Think, Invest! by czentay@yahoo.com

FakeBen.com

2007-12-05T10:53:00.001-05:00

This website is one of the funniest, most informative that I've found in a while:

FakeBen.com

Still bullish after all these years

2007-11-21T15:46:00.000-05:00

There is a fight on at the Fed, with the non-financial-center governors wanting to fight inflation and the New York and San Fran guys wanting to lower rates. I think the Fed is going to try to con the markets by holding rates steady (or maybe down 50 bps from here) but then working with the Treasury to put lots of cash into banks. Maybe they will lower fractional banking reserve requirements. Whatever it is, the government HAS to do something, otherwise the banking system WILL freeze up. Whatever the government does, they need to pretend that (a) it does not favor one group over another [yeah right!]; and (b) it is not inflationary and does not weaken the U.S. dollar [yeah right!].

The necessity of action by the Fed is what keeps me bullish on oil and gold and bearish on the dollar.

Is the Fed going to sacrifice the dollar?

2007-11-20T06:01:00.000-05:00

I always like to keep it simple and obvious when investing.

Obvious:
1) The U.S. banking system is insolvent.
2) The Fed HAS to support the banking system.
3) The dollar is now approaching the psychologically important threshold of 1.50 to the Euro.
4) The Fed and Treasury are making NO noises about defending the dollar (internal politics is more important to them).
5) Most central banks around the world are thinking about how to get out of dollars.

Even though I can't see how the Europeans can be competitive at 1.50, and I think the Euro is overvalued and the Asian currencies are undervalued, the simple obvious facts would point me in the direction of predicting 1.70 U.S. Dollar/Euro in the not too distant future.

Eventually, the market will force to Chinese to revalue, and that might cause the Euro to fall versus the dollar, but that won't happen immediatly. The way I see it, the dollar (a.k.a. the American peso) will continue to fall against the Euro and Americans will stay buying Yuan en masse like rats jumping off a sinking ship. China will be flooded with dollars. That will force the issue.

I for one am buying Yuan. It's as if the Chinese government is writing me a check. Thanks Chinese government.

Thanks Dr. Bernanke

2007-10-29T07:37:00.000-05:00

Dear Dr. Bernanke:

I wanted to write to thank you for helping the price of Gold and to encourage you to keep up the good work. I know you will. I've never been a fan of Gold throughout my investing career, but the Fed's policies over the last 10 years have changed my mind.

I also wanted you to be one of the first to know that I am advising my readers to start putting a significant amount of their money in Gold. I recommend long-dated Gold futures, Gold ETFs (like GLD), and Gold producers (such as NEM, TRA, and CGHRF.PK). I especially like the smaller miners as they have more upside potential.

In spite of the run up, Gold continues to be a great investment. Burgeoning inflation is likely to push the price higher, as markets move from discounting Gold relative to stocks and bonds to putting a premium on it.

If I'm misguided, please let me know. But I trust you'll be there to pump lots of liquidity into the banking system.

I'm confident you will continue to argue that the appreciation of commodities and the weakness in the dollar are not important indicators of inflation. The true indicator is core inflation. The slowdown in housing and the economy will lead to core disinflation in 2008. In anticipation of this disinflation and to prevent the economy from falling into a recession, you and the FOMC will continue to lower rates.

After all, the credit crunch in the banking system is monstrous. The market and the press (in spite of so much talk) are underestimating the threat.

Just two weeks ago, your institution (the Federal Reserve) released a report that got little attention. The report showed that large bank capital had declined by $40 billion since the beginning of August. According to Merrill Lynch economist David Rosenburg, "This has never happened before over such a short timeframe and this is rather serious because such a steep and sudden compression in large-bank capital has the potential to create a negative lending environment...The large banks have been forced to take commercial paper back on their balance sheets and as a result are choking on assets they did not plan on having - thereby tying up regulatory capital." This trend could "significantly inhibit" economic growth.

According to the Financial Times, "Big U.S. commercial banks have seen $280 billion of new debt come on to their balance sheets since the credit squeeze, threatening to undermine economic growth by inhibiting their ability to make new loans. The banks have been forced to take on to their books large amounts of commercial paper and leveraged loans after investor demand for such assets dried up in the summer."

As you probably know, while these numbers sound quite large, they are only the tip of the iceberg. According to Moody's, the credit rating agency, assets held by bank-sponsored special investment vehicles
("SIVs”) were $320 billion in July. Two SIVs announced several days ago that they will be unable to pay their debts. Such moves could force more liabilities onto the balance sheets of banks, further constraining liquidity and possibly even threatening the banks' own solvency.

Through fractional banking and the rules that you set at the Federal Reserve, banks are allowed to have 20 times the amount of liabilities as their net capital. Because SIVs are off-balance sheet, banks can now have even more than 20 times. In addition, many SIVs have their own leverage, sometimes up to 10 times. In other words, only a slight move down in the value of SIV or other assets means that banks could be insolvent.

Dr. Bernanke, you need to move quickly to inject more liquidity into the system. 50 bps is not enough. A lot more interest rate cuts are needed. A lot.

Look at Citigroup as an example. Citigroup has just $65 billion in shareholder equity. Yet Citigroup alone has more than $80 billion in exposure to SIVs and another $80 billion to conduits. According to
the Associated Press, "Citi said it was suspending share buy-backs because its capital ratios had weakened partly due to the large amount of commercial paper and leveraged loans it had taken on."

You must act now. The cycle is viscous. If banks don't have enough capital, they won't lend. If they aren't lending, what will the American consumer do? And what will support housing prices? Houses are already unaffordable. Imagine what will happen if lending dries up even more! And what will keep the LBO, hedge fund, and derivatives markets running?

So please ignore those cynics who don't understand the severity of the problem. Don't worry about the price of Oil, Wheat, or Gold. Let them rise and let the dollar fall. Because the U.S. economy needs $2 billion a day in foreign cash to make up for its overconsumption and lack of manufacturing, more interest rate cuts could send foreigners fleeing the dollar. The dollar could drop by 50%. That's good.
That's exactly what we need to save the banks and housing. Who cares if a further drop in the dollar leads to fleeing capital, a further tightening of credit, and a rise in long-term interest rates? Who do these cynics think where are? Argentina? Please. We are the U.S. and A.

I know you're going to act. After all, PIMCO is now on board with Paulson's SIV plan. PIMCO's support comes as a surprise after Bill Gross, the chief investment officer, criticized the effort as "a little lame" in a television interview. Hmmmm. He must have gotten some assurances that the government hears his call for the Fed to lower rates at least another 100 bps.

Anyway, you know the banking system better than I do. I'm sure you're way ahead of me, and I'm sure you're planning even more interest rate cuts and more core inflation rationalizations.

So thanks for the good work, and please tell your friends to listen to what I'm telling my readers: "Don't sit there and moan about how the Fed is taking away your savings. Do something about it. Protect yourself and make some money in the process. Buy Gold."

P.S. While you're at it, can you do something to quiet that Greenspan guy? Now that he's out of office, he can tell the truth and it keeps hurting the markets. He's desperately trying to disassociate himself from the inflationary policies of the Fed, in a last ditch effort to save his legacy. Just the other day, according to the Associated Press, "Greenspan suggested it would be best to let SIVs and banks bear the burden of holding bad assets by making them lower prices as much as necessary to sell them, rather than setting up a fund that some see as a bailout for the banks...’What creates strong markets,’ he said, ‘is a belief in the investment community that everybody has been scared out of the market, pressed prices too low and there are wildly attractive bargaining prices out there.’" Doesn't he get it?

The government must do something. You can't be Fed Chairman and sit idly by while a recession occurs. He never did. Why should the burden fall on you?

When asked about his own attempts to bail out the banking industry while he was in office, Greenspan “said the 1998 Fed-sponsored rescue of Long-Term Capital Management worked because it took a set of assets that would otherwise have been dumped at firesale prices off the market, allowing prices to find a true equilibrium. But he said today 'we are dealing with a much larger market.'” Wasn't the entire argument behind bailing out Long-Term that the market effect was so large it threatened global stability? Ah, how short memories are.

A burger, fries, and a small side of contagion please

2007-10-18T08:28:00.000-05:00

Here’s something that’s probably not on your Christmas wish list, but should be: a little bit of contagion.

Contagion is a word you don’t hear often, unless you work at the CDC or on Wall Street. Definitions of contagion, according to dictionary.com, include: “the communication of disease by direct or indirect contact” and “the ready transmission or spread as of an idea or emotion from person to person: a contagion of fear.”

Contagion in the investing world (be careful not to ask Santa for disease contagion) is the fear that a run on one stock or asset class will spread into other stocks and asset classes, resulting in a sudden and large drop in market prices. High on the list of moral duties at the Fed and the Treasury is preventing contagion.

Here’s a general guide to how these things work. It’s been going on for a long, long time, so if you learn it now, it may help you your whole life:
• Markets go up and creative bankers invent clever ways to juice returns through “financial innovations” (Enron’s off-balance-sheet entities, liar loans, interest-only loans, negative depreciation loans, CDOs, SIVs, etc.).
• Skeptics call for greater regulation, citing the risk.
• Regulators ignore skeptics, afraid to step in front of an upwardly moving market that is creating wealth for a lot of people. Regulators claim that “free markets” are self-correcting and price assets appropriately (i.e. it is impossible to forecast bubbles).
• Eventually markets go so high that, like Icarus, they are brought down by themselves.
• The peddlers of the “financial innovations” run to regulators for a bailout, citing unprecedented and unforeseen market conditions and the threat of contagion.
• As long as the peddler is not too tainted (e.g. Ken Lay) and the threat of contagion is credible enough, regulators move into action.

In watching Fed and Treasury, look for them to selectively use:
• “free markets” as a justification for not regulating (when markets are going up), and
• “the interest of the greater good” as justification for regulating (when overpriced asset come down and threaten contagion).

Greenspan was the master of this tactic, but Treasury Secretary Hank Paulson is a quick study. Paulson, who has repeatedly argued against regulation of hedge funds and mortgage markets is now calling for government intervention. According to the Wall Street Journal:

“The regulators didn’t have clear enough visibility with what was going on in terms of these off-balance-sheet SIVs,” Mr. Paulson said to reporters…In the short term, Treasury officials said the financial markets were in danger of a large-scale dumping of assets by the banks, which would have hurt capital markets and potentially spilled over to the broader economy [contagion!]. To avoid that, Treasury stepped in to facilitate discussions among the banks…Some have criticized the Treasury for essentially helping big banks avoid the financial pain associated with risky bets that didn’t pan out. The reaction in Washington, though, was more muted. Democrats sought to use the Treasury’s willingness to get involved to bolster their demands that the Bush administration do more to help homeowners who are also suffering from the subprime downturn [more government intervention by the Republicans means the Democrats should get theirs, too].

So what’s my beef with how this world works? Not much, in that knowing about it, I am able to make a lot of money trading various stock and commodity positions in a way that is favorable to me. However, despite the benefit it provides me personally, I wish it didn’t exist. I am concerned about the greater good (wink, wink). My concern centers on inflation.

It’s simple really. If bubbles go up (like housing) and then aren’t allowed to come down, the result will be inflation. Housing prices have gone up way too far. By almost any metric, they are overpriced. First time buyers cannot afford new homes. Mortgage payments as a percentage of income are elevated. Owning a house vs. renting one is extremely expensive. Whatever way you look at it, housing is overpriced.

If free markets are allowed to run their course, house prices will come back down, possibly causing a short-term recession, but paving the way for long-term economic growth. It will be painful, quick, and healthy.

But that’s cruel, politicians will argue. People will suffer. Consequently, politicians and regulators are trying to help. Bernanke wants to lower rates to keep the subprime meltdown from spilling over into the broader economy, Hank Paulson wants to save the big banks from suffering major losses, and the Democrats want to help bail out subprime borrowers.

The road to hell is paved with good intentions. Each of these policies is inflationary. If housing prices don’t come down, everything else will have to go up in value. How else will people be able to afford these houses relative to their incomes? Either house prices must come down, or incomes must go up. With banks running into liquidity problems, we’re going to need a lot more help (a.k.a. money) from the government, which means more money supply, more credit, and a weaker dollar – all of which is going to lead to more inflation.

Markets, of course, are starting to get one step ahead of the regulators, driving up the price of oil, food, gold, and more. Oil is already at $87 a barrel and could easily go to $100 or more. Nonetheless, market watchers expect the Fed to lower interest rates again on October 31st.

Until the regulators, led by Bernanke, change their tune and start taking the threat of inflation seriously, it will continue to be advantageous to your portfolio to own:
• oil & gas companies, like Devon Energy (DVN) and SouthWestern Energy (SWN)
• gold companies, like Nemont Mining (NEM), Tanzanian Royalty (TRE [a well-run gold company doing a lot of prospecting in Tanzania]), and GoldHawk (CGHRF.PK [another well-run mining company that started production Oct. 1 at a Peruvian gold mine it acquired for a good price]
• metals companies, like CVRD (RIO), and Liberty Minerals (LBEFF.PK [a Canadian company opening new metals mines]).

If the smaller companies (TRE, CGHRF.PK, and LBEFF.PK) can get their new mines up and running according to plan and without cost overruns, and metal prices continue to move up, their stock prices could do extremely well. These companies are good inflation hedges.

I also continue to like generators of capital, such as Unico America (UNAM), a small California insurance company which trades just under book value (http://seekingalpha.com/article/49078-unico-american-corporation-true-value-again-and-again).

Don’t worry about people claiming that oil and metal prices are already too high. Unless Bernanke gets serious about inflation, prices should move higher. Why? Because interest rates are a lot more accommodative than most analysts are saying. Overall inflation (WITH food and energy) is higher than core inflation. Yet, everyone is measuring by core inflation. I think it’s incorrect to do so.

Core inflation was developed to take out temporary spikes in food and energy. But what if food and energy are on a long-term uptrend and core inflation is on a long-term downtrend (driven by globalization)? If that is the case, one misses the true trends by taking out food and energy. Greenspan recently said that the theory of using core inflation is starting to lose some credibility (he can tell the truth now that he’s no longer in office).

But Bernanke is doing the opposite, arguing more than ever for the validity of core inflation. Bernanke is under tremendous pressure to provide liquidity (via lower interest rates) to the banks. To do so, he must argue that higher oil and a falling dollar are not important. Only core inflation matters.

It seems as if hedge funds are the first to catch onto this inflation theme. Eventually, they will be followed by PIMCO (but don’t hold your breath), and finally coming in last will be Bernanke.

A recent AP article gave clues about the direction he is leaning:

Bernanke once again pledged to "act as needed" to help financial markets [in other words provide inflationary liquidity]…"The further contraction in housing is likely to be a significant drag on growth in the current quarter and through early next year," he said [I believe he’s using weak housing throughout 2008 to justify future rates reductions]…On the inflation front, Bernanke noted that the prices of crude oil and other commodities have been rising and that the value of the dollar has weakened. Oil prices galloped to a record high of $86.13 a barrel on Monday…
Fielding questions after his speech, Bernanke said, "Part of the reason that we have some confidence in inflation remaining well controlled is we expect to see the economy growing more slowly at the end of this year" and early next year [again the weak economy from housing is Bernanke’s justification for the Fed keeping liquidity flowing]. He said Fed policymakers were prepared to “reverse" the rate reduction if inflation turned out stronger than expected [this statement is probably his most important, but is it true?. If core inflation goes above 0.3%, will he backtrack or follow through with this threat/promise and force the economy into a recession? Watch the core inflation number! It’s the most important economic number right now].

