking away from their homes, according to housing-market watchers.

These typically are people who can afford their mortgage but don't want to pay on a loan that is more than their house is worth. They'll live with the stigma or credit ding from a foreclosure just to get out from under their loan.

The growing trend, called "jingle mail," is pushing up foreclosures and alarming market watchers, particularly in metropolitan Phoenix, where home prices have dropped 18 percent in the past year.

Foreclosures across metropolitan Phoenix climbed to a record 2,365 in March, according to the real-estate data firm Information Market. That is more than quadruple the number from a year ago.

Joan Shaffer is turning in the keys of the north Phoenix Tatum Ranch home she bought with her daughter in late 2005. They put nothing down on the home, took out a loan that let them pay less than they owed each month and now their loan is $200,000 more than the house is worth.

"We paid $585,000. It was the peak of the market, but no one told us," said Shaffer, a real-estate agent from Colorado. "We would probably have to spend the next 20 years trying to get right on the mortgage. That's crazy."

The mortgage industry is struggling to estimate how many homes are going into foreclosure because of people who don't want to pay, rather than because of people who can't afford to pay.

Industry estimates and anecdotes suggest the figure is climbing in the Valley because so many people who bought during the peak are now upside down in their mortgages.

Real-estate agents are hearing it more often from people who can't sell. Mortgage lenders are reporting getting more jingle mail, and now there are businesses advising homeowners how to walk away.

"Even if someone put 5 to 10 percent down but bought in the Valley during '05 or '06, they are likely upside down now," said Brett Barry of the north Phoenix office of Realty Executives. "I don't advise people to walk away, but how do you convince someone to keep paying when they owe so much more than their home is worth? They can't sell, and their lender isn't going to forgive $100,000 in principal. It's not good."

Investors started the walk-away trend, but it has spread to the typical homeowner.

Housing analyst RL Brown said he is hearing about young families who bought during the peak and are now walking away from houses as the interest rates on their loans reset and payments increase.

"Instead of calling it a foreclosure, these couples are saying, 'We're giving it back to the bank,' and then moving a couple of blocks away and renting a home for half their mortgage payment," he said. "These people are finding it easier to walk away."

Businesses are popping up that guide homeowners on the best way to walk away from their mortgage. One firm,, tells unhappy homeowners to ask themselves these questions: Are you stressed out about your mortgage payments? Do you have little or no equity in your home? What if you could live payment-free for up to eight months and walk away without owing a penny?

For the first time, homeowners seem to be more willing to let their houses go into foreclosure to stave off bankruptcy.

In the past, homeowners would file for bankruptcy to keep their houses. Now, mortgage delinquencies have climbed faster and higher than late payments on credit-card and car loans. Economists say that is a sign people are more concerned about their credit than their home.

"Homes have gone from being a place to live to a disposable investment for some," said Jay Butler, director of realty studies at Arizona State University's Polytechnic campus. "It used to be that paying the mortgage was the top priority. Now, it's keeping the credit cards."

He said one reason is some homeowners think that with all the foreclosures, there will be programs to help them when they buy again.

It usually takes three years of perfect credit payments after a bankruptcy before someone's credit score is high enough to buy a home. Recently, people could buy a home again two years after a foreclosure.

Also, the Mortgage Forgiveness Debt Relief Act of 2007 took some of the penalty away from a homeowner filing for foreclosure. Before the act, if a bank sold a foreclosed home for less than the mortgage and forgave the rest of the debt, the borrower had to pay tax on the difference. Now, the Internal Revenue Service is forgiving the difference.

But now as the number of people walking away is climbing, lenders are working on ways to punish those homeowners.

Earlier this week, mortgage giant Fannie Mae said homeowners who stop making payments and then send their keys back to lenders months later will not be able to get another mortgage through that firm for five years. Freddie Mac also is going after walk-away borrowers, mortgage lenders say.

Neighbors of the people who walk way are already being punished by lower home values due to the foreclosure.

"People should hang in there as long as they can, ask for help and try to work with their lender," said Margie O'Campo De Castillo of Arizona Dream Realty. "Foreclosures are dragging down our housing market, and unnecessary foreclosures are selfish and unfair to the homeowners struggling to pay."

Housing Bubble? What Housing Bubble?

To think, Congress and our states are busy trying to find a way to support real estate prices. Until and unless the prices of glorified outhouses are allowed to fall to market-clearing prices, the housing downturn will continue.

From the Dr. Housing Bubble website:

Santa Monica


Price: $749,000

Square Feet: 635

Details: 2 bedroom / 1 bath

Median Rent for Similar Unit: $2,500

For those of you not from Southern California, Santa Monica is prime. Great location and one of the best cities in Los Angeles County. That doesn’t mean that we don’t have any Real Homes of Genius in the area. With this magnificent 635 square foot mansion, you will be the envy of all the people flocking to the thirty-mile zone. For this extraordinary privilege you will pay $1,179 per square foot! Bwahaha! Even in the current housing market we still have people thinking housing is going to rebound even when a similar rental would go for $2,500 to $3,000. Who would buy this place? A buy and hold investor will not buy this place. A flipper may buy this place but they would need to knock it down and build on the land. But by the time the new home is ready to flip the market will be even deeper in the dark with less buyers and more inventory

Monday, April 21, 2008

Google - A Contrarian View

We saw quite a love-fest for Google on Friday following their Q1 earnings release. Given how important this report was for the market and for psychology, it's worth spending a little time on it.

