Saturday, February 28, 2009

Buffett's Letter To Shareholders

Warren Buffett's annual Letter to Shareholders was issued today. As always, this should be required reading for anyone interested in investing. The entire letter can be found here.

There are a few segments that I'd like to highlight. The first discusses the impact of government meddling on his Clayton Homes business. One of the valid criticisms of government intervention is that it ends up favoring one constituency over another. In the current economic environment, it is those who have made poor business decisions and took on too much risk who are being bailed out at the expense of the prudent. The following demonstrates how Buffett's manufactured home business is being impacted by this:

Clayton’s lending operation, though not damaged by the performance of its borrowers, is nevertheless threatened by an element of the credit crisis. Funders that have access to any sort of government guarantee – banks with FDIC-insured deposits, large entities with commercial paper now backed by the Federal Reserve, and others who are using imaginative methods (or lobbying skills) to come under the government’s umbrella – have money costs that are minimal. Conversely, highly-rated companies, such as Berkshire, are experiencing borrowing costs that, in relation to Treasury rates, are at record levels. Moreover, funds are abundant for the government-guaranteed borrower but often scarce for others, no matter how creditworthy they may be.

This unprecedented “spread” in the cost of money makes it unprofitable for any lender who doesn’t enjoy government-guaranteed funds to go up against those with a favored status. Government is determining the “haves” and “have-nots.” That is why companies are rushing to convert to bank holding companies, not a course feasible for Berkshire.

Though Berkshire’s credit is pristine – we are one of only seven AAA corporations in the country – our cost of borrowing is now far higher than competitors with shaky balance sheets but government backing. At the moment, it is much better to be a financial cripple with a government guarantee than a Gibraltar without one.

Today’s extreme conditions may soon end. At worst, we believe we will find at least a partial solution that will allow us to continue much of Clayton’s lending. Clayton’s earnings, however, will surely suffer if we are forced to compete for long against government-favored lenders.
In this next segment, Buffett discusses the perilous state of many municipalities and the risk inherent in insuring tax-exempt bonds:
The rationale behind very low premium rates for insuring tax-exempts has been that defaults have historically been few. But that record largely reflects the experience of entities that issued uninsured bonds. Insurance of tax-exempt bonds didn’t exist before 1971, and even after that most bonds remained uninsured.

A universe of tax-exempts fully covered by insurance would be certain to have a somewhat different loss experience from a group of uninsured, but otherwise similar bonds, the only question being how different. To understand why, let’s go back to 1975 when New York City was on the edge of bankruptcy. At the time its bonds – virtually all uninsured – were heavily held by the city’s wealthier residents as well as by New York banks and other institutions. These local bondholders deeply desired to solve the city’s fiscal problems. So before long, concessions and cooperation from a host of involved constituencies produced a solution. Without one, it was apparent to all that New York’s citizens and businesses would have experienced widespread and severe financial losses from their bond holdings.

Now, imagine that all of the city’s bonds had instead been insured by Berkshire. Would similar belttightening, tax increases, labor concessions, etc. have been forthcoming? Of course not. At a minimum, Berkshire would have been asked to “share” in the required sacrifices. And, considering our deep pockets, the required contribution would most certainly have been substantial.

Local governments are going to face far tougher fiscal problems in the future than they have to date. The pension liabilities I talked about in last year’s report will be a huge contributor to these woes. Many cities and states were surely horrified when they inspected the status of their funding at yearend 2008. The gap between assets and a realistic actuarial valuation of present liabilities is simply staggering.

When faced with large revenue shortfalls, communities that have all of their bonds insured will be more prone to develop “solutions” less favorable to bondholders than those communities that have uninsured bonds held by local banks and residents. Losses in the tax-exempt arena, when they come, are also likely to be highly correlated among issuers. If a few communities stiff their creditors and get away with it, the chance that others will follow in their footsteps will grow. What mayor or city council is going to choose pain to local citizens in the form of major tax increases over pain to a far-away bond insurer?