To understand the pressure Bernanke is under, and why I believe he and other regulators will continue to flood the market with liquidity (in spite of high oil prices), look at the current state of the real estate markets.

One of my readers wrote saying he is a real estate agent, and that volume is off 2/3 from normal. “And prices are soft,” he wrote. “The lenders will only provide an equity loan at 80% of value [if you have a credit score in] the 750 fico range…if not forget it. When purchasing you need 725 [fico] and 20% down…who has 20% in savings for a down payment? Not many…this is a huge problem and the main reason homes are not selling. Not many can qualify under the new standards!”

Another reader, also a real estate agent, wrote:

There are going to be a massive amount of foreclosures. About 47% of homes on the market here are vacant. Many of these same sellers did refinancing, pulling huge amounts of cash out of these homes, leaving them with negative equity in the face of falling prices. In effect, these homes were sold to the banks and eventually the home debtors will walk away with their cash. Thanks to the new Mortgage Debt Forgiveness Act, there will be little impact from this fraud [compare that to Paulson calling for more government action!]. However, the lenders will continue to tighten and those defaulting will be out of the home market and credit market for seven years. When I drive through a prospective neighborhood, I try to ascertain the yearly median income. I multiply that times three to get a neighborhood sales price range. Here in Phoenix, we need to come down 40 - 50% more [again, either housing prices must come down or incomes must go up]. Since I have lived in the same home for 30 years, I know this is pretty accurate for my own neighborhood. Like you say, sellers are reluctant to drop price. We have a long way to go.

Unless housing is allowed to run its course, the government will only cause inflation, or more likely stagflation,. So although you probably didn’t think you wanted it, you might want to add a little contagion to your Christmas list.

In case you don’t believe me, here are some final thoughts on stagflation from Wikipedia (emphasis added):

Stagflation…a term…used to describe a period of out-of-control price inflation combined with slow-to-no output growth, rising unemployment, and eventually recession. Stagflation is a problem because the…principal tools for directing the economy…offer only trade offs between growth and inflation. A central bank can either slow growth to reduce inflationary pressures, or it can allow general increases in price to occur in order to stimulate growth. Stagflation creates a dilemma in that efforts to correct stagnation only worsen inflation, and vice versa. The dilemma in monetary policy is instructive. The central bank can make one of two choices, each with negative outcomes. First, the bank can choose to stimulate the economy and create jobs by increasing the money supply…but this risks boosting the pace of inflation. The other choice is to pursue a tight monetary policy…to reduce inflation, at the risk of higher unemployment and slower output growth. In neo-classical economic theory, stagflation is rooted in the failure of the overall market to allocate goods and services efficiently. The root cause of this is generally thought to be excessive government regulation…Stagflation in the U.S.A. was defeated by the then Federal Reserve chairman, Paul Volcker, who sharply increased interest rates to reduce money supply from 1979-1983 in what was called a “disinflationary scenario.” Starting in 1983, fiscal stimulus and money supply growth combined to create a sharp economic recovery which is in line with standard macro-economic models; however, there was a five-to-six-year jump in unemployment during the Volcker disinflation. It appears that Volcker trusted unemployment to self-correct and return to its natural rate within a reasonable period, which it did.

Paul/Volcker in 2008!

More on housing not being over yet

2007-10-16T21:03:00.000-05:00

Wow! This is truly astounding. This FT article really is scary. I've been pessimistic about housing and finance companies, but this latest information is truly shocking.

Say goodbye to a couple of homebuilders. Expect the dollar to fall further. Hold on to those oil & gas, gold, and metals stocks.

The financial meltdown ain't over yet!

From the FT:

Big US commercial banks have seen $280bn of new debt come on to their balance sheets since the credit squeeze, threatening to undermine economic growth by inhibiting their ability to make new loans.

The banks have been forced to take on to their books large amounts of commercial paper and leveraged loans after investor demand for such assets dried up in the summer.

David Rosenberg, economist at Merrill Lynch, said that this amount had risen to $280bn since the start of August.

He added that according to data from the Federal Reserve, large bank capital - represented by net assets - had declined by $40bn since the beginning of August. "This has never happened before over such a short timeframe and this is rather serious because such a steep and sudden compression in large-bank capital has the potential to create a negative lending environment," he said.

If left unchecked, this could "significantly inhibit" economic growth, he added.

European banks are facing similar pressures with many observers expressing concern at the ability of some smaller lenders to handle the potential strain on their balance sheets.

Fears over the effect of the credit squeeze on US bank balance sheets was one factor behind the US Treasury's encouragement of the creation of a "super fund" to take on the assets of troubled investment vehicles.

The three top US banks - Citigroup (NYSE:C), JPMorgan Chase and Bank of America - this week unveiled plans for a fund that would buy up to $100bn of mortgage-backed assets from structured investment vehicles.

Citigroup, which manages $80bn of assets in such vehicles, has bought some of the vehicles' commercial paper.

On Monday, Citi said it was suspending share buy-backs because its capital ratios had weakened partly due to the large amount of commercial paper and leveraged loans it had taken on.

According to Moody's, the credit rating agency, assets held by bank-sponsored special investment vehicles fell to $320bn from $395bn in July.

"The large banks have been forced to take commercial paper back on their balance sheets and as a result are choking on assets they did not plan on having - thereby tying up regulatory capital and in turn possibly leading to a reduction in credit extension," said Mr Rosenberg.

He pointed out that 30 per cent of the growth in the debt that US households took on was backed by asset-backed investors.

Why the housing slump isn't over yet

2007-10-15T09:04:00.000-05:00

For years, I bored my friends with talk that housing was in for a downturn. No one believed me, and people urged me to buy in before I was shut out of the market.

Despite the obvious slowdown in housing, I continue to sing the same tune. I've been doing a lot of reading this weekend about the housing market, and I've concluded that we still have a long way to go before housing reaches bottom.

Why? The main reason is that in spite of all the whining and moaning about the housing slowdown, prices haven't come down that much (maybe 10%) and affordability is still very low by historical standards.

Here are some other reasons to be wary of housing:

- There is a ton supply out there (supply is at a record, and 2x its normal rate over the last several years). It has just skyrocketed and it is not going down.

- Affordability for new home buyers is still at lows.

- More people own houses than ever before (meaning fewer buyers out there).

- The Fed will have trouble lowering interest rates in the face of $85 oil and a Euro of 1.42.

- Credit standards are tightening, meaning fewer mortgages and therefore fewer buyers.

- A large amount of ARMs are still resetting, with a tremendous amount due to reset in the second half of 2008. ARM resets are leading to more foreclosures, and therefore even more supply.

- Homebuilders are under enormous pressure with debt coming due and therefore will be willing to dramatically lower their prices.

- The economy seems to be softening, with economists raising the chances of a recession.

- Cap Rates (the income from rents) are still very low, making housing an unattractive investment.

- All of the above is leading to a change in the mentality towards housing. It is going from something people want to own to something to be wary of. This change in attitude towards housing can take a long time to set in and have a tremendously negative effect on pricing.

Frankly, the only bright spot I see in housing is that the weak dollar is leading to more foreign buying of U.S. real estate (in places like New York), but the effect of this buying is minimal compared to the other negatives. I just don't see other positives.

I think owners are stubborn and resistant to lower prices. Therefore, the market is not correcting itself quickly. The slowdown is likely to last several years.

Until Cap Rates are higher than Mortgages Rates (meaning it actually pays to be a landlord), I think the market will continue to head down. Unfortunately, we're not even close to having attractive Cap Rates.

I wouldn't be surprised if a major homebuilder declares bankruptcy in the next 6-12 months. I also wouldn't be surprised if homebuilders and banks start to move to more aggressively clear inventory, which will lead to big price declines.

Recommending UNAM again

2007-10-03T22:19:00.001-05:00

Shhh. Here's a little secret.

There is a stock I've owned for 5 years. It's gone from $4 a share to over $11. And you know what? It's STILL trading under its book value of $11.80.

This company is Unico American Corp. (symbol UNAM), which trades at 10x earnings and generates around 10% ROE. It's kind of like a bond yielding 10%, backed by book value and with upside potential.

UNAM is a California property & casualty insurance company. UNAM is conservatively managed, with very disciplined underwriting. Several quarters ago, UNAM's book value and shares got a boost, as loss estimates were marked down thanks to good underwriting. Here's how UNAM states it: "Despite the increased competition in the property and casualty marketplace, the Company believes that rate adequacy is more important than premium growth and that underwriting profit (net earned premium less losses and loss adjustment expenses and policy acquisition costs) is its primary goal." Now that's the smart way to run an insurance company. So don't be fooled by the declining sales numbers. They are intentional and investor friendly. It's tough not to chase business, but it's the right thing, as UNAM's stock price proves. In addition, UNAM has not chased risky assets like CDOs. Rather they remain conservatively invested in short-term treasury bonds.

Their market cap is under $65 million, yet their latest 10Q shows $146 million in assets (mostly short-term treasuries) and shareholding equity of $64 million (which is the real thing, coming from retained earings, not from goodwill or other funny stuff).

The subprime market fallout caused this stock to move down from $14. However, this stock has absolutely no exposure to the financial crisis. If anything, it will benefit, as there might end up being less competing capital in the insurance markets.

It's hard to find value in today's market. But if you invest in UNAM, you're likely to find true value, again and again.

It's the currency, stupid!

2007-09-27T19:00:00.000-05:00

“Don't worry,” a friend told me this last week. “Bernanke is a very smart man. He's doing a good job. He's a much better economist than Greenspan. He's going to take care of us.”

While my friend is one of the most respected oil analysts in the country, I could not bring myself to feel the same level of confidence as he does. As I lay in bed each night last week, I keep hearing over and over what Ronald Reagan claimed were the 9 most dangerous words in the English: “I'm from the government, and I'm here to help you.”

I'm confident that forthcoming events will cause the public to lose faith in the Fed, but I’m perplexed as to why so many people are still hoping the Fed can save us from a situation they largely created.

What is the situation? Debt. Plain and simple. The U.S. is suffering from excessive debt. Don't believe me? Check out the statistics. Debt-to-GDP levels are at records, debt-to-output is at records, and debt-to-income is dangerously high [What I like about these measures are that they are relative to the size of the economy and therefore take into effect changes in inflation, population, and the like. In other words, with more people and more money, we can support more debt, but we cannot realistically support more debt relative to the size of our economy.] Government debt is reasonable relative to GDP and business balance sheets are strong, but consumer debt is simply too high. The z1 report from the Fed shows the consumer in good shape only because asset values have grown with debt, but if housing prices prove illusory, future z1 reports could reveal a much bleaker reality. The fact that the Fed cannot raise interest rates to 5.25% without slowing the economy indicates clearly that debt is a serious burden.

Furthermore, with all the fancy financial innovations, such as CDOs, CLOs, and
derivatives - not to mention the rise of leveraged hedge funds and private equity firms - our economy might be even more leveraged than stastics show. No wonder the Fed panicked and lowered rates 50 bps - even though major banks reported solid earnings last week.

Why have our debt levels grow so much? While there are undoubtedly many reasons, the simple fact of the matter is that the Fed has kept interest relatively low for 20 years. With the introduction of hedonics and substitution into inflation calculations in the 90s, inflation rates began to come out lower than previous forms of measurement. Measured the same way as in the 1980s, inflation has been way above the Fed Funds rate for a long, long time. To me, that's a clear signal to consumers that it's much better to borrow than save.

If a centralized committee (the Fed) is going to keep short-term rates below inflation rates, it is much smarter financially to borrow and buy assets. Look at housing as one example. Housing prices have gone up over the last nearly two decades while the value of the associated mortgages has gone down. With low real interest rates, it's the savers who are suckers! As John Stewart, who gave one of the best interviews of Alan Greenspan I’ve ever seen, asked “When you lower the interest rate and drive money to the stocks, that lowers the return people get on savings in the bank. So they’ve [the FOMC] made a choice: we would like to favor those who invest in the stock market and not those who invest in a bank…It seems to me that we favor investment but we don’t favor work…there’s this whole other world of hedge funds, short betting – it seems like craps – and they keep saying ‘Don’t worry about it, it’s free markets,”…but it really isn’t. It’s the Fed…It’s about making people believe the system is sound…If the stock market is high, people are confident in spending, and if it lowers, they feel less confident.” Amazing that a comedian came up with one of the better critiques of the Fed I’ve heard in a while.

“But if the economy slows because of the debt burden,” a business associate recently asked, “then wouldn't the economic slowdown reduce aggregate demand and therefore inflation?” That's the theory, and a large basis of Fed policy, but it's misguided. Because it doesn't factor in the currency effect.

In short, the Fed can inject liquidity into the U.S. market and support the U.S. stock market and banks, but it only moves the crisis of confidence from the lower lying banking level to the currency level (as we’ve seen in the past several weeks with the dollar reaching new lows). Bernanke claims that the Fed caused the Great Depression by not flooding the system with liquidity, but few remember that the market was getting ready to make a run on the dollar and the Fed was trying to defend the dollar and faith in the U.S. Back in those days, if you abandoned your currency, there were major consequences. Today, are there no such consequences?

The Fed claims that if inflation rises, they will raise interest rates, thereby reducing aggregate demand, slowing the economy, and eliminating the excesses that are causing capacity constraints and inflation. If the economy slows, the Fed will lower rates, which will have the opposite effect. This Fed model, however, is flawed, because what happens if there is a crisis of confidence, and people start moving money away from the dollar?

If the U.S. experiences a falling currency, the effect can slow the economy AND cause inflation. Just ask anyone who has lived in Argentina, Zimbabwe, or numerous other countries whose governments created more and more money supply to try to rescue their economies. If a country acquires too much debt, other nations (as well as the country's own citizens) can begin to lose faith in the strength of the currency. As the currency begins to sell off, the economy begins to slow. In an attempt to rescue the economy, the government prints more money, but that only causes a further fall in the currency, slower economic growth, and more inflation. While not Argentina, the U.S. is showing similar characteristics, which should - if the inflation of the 1970s is any lesson - be addressed immediately, even if that means a deep but temporary recession.

The risk the Fed is running is that if the world begins to lose faith in the dollar then the Fed is useless. The dollar, and their ability to print more dollars, is the source of the Fed's power. Without that, they will just be a bunch of useless academics. The great market thinker Peter Schiff was on CNBC this weak and he suggested that the Fed should have raised interest rates not lowered them. He made a similar argument as I’m making. He was literally laughed at – by his fellow panelists and by the interviewers. We’ll see who laughs last.