Earlier in the week, comScore released a report in which they estimated Google's paid clicks grew only 2% during the first quarter. Concerns about this slowing had led to a sharp decline in the stock price of Google since the beginning of the year, falling from just over $700 to about $412 last month. With Thursday's earnings release, Google disclosed that its paid click growth actually increased 20% in the quarter. With revenue and earnings coming in above the whisper numbers (GOOG doesn't provide earnings guidance), we saw a huge relief spike in the stock.

There is plenty of positive press out there, so there's really no point in just rehashing it. Let's have a little fun instead and play devil's advocate.

  • Even though paid click growth came in well above expectations, the 20% increase is a marked deceleration from last year's 43% growth rate. The bulls and the company argue that this is due to an intentional move by the company to decrease the quantity and improve the quality of presented ads. They hope to charge more for the fewer higher quality ads to offset the volume decrease. When asked about this on the call, management essentially said that the improvements were made later in the quarter, and it was too early to judge their impact. Fair enough on pricing, but then why the decline in paid click growth to 20%?
  • ComScore claims that they only monitor US consumer growth, but Google's paid click data includes international. It seems very likely that US growth has matured and slowed dramatically while international growth remains very strong. If so, the fact that the huge US market has slowed so dramatically and so soon should be very concerning.
  • Year-over-year revenue growth has been steadily declining.
  • The company was adamant that they have seen no impact from the slowing of the economy. I don't really get this. Overall growth at GOOG is clearly slowing, and it appears that U.S. growth is slowing dramatically. How the company can be sure that the economy isn't a factor isn't at all clear. It seems logical to think that the economy has played some role and that growth may have been even stronger had the economy not weakened. Investors are typically less likely to pay a premium multiple for an economically-sensitive growth stock.
  • GOOG is trading at 26x this year's EPS estimate. That's not particularly cheap, especially given the slowing growth trends (EPS growth is much lumpier, but it too has been slowing).
  • Let's not forget the law of large numbers. Growing $5 billion of revenue at a 40% rate is much harder than growing $100 million at the same pace. Let's make sure expectations are realistic. Were Google to increase revenue at a 40% annual clip, they would overtake the current GDP of the U.S. in just under 19 years. That's not going to happen. As can be seen from the price action of GOOG stock this year, the market doesn't take kindly to strong growth stocks that falter. It's just a matter of time given their revenue base.
  • As for this quarter, the company did benefit from a tax rate that was 1% lower than last quarter due to international growth (and weaker US?). That boosted EPS by about 7 cents. Also, though it wasn't discussed, clearly the company was a big beneficiary of the weaker dollar in the quarter. That's fine, but it isn't growth driven by improving operations. So, the quality of the earnings beat wasn't quite as dramatic as the press would have you believe.
Bottom line: We saw a huge relief rally when the paid click number came in much better than feared and the company exceeded revenue and earnings expectations. This was a case of the bar being set pretty low and being relatively easy to hurdle. The market had priced in worse numbers than the company posted, so the stock rallied. However, the quality of the beat was not as solid as indicated in the press, and the longer-term trend of slowing growth continues.

I'll be keeping an eye on GOOG and possibly adding a long put position as we move through the quarter should the stock continue climbing and volatility moderate.

Thursday, April 17, 2008

The Bank of Microsoft

What do you do when your customers are stretched too thin to afford your product and can't get the money from their bank? Apparently, you lend them the money yourself. That's what Microsoft is doing.

This is one of those things that just doesn't sit right in the gut. If banks won't lend your customers money, doesn't that say something? I know liquidity is an issue, but good credits can still borrow at reasonable terms. And what skill does a software technology company have in assessing credit risk? Given these issues, it would be shocking if Microsoft didn't experience a relatively high loss rate on these loans.

I guess I'm just a little old fashioned. You know, stick to your knitting. If you're a software company, focus on making the best software possible. If you're a bank, focus on making quality loans and accurately assessing risk. Keep the chocolate out of the peanut butter.

From the Wall Street Journal:

With small-business customers finding it harder to finance high-tech purchases, Microsoft Corp. plans to increase the amount it lends them for purchases, by as much as 60%.

The move -- coming amid a historically tight credit market and at a time when other technology giants are considering selling their financing units -- raises the risk for Microsoft, which says the number of defaulting loans will likely rise and that its exposure to bad credit is "approaching materiality."

[Independent Street blog]
What are the pros and cons of vendor financing? Read the latest post and share your thoughts.

Microsoft said it expects to issue $1.25 billion in loans in 2008, compared with the $780 million in financing it extended in 2007. The increase may help the Redmond, Wash., software giant prop up an important sales channel for the company. "The decision to do all this was tied to the macro situation," said Brian Madison, general manager of Microsoft Financing. "Information-technology buyers keep accelerating their leasing and financing, so we see this as a time when we can make a big difference by making things easier."

Microsoft offers an array of loans between $100,000 and $500,000 -- a "sweet spot for small businesses," Mr. Madison said. Still, the financing Microsoft expects to extend in 2008 represent only about 2% of the company's expected fiscal 2008 revenue.

As credit becomes harder to come by, especially for smaller businesses, financing programs like Microsoft's are becoming a key part of the way companies buy technology products. Research firm IDC expects technology buyers to finance 38% more of their high-tech purchases by 2011, with financing reaching $111 billion, or 8% of all high-tech spending.