Insuring tax-exempts, therefore, has the look today of a dangerous business – one with similarities, in fact, to the insuring of natural catastrophes. In both cases, a string of loss-free years can be followed by a devastating experience that more than wipes out all earlier profits. We will try, therefore, to proceed carefully in this business, eschewing many classes of bonds that other monolines regularly embrace.
Finally, here are Buffett's thoughts on the pricing of risk and the yield on cash and Treasury bonds.
The investment world has gone from underpricing risk to overpricing it. This change has not been minor; the pendulum has covered an extraordinary arc. A few years ago, it would have seemed unthinkable that yields like today’s could have been obtained on good-grade municipal or corporate bonds even while risk-free governments offered near-zero returns on short-term bonds and no better than a pittance on long-terms. When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary.

Clinging to cash equivalents or long-term government bonds at present yields is almost certainly a terrible policy if continued for long. Holders of these instruments, of course, have felt increasingly comfortable – in fact, almost smug – in following this policy as financial turmoil has mounted. They regard their judgment confirmed when they hear commentators proclaim “cash is king,” even though that wonderful cash is earning close to nothing and will surely find its purchasing power eroded over time.

Approval, though, is not the goal of investing. In fact, approval is often counter-productive because it sedates the brain and makes it less receptive to new facts or a re-examination of conclusions formed earlier. Beware the investment activity that produces applause; the great moves are usually greeted by yawns.
No arguments here.

The Market Rubbernecker is affiliated with Aspera Financial, LLC, a registered investment advisor. Please read the disclaimer on the home page of the Market Rubbernecker site.

Wednesday, February 25, 2009

One Simple, Bold, Realistic Move

I've been thinking about what I would do to address this crisis if I were President Obama. Abdicate and hit the speaker's circuit for a huge stress-free payday is the obvious choice. I have plenty of suggestions as to what should be done, but I am a realist. My ideas as to what should be done don't have a serious chance of being implemented until we default on our debt, suffer a collapse of our currency, suffer from hyperinflation, and/or lose a war against Switzerland.

Until then, I do have one idea for Obama which could actually be implemented and have an immediate positive impact. I would "ask" Treasury Secretary Geithner to resign for "personal reasons," and I would immediately appoint Paul Volcker as the new Treasury Secretary. Volcker has presently been relegated to the role of heading the President's Economic Recovery Advisory Board. That means that it's his job to bring the donuts in the morning.

I don't know of anyone in the financial world right now who has more credibility than Volcker. He's the only U.S. official in the past 20 years who has been able to conclusively prove himself a vertebrate. Volcker was appointed Chairman of the Federal Reserve in 1979 and proceeded to take the politically dangerous path of jacking up interest rates to pull our country out of the stagflation of the 1970s. That's exactly the type of leadership and experience we need right now.

Let's not kid ourselves. We face many real problems which will take some time to unwind no matter what the government does. At the margin, however, credibility and confidence do play a role. So far, the government's mixed messages, flip-flopping, half measures, speeches devoted to future speeches about plan details, and lack of transparency have led to increased uncertainty and volatility. Appointing Volcker along with a firm statement that Volcker had carte blanche to clean up the banks would be a tremendous step forward. I would be buying equities on the day of that announcement.

In the meantime, I plan to await the administration's plan to start planning on a plan to plan for the planning of a speech to lay out their plans for this crisis.

The Market Rubbernecker is affiliated with Aspera Financial, LLC, a registered investment advisor. Please read the disclaimer on the home page of the Market Rubbernecker site.

Monday, February 23, 2009

Curse Of The Contrarian

It's so ugly out there, it's hard not to be a little bullish. My contrarian sympathies have certainly been helpful in avoiding complete disasters over the years and have been instrumental in all of my most profitable investments. But everything has a cost. The curse of the contrarian is often being early in your calls, sometimes quite a bit early. That has always struck me as a very fair trade.