“But no one really knows the cause of inflation from the 1970s,” said my business contact, “There were many psychological components.” My oil analyst friend said something similar: “There is a psychological risk of panic. The Fed was right to lower 50 bps.” While it would be foolish to deny a psychological element to movements in markets, these “moods” are temporary in nature and are only caused by underlying fundamentals. The crash of 1929 could not have occurred without massive debt growth throughout the 1920s. Was it the panic that caused the Great Depression, or the euphoria that led to the excessive debt build up that caused the panic? By 1929, the fundamentals in the economy were weak and prone to collapse. Conversely, with nearly $1 trillion in currency reserves, China is looking very strong. I can't imagine a run on the Chinese currency for “psychological reasons!” It’s almost preposterous to say that. Sure, there could be a run on the dollar for psychological reasons, because people around the world could wake up and see the fundamentals for what they are! So we should focus not on trying to prevent the “psychological panic,” but we should focus on the root sources of weakness in our economy, what caused them, and how we can fix them.

A final point I'd like to make is what I'm calling the debt productivity theory. The theory is quite simple, but if proven to be true, it would have tremendous consequences in terms of how the Fed conducts its monetary policy. The theory surmises that low interest rates are highly beneficial in the short run. They encourage the acquisition of low-cost debt, which provides extra growth and seemingly increases productivity, because more low-cost debt actually reduces a company's or a consumer’s costs. However, when debt levels become too high, and rates must be raised to continue to attract capital, the opposite effect is true. Debt costs go up, and productivity goes down. The implication is that lowering rates might help the economy in the short-term, but it has a strong hangover effect, especially when debt levels are allowed to get too high relative to GDP, output and input.

So when inflation comes, don't buy the “surprise” that officials express. There have been many people warning of the consequences of higher debt for years. It's like the CEO of Countrywide, who claimed the market for housing was great, great, great. He did so for years. Finally when the bubble went pop, he expressed total and utter surprise. Surprise?

According to the New York Times, “In July 2001, Paul McCulley, an economist at Pimco, the giant bond fund, predicted that the Federal Reserve would simply replace one bubble with another. ‘There is room,’ he wrote, ‘for the Fed to create a bubble in housing prices, if necessary, to sustain American hedonism. And I think the Fed has the will to do so, even though political correctness would demand that Mr. Greenspan deny any such thing.’ As Mr. McCulley predicted, interest rate cuts led to soaring home prices, which led in turn not just to a construction boom but to high consumer spending, because homeowners used mortgage refinancing to go deeper into debt. All of this created jobs to make up for those lost when the stock bubble burst. Now the question is what can replace the housing bubble.”

More Oily Thoughts

2007-09-26T07:38:00.000-05:00

My oil post drove record traffic on my blog! Thanks to everyone who visited.

I wanted to follow up with some brief additional thoughts that have been inspired by discussions on my FAVORITE investor board, the FAX board at investorvillage.com.

On that board, there has been a lot of talk about whether oil is experiencing an unsustainable price boom similar to housing, internet stocks, and other past bubbles.

I have argued that the run up in price for oil has been driven by real demand, a demand which is necessitating the addition of supply in the near and immediate terms. Because it is not easy to create additional oil supply quickly, the market is driving prices higher and rewarding those who risk their capital on new, expensive oil projects. The fear is that eventually these high prices will lead to too much euphoria and too much investment in new supply. However, I don't think we're there yet, as the forecast for new mega-projects shows only marginal supply additions coming online over the next several years.

From my point of view, the real issue is demand. Until the central bankers of the world get serious and raise interest rates to reduce demand, high prices should continue to exist, especially given the potential for price spikes because of the limited amount of excess spare capacity. Therefore, I would expect high price to remain in place until we see evidence of inflation in the U.S. CPI numbers and a willingness on the part of the Fed to address this inflation.

Of course, this forecast assumes that the Fed will act aggressively in the event the U.S. economy begins to slow. My belief is that the economy is already slowing significantly and that the Fed will continue to lower rates. Remember, the Fed is a political organization (despite their claims at independence). They are under tremendous pressure to keep the economy out of recession in the short term. During a recession, the pressures to lower rates are enormous, even if inflation is beginning to increase.

Looking a year or two out, sustained high prices might lead to a plethora of new supply projects just as the Fed is being forced by higher inflation to end its 20+ year policy of consistently lower average rates. That would indicate a good time for investors to begin cashing in on their oil investments. Until then, I think oil and natural gas continue to be the best investment to protect against the irresponsible policies of the Fed.

Finally, here is a good piece on the Apache website about how this upcycle in oil is being demand driven:

"During the past 20 years, each region of the world, except Africa, has experienced declines in oil demand. However, there have been only two minor decreases in worldwide oil demand in the same time period: 19,000 barrels per day (Bpd) in 1991 and 141,000 Bpd in 1993.

"Nominal oil prices rose dramatically in the 1970s and early 1980s, contributing to high inflation rates. The chart below shows a spike in oil prices associated with U.S. economic recessions. Those spikes were generally caused by supply disruptions. On an inflation-adjusted basis, current oil prices are still not at the level reached in the early 1980s. The recent rise in prices has been caused by a strong growth in demand rather a supply disruption. Despite a dramatic rise in oil prices, no recession has yet occurred and inflation has remained in check.

"During the past four years, the U.S. dollar has fallen over 30 percent against major currencies. Because oil is priced in U.S. dollars, the rise in oil prices has had a lesser impact on foreign buyers of oil."

http://www.apachecorp.com/Explore/Explore_Features/20070924/Topic_Report_Recessions_and_Global_Oil_Demand/?cid=EMC-newsletter&link=20070925b

On Oil and Natural Gas

2007-09-24T16:45:00.000-05:00

In many previous posts, I have talked about the negative consequences of Federal Reserve policy and the seemingly imminent threat of inflation.

In this post, I'd like to talk about something positive: how to make money from what’s happening in financial markets.

In the world economy, competition for labor and resources is heating up. So far, this competition has been most evident in the price of oil - in large part because oil is so easily transportable and because it is so important to every economy. Oil is not only important for transportation but also for the manufacturing of petrochemicals, which are used for so many purposes.

However, with oil prices having risen from $12 in the late 90s to around $85 today, it is fair to ask: is this just another bubble waiting to pop?

In investing, my preference is always to ignore the "psychology" of the market, to try to understand the fundamentals, and then to set a long-term horizon for my investments (by not being leveraged or overcommitted in any way – in case my trades move against me even as the fundamentals stay in my favor). I believe that over the long term markets are rational (even though they can be highly irrational in the short run, cough, pets.com).

So, what are the fundamentals for oil and natural gas?

Today, according to the International Energy Agency ("IEA"), oil consumption is currently slightly ahead of production. IEA figures estimate demand at 85.9 million barrels a day ("mb/d") and production at 84.6 mb/d.

Despite alternative sources of energy and energy efficiency initiatives, demand for oil has grown tremendously over the last 30 years. In 1980, demand for oil was a little over 60 mb/d. After the 1981 recession, demand sunk just below 60 mb/d, but has since climbed to over 85 mb/d. With emerging economies growing quickly, demand is estimated to continue to grow. According to the U.S. Department of Energy, worldwide production is expected to increase to 98 mb/d by 2015 and 118 mb/d by 2030.

Growth in oil consumption is being driven by strong demand from Latin America, the Middle East & Africa, and Asia. In the early 80s, Latin America consumed around 3 mb/d. Today they are consuming over 5 mb/d. In the early 80s, the Middle East & Africa consumed around 3.5 mb/d. Today they are consuming around 9 mb/d. In the early 80s, Asia consumed around 9 mb/d. Today they are consuming over 18 mb/d.

India's demand alone has grown from under 1 mb/d in the 80s to nearly 3 mb/d today. China's demand has gone from around 1.5 mb/d in the early 90s to around 6 mb/d today. No wonder the U.S. Energy Information Administration expects China's demand to triple by 2030. India and China have over 2 billion citizens combined, versus 300 million for the U.S., yet their combined oil consumption is around 9 mb/d vs 21 mb/d for the U.S.

Another factor driving consumption growth is central bank policy. Money supply worldwide is growing extremely quickly, meaning more consumers have more money to spend, even in spite of higher oil prices. Until central banks launch a serious campaign to raise worldwide interest rates and reduce aggregate demand, oil consumption growth should continue at a rapid pace. Money supply in China is growing around 15% a year. The same is true in India. Even M3 in Europe is growing around 10% a year, and reconstructed M3 in the U.S. is likely growing by similar amounts. Oil-rich countries in the Middle East are experiencing even faster money supply growth.

Although some central banks are starting to show slight concern about inflation, few of them have taken serious steps to reduce their money supply. In the 1970s, it took nearly a decade of inflation for the U.S. Federal Reserve to become serious about fighting inflation. Many pundits and economists expressed surprise at the cause of inflation, despite the conclusion by Milton Friedman that: "Inflation is always and everywhere a monetary phenomenon, in the sense that it cannot occur without a more rapid increase in the quantity of money than in output."

Despite the rapid growth of money supply worldwide, central bankers are hesitant to take the tough and unpopular step of raising interest rates, as evidenced by Bernanke's testimony last week. Ron Paul was lambasting Bernanke, claiming a weak dollar would lead to more imbalances and difficult times. Bernanke essentially responded that as long as core inflation remained contained, a weaker dollar was not a problem. The implication: even if oil prices are high, the Fed will keep interest rates low. Only if workers start demanding higher wages in the U.S. will the Fed take any action.

Although the supply of new oil has just managed to keep up with consumption, excess capacity has fallen. Oil production is very difficult. There are often outages, due to storms, due to technical problems, such as pipeline or refinery issues, and due to political conflicts. Outages are normal for the oil industry and lead to quick, large, yet temporary spikes in price. Because it is known that outages occur so often, the oil industry relies on excess capacity, which is production that can be brought online quickly but which is not currently producing.

During the oil embargo of 1973, excess capacity shrunk to 3 mb/d. During the Iranian revolution of 1979, excess capacity was down to 4 mb/d. During the 1980s, excess capacity climbed up to nearly 11 mb/d. Where is it today? It is estimated to have sunk to around 1 mb/d a couple of years ago, and to be around a little under 3 mb/d today. Given the growth in consumption from 60 mb/d to 85 mb/d, excess capacity is extremely low, even as China, India and others consume more and more. If a political event disrupts the flow of oil now, there is hardly any cushion.

Oil rigs are used to drill for more oil and establish new, producing wells. Rigs counts went from 2,000 in the early 70s to over 6,000 in the late 70s. Following the oil bust of the early 80s, rig counts declined to nearly 1,000 by the late 90s. With the rise in consumption, rig counts have since climbed back to 3,000, but with production declining in many major oil fields around the world (the North Sea, Mexico, and even Saudi Arabia according to some estimates), rig counts may need to go even higher to meet growing demand.

Meanwhile, natural gas prices have diverged significantly from the price of oil. Historically, the price of oil has averaged around 6.2 times the price of natural gas. In other words, if oil is $80 a barrel, natural gas would normally trade at $12.90 per mmcf. Why? Because there is an energy equivalency of 6.2 times between a barrel of oil and a mmcf of natural gas. However, natural gas is not $12.90 per mmcf. Rather it ranges from $6.30 for the forward month contract up to $9.12 for natural gas delivered in the winter of 2009. In other words, natural gas is extremely inexpensive relative to oil by historical standards.

Why? For starters, natural gas is not as easily transporable as oil. Therefore, its price is driven by supply and demand in regional markets. Since Hurricane Katrina, there have been no major outages of natural gas supply in the U.S., there has been increased production (as a result of the high prices after Katrina), and the summer and winters have been mild, resulting in reduced consumption. As a result, natural gas inventory levels are about 13% above their historical averages. If natural gas exceeds storage capacity, producers have no other option than to burn the natural gas. These burn-offs are extremely costly and wasteful.

While the threat of burn-offs is real, especially if this winter is mild, for long term investors natural gas represents a great value. Natural gas is domestically produced in large quantities and doesn't have to be shipped from the Middle East, Venezuela, Nigerian, and other politically sensitive parts of the world. It burns more cleanly than oil and therefore is better for the environment. And now it is significantly less expensive. That's why industry tycoons like T. Boone Pickens have started companies like Clean Energy Fuels, which is producing natural gas to be used to power buses and cars. It may take a long time, but eventually more natural gas and less oil will be used in the United States, until the price ratios come back to around 6.2.

So how can we make money given what is outlined above?

My idea has been to invest mostly in domestic oil and gas producers. They are U.S. companies, with all the transparency and legal protection that comes from owning U.S. companies. Many also have debt in U.S. dollars, which benefits as the dollar falls and oil prices go up.

My favorite stock is Devon Energy (symbol DVN). DVN has first rate management that understands the financial and macro elements of the oil and gas industry, but they are also showing how effectively they can manage their assets by growing production through the drill bit. Production at DVN is increasing around 10% a year, which produces excellent results in times of rising prices. They also get about 60% of their production from natural gas, which means they can benefit if natural gas prices return to their historical ratio with oil. DVN also does a great job of managing their risk. Most of their assets are in steadily producing wells, while a small portion of their assets is in high-risk exploration. DVN recently was upgraded by Moody's because of improvements in the company's leverage and production.

Another company I have bought is Compton Petroleum (symbol CMZ). They have not done well with what has happened to the price of natural gas. CMZ is a Canadian natural gas producer. They have grown their company in a fast, strategic manner. They want to continue to grow in a way where they can manage costs and leverage the development of their highly-effective, efficient production team. While natural gas has performed worse than oil, especially in Canada, I believe this company will do well over the long term, whenever natural gas prices rebound. The only downside is that they are Canadian (no offense to our Canadian brethren, but Canadian companies can oftentimes be less investor friendly and subject to a government that is less business-oriented).

Another company I am considering buying is EOG Resources (symbol EOG). EOG is very conservative and smart. They are not leveraging their company, leaving their options open. They have proven themselves to be very effective in terms of increasing production organically (without acquisitions). Currently they are increasing production by 10 to 12 percent a year. As a conservative, domestic producer with exposure to natural gas, they are well positioned should natural gas prices rise.

I also own Exxon (symbol XOM) because of how well managed they are, and how diligent they are about using their capital only in projects that have compelling returns.

I recently add ConocoPhillips (symbol COP) because of their valuable refining assets, their investment in Lukoil, and because the company seems to be taking steps to restructure and improve their operations. COP has traded at a discount to other majors over the last several years, but their restructuring efforts may provide an extra boost soon.

Another new favorite is InterOil Corporation (symbol IOC). IOC is engaged in the exploration of natural gas and oil in Papua New Guinea. The company is a fully integrated, with upstream, midstream, and downstream assets. Exports should benefit from Asia’s growing appetite for oil and gas. Of note, T. Boone Pickens recently made a large investment in the company.

Why isn’t Clean Energy (symbol CLNE) on the list? Valuation. If it comes down in price dramatically, I’ll definitely add some. I think Pickens is a genius, and I love the idea of using natural gas to power buses and cars. Even with CLNE’s growth prospects, though, it seems overvalued.