The strains caused by the credit-market meltdown have exposed the frailties of some tech-financing arms. Some lenders caught up in the subprime mess were also heavily involved with technology financing. Dell Inc., meanwhile, has said it is exploring strategic options for its financing arm.

IDC analyst Joe Pucciarelli expects that in three years, at least a third of the current providers of financing for technology purchases won't exist. "The broader and more important point here is that the overall IT leasing and financing market remains stressed," he said.

Time to Foreclose on Hillary's Housing Plan

Since this post is somewhat politically-related, I need to stress the following upfront:

  • I have always been registered as an independent.
  • I find both parties equally nauseating, ignorant, and polluted (but not in a scary Unabomber kind of way).
  • I don't believe any of the three remaining Presidential candidates have a clue when it comes to economic policy.
  • I tend to mumble a bit and spasm when I watch the debates.

With that out of the way I wanted to touch on Hillary's comment about the housing situation during last night's debate. She said,

I want to see us actually tackle the housing crisis, something I've been talking about for over a year. If I had been president a year ago, I believe we would have begun to avoid some of the worst of the mortgage and credit crisis, because we would have started much earlier than we have -- in fact, I don't think we've really done very much at all yet -- in dealing with a way of freezing home foreclosures, of freezing interest rates, getting money into communities to be able to withstand the problems that are caused by foreclosures.

To say that you would have prevented the largest housing and credit bubble we've ever seen from collapsing is the height of arrogance. She doesn't say that she would have prevented the bubble itself from happening. This thing was already uber-inflated a year ago when she claims to have started talking about it. So, though she wouldn't/couldn't have prevented the bubble she believes she could have prevented its deflation. I suppose she believes she could have prevented the tech bubble from bursting and Dutch tulips from collapsing.

Trying to prevent a bubble from popping is a terrible idea. Bubbles are not healthy for the economy in the long-term as they lead to gross mis-allocations of capital. In the case of housing, far more money was thrown at housing and mortgages than warranted by economic fundamentals. A bubble is not a state of equilibrium - that's what makes it a bubble. The quicker the bubble is popped, the quicker we return to sound economics. Trying to prop up a bubble only introduces further moral hazard and prolongs the ultimate damage.

Looking at her specific proposals, she first mentions freezing foreclosures. Keeping people in houses they can't afford serves no one. Many of these people were never qualified to be homeowners in the first place. Furthermore, the ability to foreclose is one of the reasons lenders are willing to make loans in the first place. Freezing foreclosures certainly isn't going to make more money available for mortgages. Think about what you would do if you were lending your money and all of a sudden the rules are changed so that the government, at its whim, can prevent foreclosures. Would you be as willing to lend? If you were still willing to lend, wouldn't you want to charge a higher interest rate? Wouldn't you severely tighten your lending standards so that you were only lending to those with the best credit and finances? Wouldn't you require a larger down payment? Hillary (and all politicians) love to talk about making homeownership affordable for more people, but this policy would do exactly the opposite.

How about freezing interest rates? Same thing. Imagine you're a lender and all of a sudden the government can come in and freeze the rates you charge people. You've logically been charging riskier people higher interest rates, but now the government steps in and doesn't allow those rates to adjust up (think ARMs). You might be less willing to make ARM loans. Either way, you've just had a big new risk introduced. Might you want to increase the interest rates you charge to compensate for this new risk?

Next, she mentions "getting money into communities". That's fairly vague, but it certainly entails spending tax-payer money to support a bubble. The government needs to get out of the way and let housing prices fall to market clearing levels. Housing prices in many communities never should have climbed as high as they did - virtually everyone agrees with this. So why must the politicians try so hard to keep them from falling? (that's a rhetorical question)

This Sector is Full of Sh*t





The fertilizer companies have been on a tear for a while now but have recently started going parabolic. This is largely due to the increasing amount of news and attention being paid to the global food crisis. Just today, Reuters reports:

China slapped massive tariffs on fertilizer exports on Thursday in a bid to control rapidly rising domestic agricultural costs and inflation, and above all to ensure it grows enough grain to feed its 1.3 billion people.

Beijing's 100 percent-plus tariffs on some fertilizer exports should temper domestic costs but may drive up prices in world markets that depend on China's supplies, the latest in a series of commodities-related protectionist moves around the world that risk fueling rather than cooling global food costs.

They're exactly right. A number of countries have started imposing export restrictions on certain types of food and now fertilizer. These types of restrictions are often accompanied by price caps, tariffs, and hoarding. Hoarding certainly will lead to short-term price rises. More importantly, to the extent that producers are restricted from selling their food and fertilizer at prevailing world prices they are also less incented and financially able to increase their production.

These agriculture/fertilizer stocks have been some of our best performers (AGU, POT, MOS). The longer-term thesis is still attractive, but the stocks are likely a bit ahead of themselves near-term. These are some of our larger positions given their appreciation. In this situation, we're likely to pare our position very modestly, taking some of the recent gains off the table. We plan to keep a sizable position in this space since the thesis is still attractive, and we would look to add should the stocks pull back.

Sallie Mae I? No, You May Not.

I noticed SLM popped 9% this morning after their earnings release and conference call. You've got to be kidding me.

The student loan market is in disarray.