With the global economy now in tatters, stock markets hitting fresh multi-year lows, and journalists jockeying to see who can use the word "depression" most often in their articles, the contrarian in me is starting to feel a little frisky. Perhaps the stars are aligning for a nice rally. For today's exercise, we'll temporarily set aside all of the doom and gloom (of which I've contributed my share over the years), and we'll take a look at a few positive developments.

  1. We can argue about the merits of the stimulus (and I've been against it from the start), but there's a good deal of monetary and fiscal stimulus on the way. The authorities have made it clear that they will stop at nothing to "fix" the economy. Ignoring the potential longer-term negative consequences of their prescription, the current and future stimulus (yes, there will be more) will show up in the economy.
  2. Stocks in the U.S. are now off about 48% from their highs. Much bad news has been discounted.
  3. Bearish sentiment has been climbing again. The herd of bulls is thinning and those remaining are far less vocal.
  4. The Leading Economic Indicators rose for 2 straight months. Yes, it can be explained away, but at least it rose.
  5. The money supply has been rising at a healthy clip. True, it isn't making it's way into the economy -- yet. That could change sooner than expected.
  6. On a related note, there is a great deal of cash sitting on the sidelines, waiting for a little more clarity and confidence to move back into risky assets.
  7. On a related note, the fixed income markets have been showing some signs of life recently.
  8. Once again, a number of pundits are questioning Buffett's investment acumen. That's usually a good contrary signal.
  9. New housing starts are plummeting. This will help with the excess housing inventory problem. It will still take more time, but it's happening.
  10. Companies have been fairly quick to reduce costs in this downturn, and corporate balance sheets were in pretty good shape going into it. Once business finally does pick up, we could see some rapid margin expansion.
  11. Based on a number of different metrics, equity valuation looks much more reasonable. We're hardly at bear market lows, but some metrics are at levels not seen in a couple of decades.
  12. The market has fallen 14% since February 9th. It sure feels like we're oversold near-term.
That was refreshing. Again, this is not a bottom call. In the near-term, we are oversold. Markets don't go straight down. It would be more surprising to me if we didn't experience a rally imminently.

In recent days, I've added a little more market exposure, reduced our already small short position, and reduced our gold position (still one of our larger holdings). Gold is due for a healthy pullback after its recent rise, and I suspect a rally in the market may result in a decline in gold as safe haven buying temporarily wanes. Should this occur, I'll be rebuilding the gold position again.

The odds favor any rally being a trading opportunity. In the meantime, I'll enjoy basking in my relative bullishness.

The Market Rubbernecker is affiliated with Aspera Financial, LLC, a registered investment advisor. Please read the disclaimer on the home page of the Market Rubbernecker site.

Thursday, February 19, 2009

300 Million Americans. This Is The Best We Can Do?

I'm a little late to the party with this one. The clip is from last April, but I just saw it. I can't stop laughing. To remind readers, I am an independent (with a strong Libertarian bent) when it comes to politics, and I view both of the major parties and what they've done to our country with equal distaste, so this isn't an attack on Democrats (or it's an attack on Democrats and Republicans).

How does someone become U.S. Senate Majority Leader when he doesn't understand the basics of our tax system? This is the knowledge level of the people who are spending us into oblivion. I almost started feeling sorry for Harry. Almost.

Link to YouTube Video

The Market Rubbernecker is affiliated with Aspera Financial, LLC, a registered investment advisor. Please read the disclaimer on the home page of the Market Rubbernecker site.

Saturday, February 14, 2009

So, Where Are We Now?

I appreciate all of the inquiries as to my disappearance lately. I'd love to report that I've been relaxing on a beach on a remote telecommunications-free island in the Caribbean, but client business, trading, earnings season, and a beautiful, laughing, 4-month old daughter have kept me very busy these past few weeks. As earnings season slows I hope to have a little more time for the Rubbernecker, sleep, and personal grooming.

I certainly haven't avoided writing due to a lack of material! Let me try and catch up with the past few weeks and recap where we stand.