Other oil and natural gas companies aren’t as highly priced as CLNE, but they aren’t exactly cheap. By historical standards, oil and natural gas companies are highly valued relative to their book values. However, given the irresponsible actions of the worlds' central bankers, the increasing demand/supply imbalance in oil, and the divergence in the price of natural gas, I will continue to buy high quality oil and gas companies on dips in their stock prices. I'm not buying today, but if prices pull back 10% or so, I'll start adding more to my already significant positions.

The Zentay Cycle

2007-09-19T15:17:00.000-05:00

Having been born in the early 1970s, I remember coming of age politically to two important lessons. We will never forget, I heard pundits, politicians, and academics sayings, that:

1) The U.S. should not engage in any military action that is not definable and achievable;
2) Inflation should be contained at an early stage, no matter what the cost.

As such, it is with great disappointment that the two unforgettable lessons of my early childhood have seemingly been forgotten, and I haven’t even turned 35. Sidestepping the politics of the war, I’d like to focus on inflation. I’d like to explore why we have abandoned our previous caution and why the later part of this decade threatens to look a lot like the late 1970s.

As my good friend, Michael Nystrom, and I were discussing today, one of the biggest problems – and most frustrating problems – that America faces is that so few people see or care about how credit & money supply growth are creating imbalances in our economy. Because so few people care about monetary policy and economics, pundits, politicians, and academics take advantage of peoples’ ignorance to point them at the wrong causes of the problem (except, of course, Ron Paul, who’s a brave politician who points out the importance of strong money). Backing up and taking a more generalized view, we can see the cycle of money supply growth and inflation in action. The model I have developed for this purpose is the Zentay Cycle (a very modest name indeed). As many readers may recognize, this cycle owns a great debt to the Kondratieff Cycle, after which it is modeled. The difference, or rather extension of the Kondratieff Cycle, is that the Zentay Cycle seeks to bring in politicians and bankers and explain their participation and reactions within the various seasons of the cycle.

Spring of the Cycle – This is the season in which I came of age, from around 1984 to 1992. The Spring is the most intellectually pure stage of the cycle. The harsh Winter of higher interest rates and economic recession has passed (Volcker raising interest rates and forcing the 1980-81 recession), but society remembers the lessons from persistently high inflation. Central bankers are conservative and are supported in their calls for interest rates high enough to fight off inflation. Bankers and investors agree with central bankers. Bond vigilantes sell long-term bonds at any hint of inflation or whenever central bankers appear to be less conservative than is necessary. High interest rates from the Winter have left the consumer landscape with low levels of debt. Politicians may try to raise taxes or increase spending, but they only have limited success, as central bankers and pundits claim that higher taxes will slow economic growth and increased spending will cause inflationary deficits. Gradually, the high government debt levels from the Winter come down somewhat. At the start of the Spring, businesses have high debt levels and low price-earnings ratios. They begin to reduce their debt levels over time. Average interest rates begin to move lower, as the fear of hyperinflation recedes. Shockwaves of fear appear from time to time (such as 1987 and 1991), but in general the Spring is an improvement from the Winter. Central bankers are respected and increasingly well regarded. Politicians are neither popular nor unpopular. Bankers are moderately successful. Average citizens do okay, not great.

Summer of the Cycle – This is the happiest time of the cycle, from around 1993 to early 2000. The shockwaves of fear dissipate. Average interest rates come down more, government debt levels are contained, and economic growth accelerates, creating a wealth effect throughout many levels of society. The more wealth is created, the less conservative participants become. With economic growth, consumer and businesses are more willing to add debt. The debt and credit creation adds more growth and the perception of productivity gains. These productivity gains allow central bankers to relax their conservative stance towards interest rates. Lower interest rates lead to lower costs of capital, the perception of even more productivity gains, and more debt and credit creation, with all the ensuing short-term benefits. Faster economic growth leads to government surpluses. Businesses do very well, keep debt levels reduced, and see their price-earnings ratios expand. Central bankers and politicians are wildly popular. Bankers are successful. Average citizens do well. Class tensions ease. Everyone is generally happy.

Fall of the Cycle – This is the time when problems in the cycle begin to emerge, from around mid-2000 until 2007. A recession or market crash creates a slowdown in economic growth and aggregate demand. Central bankers, less conservative because of their success and popularity in the Summer, lower interest rates to “save” the economy. Debt, credit, and money supply increase even more dramatically, which temporarily leads to a mini-summer and the perception that nothing is wrong. However, productivity levels begin to decline as the burden of debt leads to systemic imbalances. Mild hints of capacity constraints and inflation appear from time to time. As the mini-summer begins to fade, more serious problems emerge. Politicians are increasingly unpopular. Businesses add more leverage, oftentimes through innovative and off-balance-sheet mechanisms. Bankers continue to be successful through increased leverage, but average citizens struggle. Class tensions begin to escalate towards the end of the cycle. Skepticism towards leaders and centralized institutions is rampant.

Winter of the Cycle – In an effort to prevent the onset of Winter, central bankers try to lower rates dramatically, and begin to do whatever they can to create more credit and money supply, but economic problems remain. Politicians, unsatisfied with the results from the central bankers’ actions, call for more government spending and government-induced demand-side solutions. Central bankers continue to call for restrained spending by politicians, but central bankers are less and less popular and lose credibility. Taxes are increased to cover the expenses of government programs. Productivity falls. Inflation begins to increase persistently as capacity constraints spread and demand-side solutions exacerbate these constraints. Pundits wonder at the cause of inflation and many short-term solutions are proposed with little success. Economic growth flounders and unemployment increases. Bankers lose money as confidence in the financial sector falls and long-term interest rates rise. Businesses and banks suffer from lower economic growth and the higher leverage incurred during the Fall. Bankers, too, turn on central bankers. Class tensions are high as different parts of society fight over the validity of different government-sponsored solutions. The Winter is long and hard. Exhausted by the duration of the Winter and already wildly unpopular, central bankers come to the realization that the only way to end the Winter is the opposite of their past solutions. Rather than creating more credit and money supply, they seek to dramatically reduce credit and money supply. Interest rates go up significantly, economic recession is harsh, citizens suffer, businesses and banks are hurt, but the end of inflation and Winter is achieved.

If the Zentay Cycle is in fact correct, I believe we are at the cusp of generating higher inflation. Productivity gains from the Summer are fading, credit and debt levels are too high, central bankers are beginning to try very hard to increase liquidity, and politicians are starting to talk about demand-side solutions. However, employment levels are already high, capacity utilization is high, and other parts of the economy show little excess capacity. Certainly housing is in decline and has excess capacity, but housing seems to be the exception rather than the rule. For example, more oil is being consumed worldwide than produced. Fertilizer companies are reporting significant demand and an inability to meet some customers’ orders. Hotels are often full and prices are going up. Airlines are operating near full capacity and starting to raise rates for the first time in many, many years. The important core-driver of unit labor costs is now increasing 5% a year. In other words, economic volatility is NOT reducing costs.

Unfortunately, those in power have not seemed to have learned the lessons of the past. The late 2000s is unlikely to be identical to the late 1970s. “History,” Mark Twain said, “doesn’t repeat itself, but it does rhyme.”

New stock recommendation

2007-07-19T15:31:00.000-05:00

I'm recommending QNTA at $2.71.

QNTA is very similar to a play I made last year called PXRE, which did very well. QNTA is trading at an even lower valuation than PXRE was. It is trading just around 0.5x book value.

QNTA is an insurance company that had a lot of exposure to Katrina. Most of the operation is now being run off. Run off is when they are not writing new insurance, but just winding down their positions. What happens in run off is that they own bonds and then have liabilities associated with their contracts for insurance. They pay what is needed on these insurance contacts (losses) and take it out of their bond holdings. The hope is that they have correctly estimated the losses and that therefore their book value stays as stated. If the losses are greater, then they can eat through their bonds (and therefore book value) more than they thought.

The same part of their operation that remains is expanding rapidly.

They are also tendering their outstanding preferreds shares. That indicates to me that they think they have enough bonds/cash to pay these and still be able to meet their insurance loss needs over the long term. That is a big positive, especially for the preferreds, which yield over 10% a face value and are trading at a discount to that. I highly recommend the preferreds, QNTAP.

I'm not sure what their ongoing hurricane exposure is for future hurricanes, since they are winding down their operations. I have enough plays (Nat Gas: CMZ, DVN) that would tremendously benefit from a new hurricane, so I feel I can take this risk. There is also a shareholder lawsuit, which might pose some risk.

A value guy named Klarman whose funds have been returning 20% in spite of his being 50% in cash bought a lot of QNTA at a slightly higher price.

Despite the risks, I really like this value play. It's usually good if you can buy at a lower price than Klarman!

The subprime mess and the Fed

2007-07-18T08:24:00.000-05:00

Why look for complexity when there is simplicity?

If you want to see some great analysis, read this piece:

http://www.fpafunds.com/news_070703_absense_of_fear.asp

In it, you will see facts - simple facts about how simple what happened and is happening is.
Here are some obvious ones:

"Since 1965, the median dollar volume of single-family homes sales as a percentage of nominal GDP has averaged 8.4% versus 16.3% at the 2005 peak."

"between 1998 and 2006, with the major changes occurring in the last two or three years: ARM % of originations rose from 0.7% to 69.5% Negative Amortization rose from 0% to 42.2% Interest Only rose from 0.1% to 35.6% Silent Seconds rose from 0.1% to 38.7% Low Documentation rose from 57% to 79.8%"

AND TO THINK MOODY'S AND S&P WERE USING HISTORICAL DEFAULT MODELS. WHY USE HISTORICAL MODELS IF YOU ARE EXPERIENCING NON-HISTORICAL LENDING PATTERNS? OUTRAGEOUS!

What is wrong? Well, everyone wanted the rating agencies to rate everything highly; otherwise it wouldn't sell! So everyone agreed to look the other way.

It's as if the authorities have been sitting in a casino for years and now declare that they are shocked that gambling is occuring.

Put simply, there was massive overlending by the banks aided and abetted by the Fed. Now the major banks are starting to complain, because they run the risk of losing a huge amount of money, because they overlent in a risky environment. Thankfully, there are plenty of structures within the system (like Moody's and S&P) that allow them to lay the blame elsewhere and cry out that systemic risk is upon us and contagion may happen.

Why look for complexity? Bernanke is starting to doubt his inflation forecasting models and he is talking about academic concepts (like the "sacrifice ratio") as a way of preparing for interest rates cuts, even in the face of the continued threat of inflation and a plummeting dollar.

As The "Great" Mogambu Guru writes:

"For an example of more academic crap, he [Bernanke] said that the Fed uses the 'sacrifice ratio' in policy deliberations, which is an academic concept that the Federal Reserve uses to justify never raising interest rates. Essentially, the sacrifice ratio (according to investopedia.com) is 'An economic ratio that measures the costs associated with slowing down economic output to change inflationary trends. The ratio is calculated by taking the cost of lost production and dividing it by the percentage change in inflation.'

"The rationale is provided when we learn that, 'If inflation is becoming a problem, central banks will try to cool economic growth in a bid to reduce inflationary pressures. However, this reduction in output costs the economy in the short term, and the sacrifice ratio tries to measure that cost.' Hahaha! Attempting to measure pain, as if it is just a matter of using a few constants in a few equations! Hahaha!

"The funny part - as in 'I can't believe I am hearing this crap!' - was when he announced that the Phillip's Curve was dead, and then repeatedly used it to show how inflation would come down! Hahaha! Too, too much!"

In my opinion, to help his friends at the big banks means overthrowing the important inflation lessons we learned in the 70s. To do so, Bernanke must academically define a new paradigm to justify his irresponsible actions. Why, he will aruge, fight inflation if it means a painful recession? Of course, it was the Fed who created the threat of inflation in the first place, by irresponsibly creating massive money supply growth!

The Fed is a political organization. Bernanke is a politician. If you look at him through the complex eyes of an economist you will miss the point. The point is that the power structures are putting political pressure on him to lower interest rates and he is shifting the academic landscape to accomodate them.

Simple.

None of this is good for the dollar nor the long-term inflation outlook, but it is good for bankers and their bonuses. The questions are "have the bankers learned their lesson? Or will they continue to overlend?"

And as a bonus, here is another great article that debunks the current myth of a goldilocks economy:

http://www.safehaven.com/article-7977.htm

Fore! ALDA drives value

2007-06-18T09:28:00.000-05:00

Imagine a company with an $85-million-dollar market cap, with $18 million in unrestricted cash, $44 million in total working capital, $51 million in total stockholder equity and which generates about $11 million in earnings a year. It trades just above 1 times sales, 8 times earnings, and yields just under 4%. In addition, this company has increased sales from under $38 million in 2003 to over $72 million in 2006.

Sound too good to be true? It’s not.

The company is ALDA, manufacturer of golf club shafts.

The reason I believe that ALDA is trading at such a low valuation is because of its performance in the 1990s. The company went public in 1993 and closed its first day of trading at $28.38 (adjusted). Today, the stock trades around $15. According to the company’s SEC filings: “During the 1990’s, the graphite golf shaft industry became increasingly competitive, placing extraordinary pressure on the selling prices of the Company’s golf shafts and adversely affecting its gross profit margins and level of profitability. The Company’s average selling price decreased by 64% from December 31, 1990 through December 31, 2002. The pressure was mainly attributed to the increased competition for OEM production shafts, and a shift of our customers away from branded shafts to customized OEM production shafts.”

However, in 2002 ALDA began to change course. And the stock has recovered from around $1.50 a share. Again, according to the company’s SEC filings: “The Company’s response to the pricing pressure it faced during the 1990’s, and continues to face in the OEM production shaft segment, has been to vertically integrate, reduce its cost structure and to focus on continued penetration of the branded and co-branded shaft segments.”

In addition, ALDA opened factories abroad: “the Company also reduced its cost structure by shifting more of its shaft production to lower cost labor markets, such as Mexico, China and in 2007, Vietnam.”

It also became trendy again: “Beginning in 2003, the Company was able to achieve higher average selling prices as it enjoyed increasing success in the branded segment of the business…The introduction of co-branded shafts and the continued success in the branded segment had the effect of increasing the Company’s average selling prices over the last few years. The Company’s average selling price increased by approximately 70% for the year ended December 31, 2006 as compared to the comparable period in 2002.”

In 2006 and 2007, the company has driven ahead: “The Company has re-emerged over the past couple of years as an innovator in the branded segment of the business, in which shafts tend to sell at higher prices and gross margins than the customized OEM production shafts sold to club manufacturers...In 2006, PGA Tour, LPGA Tour and Nationwide Tour professionals using Aldila NV TM or VS Proto TM shafts in their clubs have won a total of 32 Tour events. The Aldila VS Proto TM and NV TM Hybrid shafts combined have been the number one hybrid shafts at every event this year on the PGA Tour, according to the Darrell Survey Company. In addition, Aldila Hybrid shafts won the Annual Golf Magazine Club Test for 2006. Forty club testers evaluated hybrid clubs for Golf Magazine and clubs featuring Aldila Hybrid shafts received the highest rating in every category for hybrid clubs. Overall the Aldila shafts helped give the testers the best feel, playability, forgiveness and distance with their hybrids compared to the competition. As the 2007 PGA Tour has began, Aldila was once again the leading shaft manufacturer represented at the Mercedes Championship, winning both the wood and hybrid shaft count.”