  • Cuts made to the federally guaranteed loan program have hurt.
  • The credit crisis has resulted in less funding being made available to the student loan companies.
  • The lack of liquidity in the market has made it difficult for lenders to package and sell (securitize) their loans in the asset-backed market. The securitizations that they can sell are being done at very high spreads (they're very expensive to the lender). As a result, new loans are being made at a loss.
  • Fifty-seven lenders have dropped out of the program, and 19 lenders have suspended private student loans.
With that, let's take a quick look at Sallie Mae's (SLM) press release from last night. To their credit, in the first paragraph they state that, "Under current conditions, however, loans can only be made at an economic loss. Reflecting this environment, the company is assessing how best to balance its resources and its mission to provide access for higher education."

In the next 4 paragraphs they go on to discuss "core earnings" and explain how according to "core earnings" they registered a nice $0.48 in EPS for the quarter. Finally, in the 8th paragraph, they get around to discussing GAAP earnings. Turns out they managed to LOSE $0.28 share according to GAAP.

Basically, they tell us that we should ignore the markdown they took on their derivatives position and forget about their intangible assets. Leave out the bad stuff and things don't look so bad.

Some other points. The loss provision they took didn't look overly conservative given the environment. The company admitted that they can't write new business at a profit. The company isn't sure whether any legislation coming out of Washington would help or hurt them. The company's reliance on forbearance continues to increase. Their access to reasonably priced capital continues to deteriorate. Equity is a whopping 2% (that's sarcasm) of assets. Even "core earnings" are expected to be at the low end of their range (I'd be surprised if they even hit that.).

With all that, the stock is up 9%, north of $17.50. Apparently, the market feared something worse than what the company reported, and this is some sort of relief rally.

Given the risks and uncertainties surrounding this company and its business, this would not be a good investment for your kid's education fund given what we know today.

Wednesday, April 16, 2008

IBM - The Falling Dollar Ain't All Bad

If you want to see the benefit of the falling value of the U.S. dollar just take a peek at IBM's earnings release today. The headline is that they destroyed the analyst estimate of $1.45 by reporting $1.65. True enough, but lets look at the details and the quality of those earnings.

First off, revenue reportedly increased 11%, but if you take out the currency gain that growth shrinks to 4%. So, of the reported $2.5 billion increase in revenue, $1.6 billion of that came from currency.

Next, relative to the same quarter last year the company benefitted from a 1.0% lower tax rate.

If you take out the currency and tax benefit the company would have reported EPS of $1.29 instead of $1.65, barely ahead of last year's $1.23.

The other part of this is that the company has been a steady purchaser of its own stock. The purchases over this past year benefitted the company by another dime.

So, tonight and tomorrow when you're reading all of the glowing reports about how IBM knocked the cover off the ball, just remember that a minority of the strength really came from improved operations. This isn't a high quality beat.

Housing Starts fall 11.9% in March

According to today's Census Bureau release:

Privately-owned housing starts in March were at a seasonally adjusted annual rate of 947,000. This is 11.9 percent (±11.6%) below the revised February estimate of 1,075,000 and is 36.5 percent (±5.2%) below the revised March 2007 rate of 1,491,000.

Single-family housing starts in March were at a rate of 680,000; this is 5.7 percent (±11.1%)* below the February figure of 721,000. The March rate for units in buildings with five units or more was 247,000.
The headline is pretty ugly. 11.9% fall in March. The chart above is even uglier. The total housing starts series goes back to 1959. The highest monthly figure is 1,837,000 starts in January 2006. That number has declined 63% to the current run rate of 680,000 annual housing starts.

The lowest figure since 1959 was 523,000 and that occurred in October of 1981 as Volcker was busy jacking up interest rates well into the teens to combat inflation. We're not all that far from a new record low.

This is actually good news. We have a huge oversupply of housing currently, and the only way to stabilize the housing market is to lower supply and/or increase demand. Lower housing starts helps to lower supply. With demand still weakening this isn't going to be fixed overnight, but the housing market is adjusting as it should. I expect this to take longer to correct than most and continue to be net short this sector.

Youngstown, Ohio is doing its part to speed the correction. Link to article.

Second Careers

I can't be sure, but I think this is the former head of risk management at Bear Stearns.

link to story

JP Morgan - Will the Real EPS Please Stand Up

I just finished going over the JP Morgan earnings release and listening to the conference call. Here's a summary of what stood out to me:

  • The company reported EPS this quarter of $0.68 versus expectations of $0.64. This is down from $1.34 for the same quarter last year. That's a 49% decline. Furthermore, $0.27 of this quarter's earnings came from a one-time gain from the sale of Visa shares in its IPO, so operating EPS was more like $0.41.
  • This next part is a little tricky. According to fair-market accounting rules, firms get to report a gain when the debt that they've issued weakens. According to a recent Barrons article, "Here's how the accounting works: When a company's credit weakens and the yield on its debt rises relative to risk-free Treasuries, the debt becomes worth less to the holder. The financial company, which is the debt issuer, then takes a gain, because theoretically it could buy back its debt below face value." This quarter, JPM recorded a $949 million benefit from this accounting treatment in its investment banking treatment. Management stated that there was an offsetting amount in several other business lines to the tune of "several hundred million dollars." No one followed up on this during the call, so we don't know the exact figure, but let's assume that the company's net benefit from this was $500 million. That works out to about $0.10 of EPS.
  • Any financial company has a bit of latitude in massaging its earnings due to their control over the amount of money they set aside for loan losses. This is as much an art as a science. Overall, JPM added $2.5 billion to its credit reserves which isn't terribly surprising. When you look a little closer at the pieces, however, there are a couple surprises.
    • The Card Services division actually had a lower provision for losses (by $112 million) this quarter than last quarter even though net charge-offs increased from 3.89% to 4.37% and the 30-day managed delinquency rate was 3.66% vs 3.48% last quarter. Given the stress on the consumer in the current economic environment and the fact that the company's loss experience is deteriorating, I would think the loss provision should be increasing. The managed portfolio did shrink by 4% over this period, but the reserving here could have been much more conservative.
    • The allowance for loan losses in the Commercial Bank segment was essentially flat with last quarter at $101 million even though nonperforming loans increased by $300 million. The net charge-off rate rose sharply from .21% last quarter to .48% this quarter.
    • Every $100 million in loss provision works out to about a $0.02 swing in EPS.
  • The Commercial business is growing nicely. This could be a bit concerning given the deterioration in the economy. The company stated that they're not doing much real-estate related business, and they specifically mentioned government and non-profit business as areas of recent focus. The charge-offs in this division have started rising, so this needs to be watched closely. The company claims this recent increase is just a normalization from very low levels of losses. We'll see.
  • Their page on Prime Mortgages was very disconcerting. The 30-day delinquencies have been moving up strongly from just under 1.00% last June to over 3.00% this quarter. The company has obviously been tightening underwriting standards, but this is troubling.
  • The Bear Stearns acquisition remains a big question mark. It's expected to close June 30, 2008. Time will tell whether this turns out to be a terrific buy or an albatross.
JP Morgan management made it clear on the call that they're open for business, and they're using the current financial turmoil to opportunistically expand their business. Should the financial markets and economy not suffer a severe recession, JPM stands to be a big winner. However, if we do suffer a severe recession and credit deterioration continues to expand, their purchase of Bear and continued balance sheet growth could do some serious damage. This is ignoring the potential ramifications of their huge derivatives book. Either way, JPM is clearly too big too fail.

I expect this stock to move with the financials which will continue to be subject to violent swings in sentiment. We seem to alternate between "The worst is behind us. It's time to buy!" and "Run for cover! Here comes another wave of write-downs!" At some point, the financial sector in general will again be a buy, but for the time being I'm comfortable opportunistically adding to my net short position.

Tuesday, April 15, 2008

A Blockbuster of a Short Circuit

Circuit City 1-Year Chart (credit
Blockbuster 1-year Chart (credit

Blockbuster reported yesterday that it had made a preliminary offer to acquire Circuit City for at least $6/share in cash. Today, Circuit City acknowledged receipt of the offer and also disclosed that Blockbuster had previously made another private offer for Circuit City. From the two charts above, it's pretty clear that both of these companies have been floundering. Circuit City has been constantly rejiggering to try and compete with Best Buy, and Blockbuster has had its lunch eaten by Netflix. What to do? Of course! The failing Blockbuster should buy the failing Circuit City!

According to the Blockbuster press release:
The transaction would allow both companies to benefit from the revenue growth generated by their complementary products, while the resulting synergies would substantially improve consolidated financial performance, thereby increasing shareholder value.

Blockbuster Chairman and Chief Executive Officer Jim Keyes said, "Our proposal offers Circuit City a significant premium to its existing stock price and creates a game-changing retail concept with a sustainable competitive advantage. We believe the combination will result in a compelling consumer proposition that will drive significant revenue and margin enhancements as well as cost synergies."
What? Benefit from the revenue growth generated by their complementary products? I guess all the people who aren't going to Blockbuster will be able to buy all the products that the people who aren't going to Circuit City aren't buying. And vice versa.

Maybe I'm not being open-minded enough. Let's see. The CEO is telling me this will create a game-changing retail concept. Renting videos and selling technology/electronics products at the same location. Of course! I don't want to go to Blockbuster, and I don't want to go to Circuit City, but put them together and.....................wait a sec, I still don't want to go there.

As for Circuit City's response, the following is from today's press release:
Circuit City, Blockbuster and their respective financial advisors have been in a process of exchanging information regarding the proposal, but to date Blockbuster has been unable to satisfy Circuit City and its advisors that Blockbuster's proposal could be financed. In particular, Blockbuster's proposal appears to contemplate a rights offering of unprecedented size relative to the issuing company's market capitalization and at a price that is at a significant premium to Blockbuster's current market price. Circuit City's advisors have noted that most rights offerings, of which there have been very few in the United States, occur at discounts to market.
So, Circuit City is justifiably concerned about how Blockbuster would finance the purchase. Given how far below the offer price Circuit City stock is trading, the market is also skeptical of the deal.

As for how to play this, I see no reason to get involved, especially on the long side. Both companies have so far failed to accurately anticipate or respond to competitive market forces. It's difficult to envision 1 + 1 summing to much more than zero in this case. The only winners, as is often the case, are likely to be the investment banks, consultants, and lawyers.

Monday, April 14, 2008

Peak Oil - Bullish News from the Russian Bear

In an article in today's Financial Times, Carola Hoyos and Javier Blas quote a senior executive at Lukoil as stating that Russian oil production has peaked. Some of those refuting the peak oil thesis have been pointing to the vast reserves of Russia as a source of higher future production. It will be important to keep an eye on export data from the large producers over the next few years as their domestic demand continues to increase while supply stagnates.