  • As we know, the Fed has driven interest rates to ridiculous below-market rates.
  • These low rates are devastating for the savings of retirees who have no business moving out on the risk curve in search of higher yield.
  • These low rates are also supposed to encourage more borrowing despite the fact that our economy is currently suffering from too much debt.
  • Congress is angry that the banks aren't lending their bailout funds to people who already have too much debt in the middle of some type of economic "ession."
  • Congress is criticizing bankers for paying themselves too much, over-levering their balance sheets, and maintaining huge off-balance sheet liabilities while Congressfolk continue to pay themselves too much, over-leverage our nation's balance sheet, and maintain huge off-balance sheet liabilities.
  • The collective earnings of the S&P 500 companies will register its first decline ever in the fourth quarter of 2008. Ever.
  • Congress just passed a $787 billion stimulus plan that will further increase our national debt and displace private investment. The notion that this and future stimulus is only temporary and will be withdrawn once the economy recovers is laughable.
  • Over $8 trillion in spending/promises have been incurred in the past year.
  • We have a Treasury Secretary in charge of both the financial industry bailout and the IRS who either isn't smart enough or honest enough to do his own taxes properly.
  • This same Treasury Secretary just announced an eagerly-awaited financial bailout plan that included no details and no plan aside from somehow spending a lot more money.
  • The Obama administration is now working on some scheme to "save" the housing market. Whatever the details of the plan, we can be sure it will entail using the tax dollars of those who were prudent to "rescue" those who made bad choices. It will also impede the housing market finding a bottom.
  • This year's Federal budget deficit is creeping towards $1.5 trillion, and is sure to rise further as tax receipts continue to fall.
Debt, Debt, and More Debt
Simply put, this massive increase in debt is an inter-generational transfer of wealth. In other words, we're doing this for our own current "benefit" and will be passing the bill to our children. Where's the discussion of fairness? With every bailout of the past year, our leaders have told us that we must act immediately or the global economy will collapse. That hasn't left much time for educated discussion, nor has it prevented the global collapse that their swift undebated action was supposed to prevent. Last week, I explained to my 4-month old daughter that her share of the national debt is well over $200,000. You should have seen the diaper I had to change after that.

It amazes me how accepted it has become that the the cure for any slowdown of any magnitude is always to throw money at it. This is the policy that we've pursued consistently since the Great Depression, and look where it's gotten us. There's a popular quote that seems rather appropriate. "If you keep doing what you've been doing you'll keep getting what you've been getting."

For far too long, our policy makers have increased and encouraged borrowing at every whiff of a slowdown rather than let the market correct the excesses that have built up. Each time, they managed to forestall what would have been a healthy correction at the expense of preordaining a more severe future correction. Ironically, now that it's time to pay the piper, our authorities are laying the blame on the failings of the free market instead of their constant meddling. Unfortunately, their actions will only prolong the length of this downturn.

As I've stated before, the good news is that the market is still doing its job, and many of the excesses (excluding government credit and money supply expansion) are gradually being cleared away. The housing bubble is unwinding, consumers are beginning to save again, global equity markets are back to far more reasonable levels, excess production capacity is starting to dry up, etc. This process will take time, especially with the massive level of government meddling, but it is occurring, and it will eventually take us to a healthier level of economic activity -- one not dependent largely on household credit expansion.

Stock Market Rally?
As ugly as the situation is, there is a strong likelihood that the fiscal and monetary stimulus being dumped on the economy will appear to have a positive impact. As counterproductive and inefficient as most of this spending will eventually prove, the stimulus will at least help slow the rate of decline, probably beginning in the second half of the year. In anticipation of this or at the earliest sign of this, we may experience a fairly strong rally in the equity market as investors come to believe that the worst is behind us. The expected "Obama rally" earlier this year was doomed from the start as too many people were expecting it and were looking to sell into it. With pessimism growing again and less talk of an impending rally, the odds of a rally have actually increased.

To the extent that the credit bubble has not been allowed to correct sufficiently, it's hard to imagine that any such rally will be the real deal. As discussed in prior posts, bear rallies can be powerful. The Great Depression saw a 50% rally over a 6 month period right in the middle of the first leg down. Barring a dramatic change in policy, any rally unaccompanied by a significant correction in the credit bubble is likely to prove a dead cat bounce.