Given the valuation, it seems as if all this cost reduction and sales improvement is available to investors for next to nothing!

If the trendiness continues, there’s only one thing to say: Fore!

Outlook and portfolio

2007-06-01T20:42:00.000-05:00

Outlook (more to come in subsequent posts)

1) Continued high economic growth from abroad.
2) Strong sectors of the U.S. economy (manufacturing, corporate profits, etc.), but a generally slowing economy, driven by a slow housing market and moderate consumption.
3) Increasing inflation, especially in commodities as supply issues emerge (higher oil - maybe even over $80; higher food prices; higher metals prices).
4) Increasing long-term interest rates, lead by U.S. rates.
5) Possible continued upside to stocks, but limited by increasing risks as the economy slows and interest rates move higher.
6) A dollar that is generally steady, supported by higher rates, but weighed down by weak fundamentals.

Portfolio

$11.80 UNAM (good value, great management, they should benefit from higher rates)
$13.47 NAHC (good value, they should benefit from higher rates)
$18.47 USS (tight Jones Act market, tight refining market)
$19.55 DAL (good valuation because of non-investment-bank-sponsored IPO)
$26.33 NWA (good valuation because of non-investment-bank-sponsored IPO)
$27.68 PFE (cash cow)
$56.94 AMGN (cash generator and free research department thrown in)
$27.50 HELE (great value and management)
$41.61 NEM (benefits from higher gold)
$77.67 DVN (supply issues with oil)
$15.41 ALDA (value, small position)
$5.80 JRC (value, small position)

$30.50 Short GM (already bankrupt if you look into their balance sheet
$108.02 SPG (way overvalued)
$54.51 C (suffers under higher rates)
$230.71 GS (suffers under higher rates)

I have some other stocks here and there, but that's the essence of the portfolio.

Some of my stocks (DAL, NWA, HELE, ALDA) would not do well in a recession. But I'm not trying to win under one and only one economic scenario. I'm trying to construct a portfolio that wins in ANY scenario, and trying to pick better values and better companies, with a slight bias to my macro outlook.

More thoughts on GM's demise

2007-06-01T19:48:00.000-05:00

GM currently has $20 billion in cash. But it CURRENTLY owes its dealers about $10 billion in rebates, it has taken $10 billion in cash from rental car companies for fleet sales but it hasn't delivered the product yet (meaning it will incur costs but get no cash for this effort), and it owes its suppliers $30 billion. Add onto that nearly $5 billion in short-term debt, $33 billion in long-term debt, and health care liabilities of around $49 billion (I agree, pensions are fully funded at this point-in-time).

So even if I were to buy the argument that GM is well on its way to profitability (which I don't think it is), where does it come up with the money to pay what it CURRENTLY owes????

Please answer me this!!!!!!!!

This is the essence of my argument. I'm not arguing whether June sales will be good or bad. Who knows? I'm arguing that even if June sales are good, this company is TOAST.

GM knows what I'm saying. That's why they are issuing debt against the equity value of their GMAC shares, that's why the are actively selling their Allison transmission plant (even though it generates EBIT of nearly $600 million a year, that is why they are pulling cash out of their pensions.

So, tell me, where does the money come from to pay what they ALREADY owe????

An e-mail from one of my readers

2007-05-31T19:59:00.001-05:00

Thanks for your reply, and it is Medford Oregon, Rogue Valley, you may have heard of us, we and four other counties recently declared a financial emergency and they closed the library system in April for good. Josephine County just closed their library system AND terminated all deputy patrols in the county, as well as emptying out all but 30 of the 140 county jail beds (these were not characters like Otis the drunk in Mayberry either; at least half were violent criminals that got county jail time rather than state prison as part of their plea deals) and they also fired all the deputy DA's and the DA's entire staff, he will effectively be doing no more prosecutions except for the must violent should a criminal actually be caught. Search and rescue functions will now be done only by "private donation." Curry County is so hard up they are planning to dissolve the county and glom onto Josephine County; how hard up do you have to be to want to join a county with no Sheriff's patrols nor DA staff? The Sheriff in Josephine County says if funds are not forthcoming by next March he will simply open the jail cells and shutter his office for good. Needless to say half the county employees have been pink-slipped and there is no more road repairs or park maintenance. They have been passing out over 600 concealed weapons permits a month since the population will now be fending for themselves in a region noted for drugs and drug related crime.

THAT is the reality in my America today; trillions and TRILLIONS in circulation rounding the globe daily and finding their way into the boardrooms of corporate "players," but the hoi poloi, we mere citizens are being left to just die in the sticks. I know that had I been one of the witnesses against any of the 110 newly freed criminals I would be VERY worried right now.

Oddly, we now have reached the point of income and net worth inequality where it is fair to say we have TWO societies, or classes, one is that which is represented by CNBC, an imperial never never land that has it's own blindingly bright new reality in which millionaire is nothing, you ain't nobody till you are a billionaire; and the rest of us who like in the 1930's are "forgotten." The ones that still get $900 a month to keep them out of poverty such as my mother had when she was alive on her SSI. These people that depend on the "middle" class as if we still had one (they are just the better off poor compared to the new UBERAMERICANOS) and government services to get by. The disparity between rich and the rest has become such a wide gulf that they are rapidly losing all incentive to do anything but to just survive.

As to GM peddling it's liabilities to the taxpayers, well if the taxpayers have a trillion or so to blow on a faux war in Iraq they can damned well pick up the tab for pensions and healthcare for GM workers, we agree that it is the only way GM will stay and American icon. The union will make concessions but not enough to save the company, they cannot. From my point of view any lessening of liability is an increase to assets, and the government has no business giving assets to a private corporation to benefit stockholders and corporate officers that are already GROSSLY overpaid for delivering one insane policy after the next.

We are on borrowed time Charlie. It is September 1929 all over again.

Why is common sense considered so radical?

2007-05-31T12:33:00.001-05:00

http://dailypaul.com/node/213

Ok class let's review why GM is going bankrupt

2007-05-30T18:36:00.000-05:00

Has anyone looked at their balance sheet lately???

Ok class. Let's review.

As of March 31st, they had cash of around $21 billion. They had receivables of around $10 billion. BUT they had accounts payable of $30 billion and accrued expenses of $34.5 billion. OUCH!!!!

They have some other current assets (inventories, equipment on lease) but when you add up all the current assets it's still over $5 billion LESS than the current liabilities.In addition, they have $33 billion in long-term debt, $49 billion in post-retirement benefits, and $11 billion in pension liabilities.

One of the only things this organization seems to have as a positive asset is deferred income taxes (a total of over $44 billion). But even with that, they still have a NEGATIVE SHAREHOLDER EQUITY of over $4 billion!!!!

GM has just issued a secured loan against one of their last unleveraged assets (their equity in GMAC). It may take a year. It may take two or three. But as far as I'm concerned they are already bankrupt. Just read their balance sheet, and weep.

GM has spent the last two decades selling anything that made money: Hughes, EDS, GMAC. Yet they have emerged from this sales process with even more debt.

Now all that remains is their car business which is losing market share and probably has further to fall.

Don't get me wrong. There are many positives to GM. It is expanding internationally, it benefits from a weak dollar, Bob Lutz is unleashing creative talent, and GM may achieve success in its negotiations with the UAW later this year.

However, all these positives are too little too late. This bureaucratic, old-school company has not moved fast enough, and now it cannot escape that juggernaut, that reality: its balance sheet.

On the negative side, GM faces more write-downs from Delphi, possible further restructuring costs and losses, and its expenses and payables coming due. Furthermore, there is increasing likelihood the U.S. economy could remain slow or even contract a little. This situation is likely to force GM to seek even more debt financing, but given that they are out of assets to secure, who will lend more money to this Frankenstein monster? I doubt any banks will step in.

Chrysler, which had some unsecured assets left, was essentially given away to Cerberus. GM, on the other hand, still has $17 billion in market cap at today's stock price of $30 a share. GM has had a nice bounce up, but it seems like a dead man's bounce. I doubt even private equity can save GM now.

Two options positions I have

2007-05-28T15:31:00.000-05:00

I've decided to add some of my "positions" to my blog, instead of simply talking about macroeconomic trends and monetary policy. I'll probably start doing more and more posts like this one in the future.

For now, here's just a quick look at two positions I have (note, on this date GM is at $30.49 and DAL is at $18.76). Any thoughts (positive or negative) are greatly appreciated.

I have a lot of LEAP puts on GM and a lot of LEAP calls on DAL.

I think GM is going bankrupt, and the only thing that could save them would be private equity making a stupid bid, but interest rates likely to go up and with bank lenders becoming more cautious, I think the negatives of GM will start to emerge again. The other potential risk (if you're in puts) is that the UAW agrees to take the health care liabilities from GM, but frankly I don't think they'll do that without a big fight.

On DAL, they just came out of bankruptcy, which is basically like an IPO without any investment bank or any type of sales & marketing channel pumping up the stock. So you get to buy the stock at what the court thinks is a fair valuation. Only several weeks and months later does Wall Street start covering it again, and often times not for a while after that because the companies are well capitalized and they don't need any products nor services from Wall Street. Look at what happened to the stocks of United and Winn Dixie when they came out of bankruptcy. I'm wondering if DAL will have the same tick up, especially if the airline industry remains strong. The economy and fuel prices would seem to be the big risks here.

To my hedge fund friend

2007-05-22T21:08:00.001-05:00

Here's what I wrote to my hedge fund friend who thinks that everything is hunky dorry. We'll see if he write me back:

Regarding inflation, if we are in a prolonged period in which commodity inflation should, has, and will outstrip core inflation, is core inflation really meaningful? The reason that everyone points to core inflation, I believe, is because of the experience in the 70s when labor inflation signaled the core of inflation. But aren't we in a different time, characterized by global labor forces and global commodity demand, when the real signal of core inflation is commodities, in my view then lagged by workforce inflation? Could it be that people are having trouble seeing a new paradigm, wherein the core of inflation is the inverse of our previsious experience? Those who rely on rear-view investing will miss this new paradigm and all its significance.

Those who benefit from leverage - hedge funds, banks, private equity, even the Fed and the government to some extent - will, undoubtedly, have an emotionally negative reaction to the above statements. Those who are open-minded and erudite might pause to think.

Let's be clear

2007-05-16T05:16:00.000-05:00

- Consumer is overleveraged and hurting.
- Economy is slowing.
- Inflation is a threat, especially Ag & Energy inflation.
- There is some financial innoviation going on, but there is also a LOT of overleveraging and overlending.
- After the subprime scare, rating agencies are stepping up their game and becoming more strict.
- The LBO/Private Equity game is driving stocks higher.
- Earnings reports remain strong outside of stocks tied directly to consumers.
- Federal tax receipts are high and the deficit is declining.

What does this all mean?

As always, it's hard too tell. Certainly, there is a lot of yield chasing, and in the long term, I don't think it will pay off. As Buffett says, it's easier to get leverage than to get rid of it.

There is too much rearview-mirror investing going on here.

The future will be different than the immediate past.

My guess is that eventually (who knows when!) the LBO bubble will pop. Maybe the slowing economy will cause it to do so. Greenspan saying there is a 1 in 3 chance of a recession probably means he really believes there is a 2 in 3 chance. It would be irresponible for him to scare the markets, but he also wants to cover his ass.

If the economy slows, default rates will rise, which is scary given how tight spreads are and how much junk debt is being issued. But a lot of the debt is long term, so that should provide some cushion. The bigger threat is that of new lending being shut off, which is what is happening in the subprime market.

Personally, I think we're in the beginning stages of less liquidity and we should prepare as such, moving to higher quality names with longer maturities. I'm getting out of my more speculative bets and becoming more conservative. I'm happy to wait it out. My fear is the the Fed goes crazy with turning on the liquidity, which decreases the dollar's value and inflation, but it's hard to play both side of the fence.

Our community

2007-04-22T13:56:00.000-05:00

I recently wrote someone about our community, and what I think it is. Here is what I wrote:

“Currencies do not float, they sink at different rates.” – blog comment

“By the end of this bull market in commodities, there will be a bounty on caribou, you will be able to see an oil rig from every beach and they will be digging a copper mine in Barbra Streisand’s yard.” – speech posted on a blog

“The holder of a government bond or of a bank deposit created by paper reserves believes that he has a valid claim on a real asset. But the fact is that there are now more claims outstanding than real assets. The law of supply and demand is not to be conned. As the supply of money (of claims) increases relative to the supply of tangible assets in the economy, prices must eventually rise.” – Alan Greenspan, 1967

Our community is especially relevant now that the dollar is approaching all time lows. Our community is about the growing trend of blogging and the sharing of information in a decentralized manner to form virtual communities. I think the overarching theme is how the Internet can lead to the empowerment of new ideas that challenge traditional power structures, even in the financial markets.

The basic gyst is that there is a whole community on the web that has lost faith in the Federal Reserve and has a very alternative and interesting viewpoint on our monetary system and its shortcomings. Collectively, this community has assembled a lot of data on what is wrong with our current monetary system and what can be done about it. While not accepted in the mainstream, the community continues to grow and gain converts. With slow economic growth and rising inflation, more and more investors and readers are turning to this community to seek advice. Personally, I’ve based a lot of my own investment selections on this community’s viewpoints, and I’ve made 15% a year for 6 years in a row now, without a single down year. Also, some mainstream voices are coming around to the same viewpoint as the community. On March 29th, William Rhodes, senior vice-president of Citigroup, wrote an op-ed in the Financial Times, which sounded just like the warnings from the community members. He wrote that “much of the good news has come as a result of extraordinary levels of liquidity pouring into opportunities around the globe. To a large extent this is due to the Federal Reserve's expansionary monetary policies early in the decade and the US administration's fiscal stimulus…pockets of excess are becoming harder to ignore…liquidity will recede and a number of problems will surface.”

The community is made up of a variety of websites and blogs. The websites are made up off articles sent in by independent writers, which are reviewed, edited, and posted. In other words, the websites are kind of a nexus, which then link out into individuals’ blogs.

There are many theories in the community, but one main theme is that the Federal Reserve has been injecting too much liquidity into the financial system for several decades now, and the current rise in inflation (with much more to come) is the result of this policy. In the 1990s, as the end of the Cold War created a massive global labor market, the effects of the liquidity increases were masked by the disinflationary effects of cheap labor. However, as China, India, and other emerging markets have become saturated with U.S. dollar reserves, and as their internal consumer markets begin to grow faster than U.S. markets, this disinflationary effect is reversing itself and becoming inflationary.