From the article:

"Leonid Fedun, the 52-year-old vice-president of Lukoil, Russia’s largest independent oil company, told the Financial Times he believed last year’s Russian oil production of about 10m barrels a day was the highest he would see 'in his lifetime'. Russia is the world’s second biggest oil producer.

Mr Fedun compared Russia with the North Sea and Mexico, where oil production is declining dramatically, saying that in the oil-rich region of western Siberia, the mainstay of Russian output, 'the period of intense oil production [growth] is over'.

The Russian government has so far admitted that production growth has stagnated, but has shied away from admitting that post-Soviet output has peaked.

Viktor Khristenko, Russia’s energy minister who is pushing for tax cuts that could stimulate investment, said last week: 'The output level we have today is a plateau, stagnation.'

Russia was until recently considered as the most promising oil region outside the Middle East. Its rapid output growth in the early 2000s helped to meet booming Chinese demand and limited the rise in oil prices."

The trend, however, has turned, with supply dropping below year-ago levels for the first time this decade, according to the International Energy Agency, the energy watchdog."

Wachovia's "Solid Underlying Performance"

From Wachovia's earnings release this morning:

"While solid underlying performance was overshadowed by market disruption- related valuation losses of $2.0 billion..."

This just isn't genuine. In just the past quarter, the company reported a 93% increase in its provision for credit losses and net charge-offs jumped 66%. The allowance for loan losses as a percent of loans has been steadily climbing the past few quarters (1.37% this quarter, .98% last quarter, and .78% in the prior quarter). However, the allowance for loan losses as a percent of nonperforming assets has actually been falling. I'd love an explanation for this. I suspect the company is still not adequately reserved.

To his credit, CEO Ken Thompson did state that he was deeply disappointed with the results, so this certainly isn't some whitewash sugar coating. But to talk about "solid underlying performance" is misleading. The charge-offs and provisioning that the company is taking now are a reflection of bad loans the company issued in prior quarters and years. Essentially, the earnings for those prior periods were overstated. You can't just talk about how strong the business is if you ignore the bad loans. This is a bank! They make loans! That's their business!

It's like a doctor touting what a terrific surgeon he is - if you ignore all the patients who died.

Sunday, April 13, 2008

Stiglitz and the Charmin Prescription

Nobel Prize winner, Joseph Stiglitz was on CNBC this past week offering his views of the current economic situation. Stiglitz is calling for a further 10-20% decline in house prices and the worst recession since the Great Depression. No argument here. He does a nice job of explaining why this recession is not your typical run-of-the-mill downturn.

Where I take issue with him is on his policy prescriptions. He (like most) is calling for a "more effective stimulus package - bigger, better design..." More specifically, he'd like to see an expansion of unemployment insurance because he feels it offers the biggest bang for the buck in terms of the stimulus you get per dollar of spending and because "it's a lack of jobs, not a lack of searching for jobs that's the problem."

He then brings up the issue of budget stress that states and municipalities will be undergoing as their balanced budget requirements require them to reduce their spending as their revenue (think property taxes, capital gains taxes, income taxes, sales taxes) falls. This is an important issue which hasn't received much attention - yet. However, he then goes on to say, "We need to have a program to stop this downturn by supplementing the income, making up for the loss of revenue. It wasn't their fault. It's the fault of macroeconomic management at the federal level."

So basically Stiglitz (like virtually all of the other pundits) just wants to bail everyone out. If you lost your job and you couldn't find a new one (or weren't willing to take a step down in pay or prestige) in 26 weeks, no problem. We'll just keep cutting you a check. Is your state struggling because current tax revenue can't support the expansion in services it approved over the past 5 years? Don't bother raising taxes or even contemplate cutting spending. We'll just cut you a check. Calm down. No need to worry about being fiscally conservative. We'll be cutting you a check. And for you states who've been the most fiscally irresponsible we'll be sending you the biggest checks of all!

Of course, the "we" is the federal government which is you and me and all of our other fellow taxpayers in this country. And, I suppose that we should consider the fact that
the we don't have the money laying around to do these things, so we would have to borrow billions on top of our already staggering debt load. And I suppose we should be concerned that increasing our borrowing from our already unsustainable level is ultimately going to cost us in terms of a weaker dollar, rising inflation, higher taxes, smaller future entitlement benefits, and/or rising interest rates. And maybe we should think about the implications for moral hazard if we keep collectively wiping this country's hindquarters every time its bowels get a little shaky.

Nah. We'll just cut a check.

Saturday, April 12, 2008

Recession Watch - Consumer Sentiment

The latest reading of the University of Michigan Consumer Sentiment Index is the lowest we've seen since the early 80's when inflation was soaring and Volcker was busy jacking up the Fed funds rate to 19%.

At least Bernanke is now talking about the chance of a recession. The talking heads are almost always behind the curve. The issue isn't whether we're in a recession but rather how long and deep it will be.

The only reason there's been any debate at all as to whether we've been in a recession is because of the manipulation of inflation statistics by the government. The real GDP figures reported by the government are overstated due to their ridiculously low calculation of inflation. The lower the inflation figure, the higher the reported real GDP.