The ballooning national debt and Fed balance sheet also need to be watched. I just can't see all of this stimulus being removed without collapsing any recovery we do eventually get. Government doesn't have a terrific track record of enacting temporary stimulus. Not surprisingly, it typically manages to morph into permanent funding. New constituents will be created who will create lobbying groups, and they won't take kindly to any future talk of decreased funding. The Fed will also find it difficult to withdraw the massive monetary stimulus it has injected. Once the printing presses are humming, it's very difficult to turn them off. Although much of the talk these days is of deflation, I see significant inflation as a much more serious threat down the road.

Strategy Update
As a result, current long-term Treasury yields strike me as unsustainably low. I had shorted the long end of the curve in mid-December and sold that position near the end of January. I didn't anticipate this being a short-term position, but we were fortunate to buy the position close to its low, and it experienced a 25% gain in just over one month. Hopefully, I'll get another crack at it. The Fed has discussed buying long-dated Treasuries. Should they follow through, I would expect another decline in long yields at which time I'll take a hard look at loading up again. Longer-term, this is a position I want to own.

Gold has typically been viewed as an inflation hedge, but it's been one of the best performers in this current deflationary phase (as it was during the Great Depression) as investors flock to its safety and low interest rates minimize the opportunity cost of owning gold. We've been overweight precious metals throughout the gold bull market and have continued to add on pullbacks. In early January, I bought a few junior mining names that had been driven to ridiculously attractive prices. More recently, I eased back on our GLD/DGP position in those accounts where the position grew just a little too large following this recent rally. We still own a healthy precious metals position and would be quick to add on any significant pullback.

Most of the balance of our aggressive portfolios hasn't changed significantly. Our bias at these levels is towards select emerging markets and commodities. I take a long-term approach with these positions and am quick to point out that I have no expectation for these positions in the short-term (less than one year). The countries I'm focusing on have already declined significantly, have experienced an outflow of hot money, are marked by high savings rates, have at least reasonably solid reserves, and are trading at attractive valuation levels. Five years from now, I expect to be pleased with their performance.

We still hold a decent cash position, and we continue to have just a few short positions as the recent leg down in the market has made it more difficult to find many compelling short opportunities. As usual, at the margin I would anticipate selling some long positions and increasing short exposure if we get a strong rally without signs of a significant positive change in the underlying fundamentals.

I think that catches me up from my relative absence the past few weeks. I now have to go explain to my daughter why she'll be learning Chinese and why her savings account is short the dollar. I'll be putting a second "backup" diaper on first.

The Market Rubbernecker is affiliated with Aspera Financial, LLC, a registered investment advisor. Please read the disclaimer on the home page of the Market Rubbernecker site.

Monday, February 9, 2009

Rep. Ackerman Tees Off On The SEC

Last week's congressional hearing on the Madoff scandal made for great theater. Harry Markopolos is the guy who tipped off the SEC 9 years ago (and a number of times subsequently) about the strong likelihood that Madoff was a fraud. His testimony was jaw-dropping. I hadn't realized just how detailed his evidence had been or how persistent he had been in making his case. I particularly loved how he stressed that it took mere minutes to figure out that something was amiss with Madoff and his purported performance. Harry also did a wonderful job of pointing out the amazing breadth and depth of ineptitude at the SEC. I'd encourage you to watch a recording of his testimony.

In the clip below, Representative Ackerman takes a nice swing at the sacrificial SEC lambs who drew the short straw and had to attend the hearing. As I pointed out when this scandal first broke, the ironic ultimate outcome of this incredible failing at the SEC will most likely be a significant boost in the SEC's budget. Nothing warrants increased government funding more than colossal failure!

Link to Video

The Market Rubbernecker is affiliated with Aspera Financial, LLC, a registered investment advisor. Please read the disclaimer on the home page of the Market Rubbernecker site.