At the same time, the U.S. financial system has become addicted to liquidity. From consumers to hedge funds to the U.S. government itself, we need the continued supply of cheap money to keep up the momentum of our economy. The result: even as inflationary forces are taking hold in emerging markets, the Fed cannot easily raise interest rates to fight this inflation because of the leveraged nature of the U.S. economy. The problem is not, however, easy to solve, because its origins line many years back, when Greenspan was keeping rates low (despite fast liquidity growth) and encouraging U.S. indebtedness, rather than taking advantage of the disinflationary trends of the 90s to prepare for a more balanced future with higher savings levels for our aging population.

At present, the Fed is in the uncomfortable position of witnessing slowing growth in the U.S. (as higher short-term U.S. interest rates slow down the housing market), higher commodity prices as worldwide growth and demand continue at a fast pace (China’s economy grew 11%), and a weaker U.S. dollar (the U.S. dollar index is nearing its all-time low versus a basket of other currencies). If the Fed lowers rates to help the U.S. economy, the dollar will continue its slide and inflation will only become more of a problem. If the Fed raises rates to stop inflation, the U.S. economy is likely to go into a recession. Therefore, the Fed is keeping rates steady, and yet the problem continues; liquidity continues to grow. Here are the latest liquidity growth estimates from one member of the community:

US reconstructed M3: up 11 percent
Euro zone M3: up 10.0 per cent
United Kingdom M4: up 13 per cent
India M3: up 20.3 per cent
China M2: up 17.2 per cent
Australia: up 12.7 per cent
South Korea M3: up 11.3 per cent
New Zealand: up 18 per cent
Australia M3: up 13 per cent
Japan M3: up 6 per cent
Russia M2: up 49 per cent

The more cynical members of the community believe that the Fed and the banks are both to blame. They believe it should be the bankers (not the robbers of the banks) who should be wearing the masks. In other words, the bankers take your money at 5.25%, then overlend at 8.25%, and to keep default rates low, they encourage the Fed to keep liquidity high to avoid systemic risk. The problem is that because the Fed is constantly assuring the banks that they will help avoid systemic risk, the more savy banks, hedge funds, and LBO firms leverage themselves even more, because they know the Fed will come to their rescue with more liquidity to avoid “contagion.” The result is a moral hazard, with more and more leverage and more and more debt coming into the system. This increasing liquidity leads to a weak U.S. dollar.

What investor, the cynics ask, should put money into a bank at 5% in a currency that is falling 5% to 10% a year? They continually point to statistics that show the declining purchasing power of the U.S. dollar vs oil, gold, housing, etc. They also show graphs highlighting how the U.S. market indexes are rising in U.S. dollars, but they are actually falling when priced in gold, oil, or foreign currencies. In other words, the only thing that is pushing up the markets is the falling dollar! The money you make on the market actually doesn’t help you buy anything more than when you put it in the market (that is, if you’re like me and you’re buying gasoline, housing, food, education, health care, etc.). These cynics think the hedge fund industry is overrated, with the average hedge fund (after fees, taxes, etc.) earning less than the amount by which the U.S. dollar is declining, so again, you as an investor are actually losing money in adjusted terms, yet the managers of the fund are making millions off 2/20 fee structures to lose you money!

If that's the case, I'd guess you'd have to call me a cynic, too!

Below are links to some of the websites and blogs. Below the links, I've included some of my favorite quotes I’ve picked up from some of these sites.

www.safehaven.com
www.depression2.com
www.bullnotbull.com
www.financialsense.com
www.biiwii.com
http://www1.investorvillage.com/smbd.asp?mb=4380&clear=1&pt=m
http://globaleconomicanalysis.blogspot.com/

Favorite Quotes:

“"I've read hundreds of articles over the last few years and everyone keeps using the US dollar as a unit of measure. The US dollar is an idea, an abstract figment of the imagination. Of course inflation of THE DOLLAR is possible, because it inherently has no value. However, look at the stock market in terms of lumber, nickle, gold, silver, steak sandwiches, palladium, real estate, or ANYTHING and you will see a picture of brutal deflation. It's amazing that so many economists overlook the fact that VALUE and TRADABLE WORTH are deflating rapidly even as assets appear to be rising. Or even simpler, assets and incomes are not rising faster than WORTH and VALUE are diminishing. This is why people are turning to more and more credit. The FED can inflate Federal Reserve Notes but it can't stop value and worth from deflating unless capital goods production in the US increases. So economists need to stop looking at the inflation/deflating debate in terms of dollars. We can all be millionaires, but if a loaf of bread cost $1,600 then we will still be drowning in MASSIVE DEFLATION. DEFLATION of our WORTH and VALUE. It's all relative. Stock charts when compared to ANYTHING but the dollar are all deflating rapidly.....and show a downslope crash into the abyss. Someone has to be pretty naive to think the stock market has been going up for the past few years.....look at the markets in terms of gold and silver if you don't believe me!! Keep up the debate.”

"the first thing that troubles me over this question is that the common man's (and i speak as someone who grew up in a time when debt was something to be feared and avoided so i am a man 'out of his time') understanding of the issue is clouded by his real world experience of how he must run his own economic affairs. bankers used to be the policeman on the corner safeguarding the children. now they're more like the drug pushers on a very different street corner, there to tempt the weak and gullible. now there isnt even caution in the breeze. lets hope the wind doesnt pick up."

"Human beings adapt best to downward changes in living standards when they come gradually.”

"Michael Phoenix at livecharts.so.uk writes: A few years ago I started to do some digging around the Fed as my distrust in the fight against inflation had become too strong to ignore. I found the very words I needed in the transcripts of a FOMC meeting. It's on page 82. You will note the remark is followed by laughter, I kid you not. So I went and looked at page 82 of the transcript of the meeting of the Federal Open Market Committee, dated August 22, 2000, which was almost seven years ago, and realize that Mr. Phoenix is right, and this is a very revealing look at how the Federal Reserve operates. In attendance was a ‘Mr. Jordan.’ The transcript takes us to, ‘Regarding the language on the balance of risks, part of me would like to say that the statement should always be that an unavoidable, permanent feature of a fiat money system is a balance of risks toward higher inflation. [Laughter].’ So Mr. Phoenix was right! They know this stuff, and yet they laugh at revealing the truth!"

"The following will not be in Allen Greenspan’s book: Between 1800 and 1913, the value of the dollar was more or less constant. Since the Feds creation in 1914, the value of the dollar has depreciated 97%. Since the maestro, Allen Greenspan took over, the dollar has lost 37% of its value. Consumers have gone deeper and deeper into debt in order to spend freely out of artificial purchasing power extracted from over valued homes. All that paints a compelling picture of an excess demand driven US economy…Our biggest export under Greenspan’s term was paper – the US Dollar. Japan and China have purchased massive amounts of US treasuries to stem their decline. They loan us money to buy their products because they need the US as a customer. When will this end? It will end when the Asian Tigers develop a consumer credit system and their three billion plus citizens become the customer. At that point we will no longer be able to live beyond our means - the dollar decline will accelerate and interest rates will rise dramatically…Foreigners currently own 45% of US treasuries. The FED can create $30 billion of paper in a week. They can raise rates, but it won’t create one drop of oil, one pound of copper or one bushel of rice… The BLS [Bureau of Labor Statistics] over time has made tiny incremental changes in the way they manipulate the statistics. In a bipartisan effort, presidents and the FED chairman have tried to make the news just a little better. Over time, these tiny changes have begun to add up. If we just go back 20 years and remove these changes, then unemployment today would be about 8%, the CPI would be about 7% and the GNP growth would be 0. On the unemployment front, if you were a discouraged worker, you were counted until the Clinton administration. During Clinton’s reign, workers who were discouraged for over a year were taken out of the number. That knocked 5 million off the broader unemployment report. U-3 is now the reported number of 4.7 but if you look in the footnotes, U-6, the old number is over 8% unemployment. The real degeneration over time is the CPI. In the 90’s, Michael Boskin at the council of economic advisors and Greenscam [sic.] at the FED wanted to fix the CPI simply stating that it was overstating inflation. They created substitution--assuming that if the price of steak went up, the public would substitute hamburger. The CPI was originally designed to measure a fixed basket of goods for a constant standard of living. Today it has changed to a basket of survival…Last year if you didn’t eat, didn’t drive to work, didn’t heat your home, didn’t visit a doctor, didn’t buy a house, didn’t buy insurance of any kind, didn’t have a child in college and didn’t pay state or property taxes, your cost of living agrees with the government’s…Today we have over $1 trillion in fiscal stimulus from the budget and trade deficits and the monetary stimulus of tremendous liquidity and some of the lowest interest rates in over 40 years. The pedal is definitely to the metal. The economy’s improvement is sluggish considering the massive size of the stimulus because of the size of the debt we’re dragging behind us…In 1966 oil was $2.90/barrel and rallied to $28/barrel. Gold was at $35/oz and rallied to $850/oz. The average price of a home increased 180%. In 1982 the stuff cycle ended and the great paper cycle began. In 1982, the public had 14% of their liquid assets in equities. The Business Week Magazine cover reported “The Death of Equities”. The P/E ratio was 7. Stocks were dirt-cheap and stuff was very expensive. Brokerage firms were selling real estate and oil and gas partnerships. 1982 was the beginning of a great bull market in paper. By 2000, the DOW was up over 10 fold. The cost of one dollar’s worth of earnings (the P/E ratio) has risen from 7 to 44, and the public had 57% of their liquid assets in equities. The Time Magazine cover featured “The Committee To Save The World: Greenscam, Summers and Ruben”. Brokerage firms were selling tech and dot coms with no earnings. The paper bull market was ending. Paper was very overpriced and over owned…Stuff, from 1982 to 2000, was in the dead zone. Oil went from $28/barrel to $26/barrel. Gold went from $850/oz to $280/oz. The average price of a house had increased 1.2% per year by ‘2000. Stuff was a bargain. In the next 10 years paper could be a trading market while stuff is in a bull or buy and hold market…There is a surplus of well educated labor. 30 years of restrained and neglected natural resource supply is being overwhelmed by demand. The longer things remain stable, the more likely they become unstable. Peace put 2 ½ billion people in the world labor market. India and China alone contain over 2 billion consumers. Suppose each of the 2 billion people consumes a mere quart of gasoline per week as their economy booms; that’s an additional 1.7 million barrels a day, new demand that is sure to increase price. Today, China is booming. They have declared the national bird to be the construction crane. Last year China’s factory floor produced 50% of the world’s cameras, 35% of the TV’s and 30% of the refrigerators sold worldwide. In the last five years china went from exporting oil to the second largest importer in the world. The Chinese will go from walking, to bikes, to motorcycles, and to autos. They will need oil and gas, chemicals, forest products and metals. At 80 cents per hour they are deflating manufacturing costs, but as they become more successful, they will throw away their bicycles and buy motorcycles and eat better, increasing the demand for raw materials. China and India are transforming their economies from poor agrarian nations to the newest industrial powers, replete with heavy industries, mass transportation and higher education. Rising from these giant new economies will come millions of new consumers, the very people who are already straining the natural resources of the earth. In 1900, the US started to industrialize. We were using one barrel of oil per person per year. By 1970, we were using 27 barrels per person. In 1950, Japan started to industrialize, they were using 1 barrel per person. By 1970, they were using 17. In 1965, South Korea started to industrialize. They were using one barrel per person per year. By 2000 they were using 17. Today, China uses 1.3 barrel per person per year and India uses .7. In 1950, Japan per capita income was 18% of the US, today it’s 96%. In 1965, South Korea’s per capita income was 16% of the US, today it’s 56%. India and China have 2.5 billion consumers, 9 times the US. The US uses 25% of the world’s energy, China and India use 2%. India and China have 280 people per car. The US has 2 people per car. Real incomes are just beginning to rise to levels that create large demands for consumer goods. Between 1950 and 1970, Japan’s urban population increased 70%. Personal consumption increased 600%. China currently is 40% urban, 60% rural. The US is 97% urban and 3% rural. China has 20% of the world’s population and 7% of the world’s land. China’s grain imports will grow from 14 million tons today to 57 million tons in 2020. Today, 1 billion people consume two thirds of the world’s raw materials. 5.6 billion people consume the other third and they are becoming more successful. There is no need to connect the dots, they over lap…Demand for raw materials has increased. In many cases, the capacity to produce raw materials has declined dramatically in the last 20 years. Tops and bottoms are creatures of extreme. Markets rise above all expectation and then go higher and then fall further than common sense suggests. The most desirable investments for the future might not be in cyber space but back to the basics. By the end of this bull market in commodities, there will be a bounty on caribou, you will be able to see an oil rig from every beach and they will be digging a copper mine in Barbra Streisand’s yard.”

Deflation & Bernanke's Party Moves

2007-03-28T12:47:00.000-05:00

I wanted to thank all those who published my last article (with special thanks to Michael Nystrom of bullnotbull.com who started the ball rolling) and also those who wrote back with comments and thoughts. I was surprised by the number and wide-ranging nature of the responses. However, a theme did emerge. More than any other comment, readers claimed that deflation was more likely to occur than inflation.

In my last article, I promised to talk about two subjects: (i) the fact that many market participants from lenders up to the Fed are trading short-term gain for more longer-term risks; and (ii) the steps we can take to avoid excessive inflation. I will talk about these subjects. However, I first wanted to address the inflation versus deflation argument, because it comes up time and time again.

In my mind, deflation CANNOT occur. I cannot say it strongly enough. Deflation occurring in Japan was a very rare occasion, and it was driven by particularities of their banking system and their central bank’s unwillingness to move quickly and aggressively enough. It was not an indication of trends to come in the U.S.

In my not so humble opinion, there are two common misconceptions when it comes to deflation: (i) once interest rates reach 0%, the government can do nothing more to increase liquidity; and (ii) if borrowers are saturated with debt and they will not borrow even with extremely low interest rates, liquidity cannot be created.

The problem with which we (those worrying about inflation/deflation) all seem to be grappling is the excessive debt (consumer, corporate, and government) that has come about in the last several decades. The question is whether that debt is intractable and will lead to a deflationary recession or even a depression, or whether the debt can be overcome through inflation. My belief is that the U.S. government could simply write a check (procedurally not so simple but possible nonetheless) to each indebted American and end this problem. The government could print its own money to cover these checks. Overnight, inflation would spike, but the debt problem would be alleviated. It is my contention that the political pressures are such that the U.S. government and the Federal Reserve will create inflation to alleviate the debt burden. The only question in my mind is whether they will do it in an intelligent way such that more debt is not created, or whether they will only dig us deeper into the same hole and be forced to create more inflation at a later point in time.

Anyway, our esteemed Chairman of the Federal Reserve, Ben Bernanke has written and spoken extensively on the subject of deflation, and I have included a long quote of his below, not to highlight his wit and sense of humor, but rather to show how well understood these issues are and to demonstrate the various tools the government has to overcome them:

"The Congress has given the Fed the responsibility of preserving price stability (among other objectives), which most definitely implies avoiding deflation as well as inflation. I am confident that the Fed would take whatever means necessary to prevent significant deflation in the United States and, moreover, that the U.S. central bank, in cooperation with other parts of the government as needed, has sufficient policy instruments to ensure that any deflation that might occur would be both mild and brief...However, a principal message of my talk today is that a central bank whose accustomed policy rate has been forced down to zero has most definitely not run out of ammunition. As I will discuss, a central bank, either alone or in cooperation with other parts of the government, retains considerable power to expand aggregate demand and economic activity even when its accustomed policy rate is at zero...gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation."