Consumption accounts for about 70% of U.S. economic activity, and the U.S. consumer is clearly in retrenchment mode. I expect this recession will be longer and/or deeper than the consensus view. Therefore, it's likely still too early to bottom fish in the consumer discretionary sector.

Friday, April 11, 2008

Ricing Frustrations

To think, I was actually a little tweaked that the cost of my Bran Flakes was 30 cents higher on my last shopping trip.

This link offers a number of brief videos from the BBC on the global rice shortage. According to the United Nations Food and Agriculture Organisation (FAO), 37 countries are facing a food crisis, and food riots have broken out in several African countries, Indonesia, the Philippines and Haiti.

The beauty of investing in commodities is that there are relatively few variables that need to be monitored and no company-specific factors to worry about. Price boils down to supply and demand. Currently, with many agricultural commodities we are seeing demand increase due to increasing populations, a rising middle class in parts of the the developing world, and new demand for ethanol. Supply hasn't kept pace.

When we look at the US Department of Agriculture's figures for rice, we find that this supply-demand imbalance has led to a decline in global rice stocks from a peak of 130 million tonnes in 2000-2001 to 72 million tonnes in 2007-2008, the lowest level since 1983-84. According to the same report, nearly half of the world's 6.6 billion people are dependent on rice and are already eating more than is harvested yearly. The price of rice on the Chicago Board of Trade has doubled in the past year.

In response, governments are curbing rice exports in an attempt to keep prices down and bolster local supply. To the extent that they're instituting price controls they're taking away incentive for farmers to expand planting, and the limiting of exports is leading to crises in import-dependent countries like the Philippines. Consumers are hoarding rice as well, furthering the supply crisis.

Clearly, demand has been outstripping supply (as with many commodities). The key will be to look for the inflection point. There's a huge incentive these days (where prices are not constrained) to put even marginal land back into farm service. Pests, disease, and weather are always wild-cards, but the incentive to plant is there. The question is whether this will result in a narrowing of the supply-demand gap.

The fertilizer companies continue to be well-positioned and should be a key beneficiary again this year. I continue to like this space, but I'll be watching the supply figures carefully.

In the meantime, I'll be expanding my pantry and hoarding my Bran Flakes.

Mortgage Cheats

An April 9th article by Ernest Istook of The Heritage Foundation entitled "Will Your Tax Dollars Go To Mortgage Cheats?" is worth a read.

Brief excerpts:
"By some estimates, borrower fraud accounts for most of the mortgage crisis now troubling the nation. It was certainly abetted by dishonest brokers. But just as honest taxpayers should not be expected to bail out dishonest brokers, so they shouldn't be expected to bail out dishonest borrowers."

"Greater than the financial threat to America is the moral threat of a bailout. What's next? Paying off car loans for those who were 'seduced' by a glib salesman? How about those who bought a bigger TV or a more powerful stereo system than they could afford? Where will this practice end of treating dishonest or incautious consumers as victims?"

A Fed Chairman Worth Listening To

I don't agree with all of his views, but Paul Volcker is the best Federal Reserve Chairman this country has seen. He understood the role of the Fed, the importance of its independence, and he wasn't afraid to administer some much needed but politically unpopular medicine to this country as Chairman of the Fed from 1979 to 1987. Greenspan and Bernanke look like confused, spineless, political, patsies next to this guy. He's always worth a listen. The following is his April 8th speech to the Economic Club of New York:

Bloomberg Video of Volcker speech

Chocolate and Beer - Part 2

To recap Part 1, financial regulation failed miserably to recognize or prevent the current credit crisis and actually played an integral role in creating and fostering the credit bubble. Most politicians, regulators, and pundits are using this failure as an excuse to expand that which just failed - regulation. Unfortunately, our policymakers are far too busy trying to look “responsible” and “proactive” to actually expend any effort examining the role the regulators themselves played in creating the current debacle or questioning whether less regulation may actually be the better policy. I’m accustomed to being on the unpopular side of many arguments, and this one is no different.

I’ve been reading quite a bit lately from all corners that the current credit crisis is proof of the failure of free market economics. This is laughable since we’ve hardly been operating in a free market system. When it comes to the financial markets, we have many organizations involved in the regulation and manipulation of our markets, our financial institutions, our money supply, our interest rates, etc. Despite all of this, we are facing the largest financial crisis since the Great Depression. It’s important to understand that regulation has been prevalent and growing for many decades. Yet, here we are.

Then how may things have transpired in a truly free market? Most importantly, moral hazard would not be an issue if the free market had been in operation. Basically, moral hazard means that people will be less cautious if they know they’ll be bailed out. Bailing out is exactly what the Fed under Greenspan did repeatedly, and it’s exactly what the Fed under Bernanke is doing currently. It’s also what the federal government does when it passes legislation to bail out certain constituents. Financial actors aren’t stupid. Greedy? Yes. Stupid? No. They’ve realized for some time now that the Fed and government were effectively putting a floor under the financial markets (LTCM, Asian currency crisis, tech bubble). The Fed repeatedly demonstrated that it was willing to aggressively intervene during relatively modest financial dislocations. In such a world, the obvious course of action is to lever up as much as possible and swing for the fences. Heads you win, tails you don’t lose.