While those in the deflation camp are no doubt unsatisfied by my concise explanation, I must leave it at that for now. If so inclined, please write me to discuss this matter further, and I will promise to raise valid points on the deflation side of the argument in subsequent writings.

Returning to the matter at hand, I wanted to talk about how pervasive our trading of short-term gains for long-term risk has become. Starting at the top, let’s examine the Fed. As you can see from the graph below, the Federal Funds Rate has been lowered (arrows) interest rates to increase liquidity during times of recession (shaded areas). However, since 1987, when Alan Greenspan became Chairman of the Fed, you’ll notice that - but for a brief period in the late 1990s - the Federal Funds Rate has been held below its historical average.

Now what’s wrong with that? Plenty! During the 1990s a massive deflationary force emerged with the winning of the Cold War and advances in technology. As Chinese, Indian and other international laborers entered the increasingly global workforce, wages for many tasks came down, leading to unprecedented gains in productivity and improvements in standards of living. Further compounding these benefits, foreign countries - which were trading with the U.S. and accepting dollars as payment – were willing to hold these dollars in reserve in their non-consuming and non-inflationary central bank accounts. However, as the economy stayed strong, rather than taking advantage of these benefits, Greenspan, due to his and the Fed’s political nature, found it more expeditious to keep interest rates low and encourage massive consumption and consumer indebtedness. Normally, keeping interest rates so low during a period of already-strong economic growth would have caused the economy to overheat and thereby have forced the Fed to raise rates. However, the disinflationary effects of the new international labor and the growth in new technologies allowed Chairman Greenspan to act like a D.J. at a party, pumping up the volume, achieving rock star status, and bringing in more punch bowls exactly when he should have been taking them away. Greenspan, a fan of gold and fan of Ayn Rand earlier in his career, even went so far as to say that money supply no longer mattered. It was no longer a good indicator of what was happening in the economy. [Contrast Greenspan’s words from the 1990s with his writings from 1967: The government has “created paper reserves in the form of government bonds which -- through a complex series of steps -- the banks accept in place of tangible assets and treat as if they were an actual deposit, i.e., as the equivalent of what was formerly a deposit of gold. The holder of a government bond or of a bank deposit created by paper reserves believes that he has a valid claim on a real asset. But the fact is that there are now more claims outstanding than real assets. The law of supply and demand is not to be conned. As the supply of money (of claims) increases relative to the supply of tangible assets in the economy, prices must eventually rise.”]

Such actions allowed for extremely good times throughout the 1990s, but they also encouraged a massive misallocation of capital into over-consumption and indebtedness rather than savings and a path to longer-term growth. When problems started to emerge and the technology bubble burst, Greenspan doubled his bets and drove interested rates nearly to zero, before slowly starting to raise them just before his departure.

And so we find ourselves in today’s predicament. Rates have been brought back up to 5.25%, still low by historical standards, and yet the economy is slowing down under the weight of its debt and the cost of that debt even with low interest rates. At the same time, the disinflationary force of international labor is beginning to run its course and actually turn into an inflationary force, as Chinese, Indian, and other laborers’ wages go up and these noble workers begin to consume! In addition, foreign central banks, up to their gills in dollars, are no longer content to keep these dollars innocuously hidden away; they too are spending these dollars – in this case to acquire other assets.

So, on one hand in emerging markets, you have younger, less affluent workers with little debt coming up the ladder and driving inflation up, and on the other hand, you have older Americans who are burdened by debt and are now becoming the source of global disinflationary forces. Oh how times have changed. And rather than prepring us for these changes, Greenspan has put us into a situation whereby we enjoyed short-term gain, but now face greater long-term risks.

The evidence, I’m afraid is all around us. On March 27, 2007 (the day I wrote this article), the Wall Street Journal had an article on its front pages with the headline: “As Economy Grows, India Goes for Designer Goods: Mr. Murjani Sell $100 Hilfiger Jeans; A Boom for Vuitton.” The article talks about how “India’s economic boom and the expansion of its companies overseas have created a new class of consumers who have money and care about global brands.” In the same Wall Street Journal, there is another article titled: “Sketchy Loans Abound: With Capital Plentiful, Debt Buyers Take Subprime-Type Risks.” This article mentions how:

"In a frank moment several weeks ago, Bill Conway, co-founder of private-equity heavy-weight Carlyle Group, issued a directive to employees warning of a corporate debt market bubble. Wall Street bankers bluntly describe it as a house of cards, too. So here’s a question. If borrowers and lenders alike agree the corporate debt boom can’t last, why isn’t anyone stopping it?...The fuller answer tunnels into the Street’s cynical heart, and why it has always been so profitable to work there: Hedge-fund managers, buyout artists, and bankers get paid for short-term performance. The long-term consequences of their actions are, conveniently, someone else’s problem. People inside the big banks are eerily candid about the credit cycle creeping to an end. They also candidly admit they don’t want to get caught missing the next big deal. Their banks, and their own bonuses, might suffer. So they ply ahead…'The fabulous profits we have been able to generate,' Carlyle’s Mr. Conway said in a letter to his employees, resulted in large part from the availability of cheap debt. The bankers, he added, 'are making very risky credit decisions.'" [Amusingly, the article right next to this one was title “How Borrowing Yields Dividends At Many Firms: The Cheap Credit Now Can Juice Returns Later.”]

In my mind, so much of the supposed financial innovation that has occurred over the last two decades is partially about spreading risk but more so about getting the risk of the deal away from its originators. That way, bankers can take more risk. They can earn large fees and bonuses, but not suffer the consequences if the deal turns sour at a latter point in time – all of which seems good during decades of declining interest rates. However, we know how this “innovation” turned out when it came to subprime lending: bankruptcies and foreclosed houses. The question is now whether we will suffer the same consequences of “innovation” in other areas as well.

If we, the worrywarts, the party crashers, the cynics, are correct and these debt problems are actually an issue, what is to be done? To inflate or deflate: that is the question. Whether ‘tis nobler in the economy to suffer the slings and arrows of outrageous recession. Or to take arms against a sea of debt and by opposing end them?

One of the respondents to my last article, Robert Waxman, succinctly captured this dilemma as follows:

"Yes, it seems that the 'inflate or die' mantra is in full force at the fed, but in that mode the dollar's value is consistently eroded. Would it not be sensible at some point for the fed to allow deflation (or the potential for it)? I ask this 'dumb question' to make my point which is this: The fed issues 'notes' which have value to the extent that society accepts them as payment for goods and services. The extreme of inflation is the worthlessness of fed 'notes' (Weimar republic or zimbabwe) while the opposite extreme is ever increasing purchasing power of fed 'notes' which become scarce during deflations. Would the fed not wish to have their 'notes' maintain or increase in value at certain times along the way to maintain credibility/confidence in their system? Yes, recessions/depressions are painful, but it seems to me that, if it remains unbroken, inflation will cause the most severe pain that the system can offer."

In my opinion, Mr. Waxman is EXACTLY correct. The Fed should care about the value of its currency. As Michael Nystrom says, the Fed’s notes (dollars) are the source of its power. If the value of those notes erodes, so does the power of the Fed. Yet, however much I agree with Mssrs. Waxman and Nystrom, I think what the Fed should do and what they will do are very different.

Already, the political pressures are mounting. In their latest meeting, the Fed decided to change their language from hinting at a possible rate hike in the future to being more neutral, such that they could lower rates if needed. Fed Governor Frederic Mishkin summed up the feeling, saying that “A substantial further decline in inflation would require a shift in expectations, and such a shift could be difficult and time consuming.”

To get a sense of the political pressures placed upon the Fed, look at not only Chris Dodd’s reaction to the subprime mess, but also what is happening in Massachusetts. According to a recent article: Boston Mayor “Menino and Massachusetts Secretary of State William Galvin are expected to call for an immediate halt to all foreclosures in the state. Galvin will propose emergency legislation that will give at-risk homeowners a chance to take their cases to court. He said tens of thousands of people in Massachusetts are ‘pre-homeless’ and about to lose their houses in foreclosures and have little legal recourse.” It would seem callous for the Fed to argue that hundreds of thousands of Americans should go homeless now for the noble goal of price stability!

Honestly, I was incredibly surprised to see an article in the main press (or near main press) clearly articulating the predicament into which the Fed has put itself. Todd Harrison of Minyanville.com writes:

"Last week, as most of you know, the Federal Reserve announced it was adopting neutral bias on interest rate policy. While inflation remained FOMC members' predominant concern, they wanted to remain balanced in their approach to the economy and the next steps they would take. That's entirely fair, given the conundrum that we collectively face. On the one hand, we've got inflation in things we need to power, educate and feed the world. That's evident when looking at an equal- weighted CRB, which is one sharp rally away from all-time highs. On the other side of the equation, we have the specter of slowing global growth, a debt-laden consumer and cracks in the sub-prime mortgage market which, while isolated, is tied to the global machination through an intricate maze of derivatives...We often say that to appreciate where we are, we must first understand how we got here. There is a difference between legitimate economic growth and debt-induced demand. A simple snapshot of our screens won't tell the entire story. One must juxtapose the U.S. dollar, which has declined 30% since 2002, against the appreciation in stocks. Viewed through that lens, we've gone nowhere fast for the past four years. Alan Greenspan, who is widely credited with navigating our markets through turbulent times, hasn't done us any favors. He rode off into the sunset claiming victory, leaving consumers with adjustable-rate obligations while warning of recession as the dust settled behind him. Make no mistake, he left Ben Bernanke and the rest of us in a pretty pickle. We're up to our eyes in debt, with roughly $3.50 owed for every dollar of GDP. That'll mute the effect of cheaper money in a profound way. Once credit demand and supply start to decline after a massive credit-based inflationary boom, a deflationary credit contraction becomes the most likely resolution. This isn't a popular statement, nor is it fun to fathom. Still, as we weigh the landscape and prepare to listen to our Fed chairman, it's a necessary context with which to absorb his vernacular."

Now, obviously Mr. Harrison is in the deflation camp. Personally, I think the Fed will choose innovative policies over hundreds of thousands of American homeless. But Mr. Harrison does do a tremendous job of summing up where we are and how we got here, and he’s gotten his piece on MarketWatch, which I was pleased to read when I logged into my E*Trade account. That said, it was released a couple minutes after midnight!

Anyway, I feel I have left several topics still uncovered, including my proposed solutions, but this article has grown long and unfortunately the real world beckons. Yet, if interest seems sufficient, I will certainly write a third part on what can be done. Until then, watch for the Fed to start preparing the road for a rate cut.

The Good, The Bad, and the Ugly

2007-03-22T15:04:00.000-05:00

The Good, the Bad, & the Ugly

When my good friend Michael Nystrom asked me to write an article for bullnotbull.com, I was first elated and then depressed. Elated at the opportunity, but then depressed at the challenge of living up to his invitation. How, after all, was I going to join together the massive amounts of information that the Internet and modern economy are supplying my aging brain? The result, for better or for worse, is what I have come to call “The Good, the Bad & the Ugly” but it doesn’t follow in that order:

The Bad

Well, indeed, it’s bad. Markets are down, and for the first time in a long time Wall Street denizens are beginning to rethink the goldilocks economy scenario that has been driving spreads tighter for years. Several multi-billion dollar subprime lenders are teetering on the edge of bankruptcy, Greenspan is warning that their could be contagion into other markets & that a recession is possible, and other pundits wonder if major banks such as Citibank and Goldman will be affected.

Yet, just several weeks ago, a friend, who is a derivatives trader at a major bank in New York, was telling me that everyone at his bank was afraid to be negative (short) because credit spreads have been doing so well for so long. “Anyone who has been short,” he said, “has been a failure.” In the Wall Street world where reputations and more importantly jobs are measured in quarters, it is much more lucrative to make a 2% gain, along with the rest of the market, and risk a 20% drop. After all, when the 20% drop occurs, you can just blame the fact that “no one saw it coming” and then lobby your friends at the Fed to rescue you from a financial crisis that threatens to subsume the global financial system (contagion is the word “they” always seem to use). ["One of the things to worry about is how much markets are worrying," says Andrew Tilton, senior U.S. economist at Goldman Sachs in New York. "A contagion in the credit markets based on fear is a possibility, though we don't think that's the most likely scenario."] Remember, it’s other peoples’ money you’re managing, but it’s your bonus.

While pundits are running around trying to ascribe a reason or a series of reasons to what is causing the recent uncertainty, in my mind it is actually quite simple. The tide is going out. The monetary tide that is. After nearly two decades of generally decreasing interest rates, interest rates (on the short end of the yield curve) have been rising, and countries around the globe (China, Japan, Switzerland, the E.U., the U.S., to name a few) have been trying to drain liquidity from their financial systems.

So the trend is changing. But two decades of cheap money and an accommodating Fed can lead to strange happenings. After all, just weeks ago, someone who have trouble paying their credit card bills could easily receive a 100%-LTV loan (meaning 100% of the value of the house). The loan would have a barely-affordable monthly payment level, which would only get more expensive in a couple of years. But what a difference a few weeks make.

And guess what? The politicians and regulators are shocked that these practices have been going on (with the exception of Ron Paul, the lone, brave voice in Congress warning of the consequences of excess liquidity). Personally, I’m shocked that the politicians can maintain such plausible deniability in the face of the obvious. My personal favorite is Chris Dodd of Connecticut, who is appalled at what is happening and calling left and right for hearings on the matter. As Chairman of the Senate Banking Committee with all the resources at his disposal and his ability to ask any American to testify on the matter, how he did not know what was going on? After all, I’m just a small-time independent businessman with access to the Internet, and I was able to figure it out enough to make a lot of money shorting the subprime lenders. But maybe “independent” is the key word in the previous sentence. Because, while Senator Dodd is claiming that we need to bail out the poor, who are defaulting on these loans, few people are aware that the largest donors to the Honorable Christopher Dodd are the world’s largest financial institutions, the ones who have been overlending to the poor in the first place to cause this crisis, and the ones who would suffer greatly if “contagion” were to spread.

But alas, in the list of the bad, the politicians are not at the top of my list. I’ve always believed it’s the bankers (not the robbers) who should be the ones wearing the masks. My friend Flipper58 (whose wisdom you can see on the FAX board at investorvillage.com) describes what has transpired as follows:

"I guess what is so fascinating [about the subprime market collapse] is these [loans] all were structured probably by a few Wall Street financial engineers a half dozen years ago. When you think about the CDO (collateralized debt obligation) structure it is quite genius and simple. Take a bunch of lower grade, non-conforming loans and put them in a big pot. Break it into levels (tranches) by drawing 10- 15 lines thru the middle. Make it so the level 1 gets interest and principle first and if [there are] extra excesses it falls to the 2nd level and on down the line. Then get the levels rated and [you’ve made] a bunch of low grade loans now investment grade in essence making these type [of] loans marketable to any investing organization. This all of a sudden creates a MASSIVE new pool of buyers. Add interest rates swaps to manage maturities and duration, add default swaps on the low grade levels and you have an incredible amount of new money that can buy these mortgages that in the past had very limited funds allowed to them. Now selling some 99% LTV mortgage is easy because the CDO structure takes the risk of 1/2-3/4 of it away.