In a free market, the issue of moral hazard disappears because no one gets bailed out. There is no Federal Reserve, or Treasury or Congress standing ready to lower rates, print money, and use taxpayer dollars to “rescue” the imprudent. The losers fail. They go away. Long-Term Capital Management would not have been bailed out. The Fed would not have guaranteed $30 billion of questionable Bear Stearns assets. The strong prosper. The weak fail. A strong signal is sent to all market participants that there is a significant and definable downside to taking too much risk. This signaling has unfortunately been overridden by the regulators/politicians in our increasingly quasi-capitalistic system of democratic socialism.

It’s important to recognize that government and regulatory intervention in our markets has led to ever larger bubbles, misallocations of capital, and financial dislocations. Without the Fed manipulating interest rates and the money supply, ever-larger serial bubbles would not have been blown, the money supply would not have been so grossly inflated, inflation would be less of a threat (by definition), and the dollar wouldn’t be nearly so weak. We can recognize all of this, but we can’t go back and undo what’s already occurred. Given that fact and given the crisis we’re currently in, what might we expect from a free market from this point forward if regulation were magically eliminated today? The following are just a few reasonable realistic possibilities:

  • Development of better risk models and more focus on risk management
  • More aversion to and higher risk premia for complicated security structures
  • Increased competition in the credit-rating market resulting ultimately in better analysis and modeling
  • Insolvent financial institutions would be allowed to fail
  • Increased financial statement disclosure
  • More accountability for evaluating risk at all levels of distribution
  • Credit-rating agencies being compensated by investors rather than by the companies they rate
  • A strong call for financial institutions to increase their capital position
  • A continuing trend of deleveraging
  • Mortgage originators retaining more security exposure to better ensure adequate underwriting standards
  • Opportunists taking advantage of illiquid markets to buy securities at deep discounts to their intrinsic value
  • Unwinding of and more sensitivity to counterparty arrangements
  • Development of more standardized derivative contracts and clearing arrangements
  • A better and more symmetrical alignment of executive compensation with longer-term shareholder goals
  • More critical analysis of credit insurer strength
  • Clearer and more robust mortgage terms disclosure
  • Fewer no-doc or low-doc mortgages and/or higher spreads on them
  • Less opaque securitizations

All of these things would be healthy for the market and would lead to a strengthening of our financial system. Some variation of many of these suggestions as well as others can be expected to occur over the next 5 years without any government intervention simply due to the demands of various financial market constituents. None of this requires government intervention.

Now let’s look at just a few examples of free market success so far in this current crisis. First is the entry of Warren Buffett into the municipal bond insurance business. This is exactly what we’d expect to see - a strong player with extensive capital and an excellent reputation entering a failed industry that didn’t adequately price its insurance or assess its risk. Other individuals and firms are also exploring entering this market. Should we use taxpayer dollars to support the incumbents (for example, MBIA, SCA, and ABK) to the detriment of the newer and stronger players? No. The free market is filling the void and will be doing so with better risk modeling and a stronger capital position.

When asset prices finally start to adequately price in risk, liquidity tends to surface. For example, on April 1 Blackstone Group LP raised a record $10.9 billion to invest in property. It was also recently reported that another opportunity fund, Dallas-based Lone Star Funds, is raising up to $10 billion to invest in real estate. Lone Star managing partner John Grayken recently told the Oregon Investment Council, ``This is as good a distressed environment as we've seen in a long time. It's a race among a number of different lenders to play this.'' This week, we also learned that Citigroup is close to unloading $12 billion of bad loans to a group of private-equity firms at 90 cents on the dollar.

There are many other examples of capital being raised. UBS recently raised another $15 billion. Lehman raised $4 billion. Washington Mutual is raising $7 billion. Sovereign Wealth Funds (SWFs) have tossed about another $70 billion into investment banks over the past year. The point is that when prices fall enough to adequately (or more than adequately) discount the risk, private funding is made available. Capitalism does work (when allowed). The quicker this process unfolds the better for the financial system and the economy. The bailout efforts by the Fed and the government are simply dragging out this price-discovery process and delaying the eventual economic recovery. Of course, others could argue that this money is only forthcoming now because of the steps that the Fed has already taken. My contention, however, is that Fed actions have been hindering and delaying the price-discovery process, keeping asset prices higher than warranted, and therefore keeping further private funding from entering the market and prolonging the correction. Granted, it's impossible to know which view is correct since we can't rewind and play it twice.

We don’t need the government to “bail out” the market, but we’re going to get it, so let’s be clear about what a government bailout means. It means the government is stealing. They’re stealing from those who were prudent – those who bought a house and selected a mortgage that they could afford, those who have been living beneath or within their means, and those who decided to save versus play. The government is using these stolen funds to support/bailout/rescue/benefit/enrich those who speculated on rising home prices, those who gambled on always being able to refinance at low rates, those who took on too much debt, those who have lived beyond their means, and the millionaires running our financial institutions. If you’re in the former group, you should be irate. The government won’t be sending you a bill directly, but they will be increasing their borrowing and increasing the money supply during this bailout. You will suffer the depreciation of your dollar assets and higher inflation as a result.

What would I like to see the Fed/government do? Put their hands back in their own pockets, get out of the way, and sit down with a nice big cup of coffee and a copy of the Constitution (to be read – not to be used as a coaster). Let the market do its job - liquidate the bad debt and the imbalances that have occurred and eliminate the ubiquity of moral hazard. It’s healthy, and it’s in the long-term best interests of our country.

If only the government could bail out common sense.