"If you look at any bubble in any market all you need to look for the NEW source of funds that caused it. IMHO, the NASDAQ bubble in 1999 was because massive number of online brokerage firms that allowed anyone to trade at will. IMHO, the CDO structure, now allowed a mass of new money.

"But now the punch bowl is being pulled. All those 100% option ARM's ain't going to happen and because the CDO structure PASSED the risk on…mortgage originators were volume focused, not quality focused…[To] see that REALLY nasty stuff went on by the mortgage brokers is not surprising. I know in my area Mortgage brokers sprouted up like grass."

For me, any bonus on and any regulation of a potential investment should be measured across the lifetime of the deal and should be returned or should become a liability if the deal turns out to be a loss maker over its lifetime! Can you imagine that? Imagine how differently bankers would behave? It’s like asking politicians to send their children to war! It’s funny how we ask human beings behave when we are managing other peoples’ money or sending other peoples’ children into harm’s way.

Too often financial products are structured to provide short-term benefits and pile increasing risks out into the future. The tide of human emotions are what drive the business cycle because those making lots of money in the upswing become increasingly convinced that past performance does in fact indicate the unlikelihood of the increasing obvious (future losses), thereby explaining investors shock when they’ve realized they’ve been sold up the river.

But the obvious signs are all around. As a friend explained this weekend, when an ad for pure bread dogs offers financing, it just may be an indication of excess liquidity. Everyone in New York keeps telling me: “Don’t worry, the risk of lending is so spread out so much that it’s no longer a problem.” Still, I don’t believe it. Why?

In fact, I would warn that the exact opposite is true. The trading of short-term profit for increased future risk has been taking place on a massive scale, from the subprime mortgage originators all the way up to the Federal Reserve! I will write more on this subject in a future article, but for now one simple stat can demonstrate what I’m talking about: Since 1987 (when Greenspan became head of the Fed), Total Credit Market Debt has grown from $13 trillion to $40 trillion and now accounts for over 300% of GDP. Many argue (including Greenspan shockingly enough) that this debt growth is not a problem, because assets have grown more. But when too much money is available to lend, the borrowers can drive up prices (alla housing). It’s only when the excess lending is taken away do we find out the real consequences, or as Warren Buffet likes to say, “It’s only when the tide goes out that you find out who’s swimming naked.” With debt growing 50% faster than industrial production, I fear that the one who is swimming naked may be Uncle Sam, which is not a pretty picture.

My predicition: a lot of subprime lenders (and other lenders) are going bankrupt, the major banks are going to suffer losses, mortgage lending will slow down, housing prices will continue to decline, and the U.S. will slip into a recession sometime this year, if it has not already.

The Good

The good news is that the Fed can always just print more money (called the “Greenspan Put” because that’s what he always did whenever things were going badly, thereby “saving” us from a recession). Although I’ve been listening to the Fed for a long time, and I’ve not bought the market’s argument that the Fed will be forced to lower rates, I am now capitulating. I think the subprime shake-out will spread to the rest of the real estate market. The stock market will continue to be volatile and banks will suffer enough such that the Fed will be forced to lower rates this year, possibly to 4.5%, or possibly more.

Once the market realizes the Fed will almost certainly be lowering rates, there may be a rally. Until then, look for instability. As I always argue with my friends who fear deflation, it’s just not going to happen. No way. The Fed can always just print more money. Plain and simple. Deflation cannot happen.

The Ugly

The ugly problem is rather the potential (and the political need) for inflation. Deflation cannot occur because the Fed can always inject more liquidity. However, inflation cannot always been contained, because the financial system as a whole has an incentive to make it happen. Just as the bankers can create products (certain derivatives contracts) that provide returns quickly and push risk out into the future, the Fed also attempts to reduce risk by adding liquidity (to avoid a recession). So what’s wrong with that? After all, no one likes recession.

Unfortunately the problem is ugly. Really ugly. It’s called moral hazard. Since Greenspan came into office, it has become increasingly clear that the Fed will pre-empt a recession. Don’t worry. If you’ve overborrowed, people like Greenspan and Chris Dodd will come to your rescue. The moral hazard is that the smarter people in the economy have come to understand that this rescue will happen, and so they are even more inclined to overland! Why not be more aggressive than the guy sitting at the trading desk next to you? As so on, down the line, from the bank officer, to the mortgage broker, to the real estate investor. And don’t forget that the leveraged buy-out guys figured this out a long time ago, as have the hedge funds.

Here’s a simple way of looking at the complex topic I am bringing up. Say you manufacture pencils and your main cost in graphite. Let’s say your job is to price the pencils, so that you make as much profit as possible but also sell as many as possible. If you price too high, you will not sell enough. If you price too low, you will not make enough profit. Simple right? Every business operates this way. Now, let’s say you have connections in the graphite production world, and you’ve used those connections to figure out in advance that the price of graphite is going down. Then, you are ahead of your competitors, and you can order more pencils to be built and lower your prices before your competitors.

If you can understand the analogy above, you can understand what is going on in the financial markets. You just have to imagine that the pencils are loans, and graphite is interest rates (the cost of loans). Because you know that the government will be forced politically to lower the cost of interest rates (graphite), you make more loans (order more pencils to be built) at lower interest rates (lower prices).

The real sinister part is that the more bankers overlend, the more the government needs to decrease interest rates. It’s what’s called a positive feedback loop, although there is nothing positive about it.

The real, real ugly part (and this point may be controversial to some) is that there may be no one to blame. It is unlike the Iraq War, where it is crystal clear there were a handful of players pushing for war (ignoring some evidence and emphasizing other points, although “they” would like you to believe otherwise in retrospect, pinning blame on the CIA, superiors, or surprisingly “faulty intelligence.”). Well, if we know the CIA has a history of producing faulty and politically-motivated intelligence, why the rock-hard conviction at the time that WMDs exist? Ah, the games people play. “I’m shocked to find gambling going on in this casino!”

In the case of the financial system, everyone can argue that they are doing their job. The politician is responding to the desires of the constituency. The Fed is responding to its dual mandate of balancing inflation and growth. Banks are just trying to stay ahead of their competitors. And lenders are just behaving according to market conditions offered to them by banks. Although there are some players who are ignoring some evidence and emphasizing other points (mostly, I would say the Fed), I did want to throw out the controversial thought that there may be something more dangerous than a conspiracy going on. In other words, maybe it’s you and me that are causing the problem, behaving in our roles as they’ve been prescribed to us. As an analogy, global warming is easy to pin on “big oil,” but it’s really caused by you and me driving to work in the morning. The ugliest and scariest part about this idea is that one of the hardest things in life to do is change people. I can’t even get my family members and friends to change the things that are most annoying about them! How then are we going to change the behavior of hundreds of millions of people?

So where does it end? Basically, as it’s always ended. With a worthless U.S. dollar. Every banking system in history that is run by fiat (meaning not attached to an actual commodity or other asset) has ended up being worthless.

But do not lose faith. There are steps we can take. First, as individuals, we can invest in commodities and other investments that will benefit from a falling dollar and protect our families’ networths. Second, in the next article, I will discuss what steps we can take as a society to create incentives to alter our behavior with a longer-term perspective in mind.

Until then…

“So we beat on, boats against the current, borne back ceaselessly into the past.”

When BusinessWeek agrees with you

2006-01-30T23:27:00.000-05:00

For years, I have read those off-white, yellowish Business Outlook pages in BusinessWeak (sic.) with some disdain. The message is always loud, clear, and the same: The economy's great! Greenspan is a genius. And you really don't have anything to worry about. So increase your leverage. Invest in stocks. And go out and buy something you don't need (and increase your subscription while you're at it).

Now, just before sitting down to write this post - having crafted the bulk of it in my mind - imagine my shock as I sat down, looked at those yellowish pages, and read much of what I was going to write!

HEADLINE:
"Bernanke May Have His Work Cut Out for Him: If the economy doesn't cool down, rates could go higher than investors expect."

I will quote much of the article, as I am chagrined to admit, because it sums up my viewpoint better than I could have written myself:
"The latest UBS Index of Investor Optimism jumped sharply to its highest reading since June 2004...A bit less than two-thirds of those surveyed said it was a 'good time to invest in the financial markets.' In particular, investors don't seem overly concerned about inflation or interest rates...The results suggest that investors believe inflation will stay tame and that the Fed is all but finished raising rates. This expectation of perfect policy from the Fed is one of the biggest risks in the outlooks for both the financial markets and the economy...But what if the economy doesn't cooperate?...Also, despite the Fed's rate hikes and the runup in oil prices, the credit markets see even less risk in the economy now than they did when the Fed began tightening policy...

"Energy is once again adding to those inflation worries...The real danger to the economy and inflation is oil at $100 per barrel, the result of a classic supply shock, should actions in Iran and Nigeria result in a substantial drop in oil flowing to world markets...

"Watch the economic data closely over the next couple of months. If the numbers fail to imply that the economy is cooling down a notch, then the new Fed chairman could have a lot more work to do in 2006, a situation that would surely put a damper on investors' confidence."

And with that, the outlook ends!!!

To me, as a investor looking for that which the market and concensus opinion have not already caught, this article is worrying - not because of its content - but because lots of people are starting to write about the same stuff: higher oil, possibilities of inflation, a further rise in interest rates (short & long), and on top of all that, the chance all this growth will lead to slower growth - as interest rates rise.

This final point - the seeming paradox that growth that is too fast can actually cause a recession - is, like most things in life, not what it first appears.

My latest thinking to explain this phenomon - as well as describe the broader trend in the economy - is actually quite simple, namely:

Changes in inflation and disinflation SIGNIFICANTLY LAG changes in money supply growth. For example, when the Fed set the stage for massive money supply growth right after 2000, inflation did not appear at once. Similarly, when money supply growth began to slow in the late 1980's, a prolonged period of disinflation was not understood to be taking place until many, many years later.

If this theory (and it is just a crackpot theory - more reverse-engineered to explain observations - rather than based upon a detailed economic paper to back it up) is correct, the implications are profound. The profound implication is that the Fed sets policy too quickly, and that the damage has already been done by the time they set out to fix it. Money supply growth many quarters ago set inflation rolling, and the Fed can only now (too late in the game) raise rates and force the economy into recession. Even so, inflation may continue to occur, and we may find ourselves in a situation similar to the 1970's and early 1980's, when the Fed had to raise rates despite a massive recession to "break the back" of inflation.

Of course, the ensuing slowdown in money supply growth beginning in the 1980's set the stage for a period of steadily lower inflation, and eventually a perception that inflation had been cured. All the while interest rates were brought lower and lower, credit growth expanded, and by the mid 1990's, money supply growth began to accelerate again, speeding up significantly around 2000.

So as I doubt my own analysis and wonder why the burgeoning concensus opinion and I are no longer at odds, I go to bed thinking: hey, we might actually all be right! And when everyone starts to believe in inflation, that's when it really begins!

Sweet dreams of Oil futures and Gold bars...
And wow are those XOM LEAP calls looking nice! Up 50% since we recommended them at the beginning of this month.

What to look for in 2006

2006-01-05T15:17:00.000-05:00

While we are sceptical of those making macroeconomic predictions, we are also warry of those unwilling to make bold enough predictions to help others actually make money.

So after much deliberation, we are going to lay out our expectations of how 2006 may unfold.

We think the big story of 2006 will be the price of Oil. We think Oil is going back through $70 a share and beyond. We think this price increase is being driven mostly on the demand side, as non-OECD countries grow their economies and increase their Oil consumption. Investments that have been made to increase supply will not prove sufficient to keep up with this demand. Already, we have seen a rising U.S. dollar towards the end of 2005, a possibily slowing U.S. economy, moderate winter weather, and yet the price of Oil has bounced off $55 strongly and now resides around $63 a barrel. We are not able to predict how high Oil will go, but we think whatever the final price, it will be a surprise for most people.

The other big story of 2006 will be interest rates. We think the Fed will be facing an unenviable dilemma: namely Oil and other inflation in conjunction with slowing economic growth. We expect the Fed to stop raising rates at 4.5% - 5.0%, with the likely final number being an awkward 4.75%. We think this rise in rates will severely hurt the housing market, which will flow through to the rest of the economy. We look for bad economic numbers (employment, GDP growth) beginning around March. To date, we have been impressed by how well the economy has performed, so we do think there is an outside possibility that the economic could continue to surprise. But given the fact that all the economic drivers of the past several years (housing, government spending, lower interest rates) are topping out, we believe an economic slowdown to be more likely. Despite the economic slowdown in the U.S., other economies may continue to advance. Japan's stock market performance, and China's, India's and Russia's booms may all continue, thereby driving the inflation of internationally-priced commodities. How the Fed reacts will be fascinating to watch. Our belief is they will be more inclined to lower rates, even as Oil advances, in order to keep the U.S. economy growing. If the scenario we forecast does emerge, we look for lots of confusion and volatility in the marketplace, as market participants attempt to disgest the meaning of this new paradigm.

So where should investors place their money in 2006?

Have some Oil stocks. We like XOM Leap Options (string 70 2008s are our favorite at $4.2) as a good hedge against our forecasted Oil inflation. We also like PTF, a Oil trust that yields over 10% and pays dividends monthly.
Short-term, high-yielding preferred stocks and corporate bonds. We think there are still a few gems out there that provide greater yield and less risk than most other debt instruments. Among these are GAJ and Amerco Series A. Both provide yields well above 8% will what we perceive to be little default risk.
Some hedge against the U.S. dollar. While the U.S. dollar has performed very well in 2005 - a result mainly of interest rate differentials - we think the long-term fundamentals signal U.S. dollar weakness. We continue to believe that a conservative and well-managed portfolio should have some protection against the U.S. dollar. We think that FAX and FCO are good ways for the average investor to achieve such protection.

What to avoid?

Financial services stocks. We think financial services stocks will perform badly throughout 2006. A flat yield curve, over-extended consumers, a slowing economy and housing market will slow growth across a variety of financial services sectors, including credit cards, mortgages, bond trading, and much more. We expect net margins to stay tight and defaults to rise. Not a pretty picture.

In the end, we don't think 2006 will be a terrible year, but one where it pays for investors to be cautious. Foreign stocks will likely continue to do well, although likely not quite as well as 2005. U.S. stocks are hardest to predict, and depend greatly on how much the U.S. economy slows. If forced to wager, we'd guess U.S. stocks will return around 5%, and that better returns can be had in the areas highlighted above.

When will the Fed stop??

2005-12-13T20:46:00.000-05:00

Today's news was that the Fed raised interest rates another quarter point to 4.25%. The real meat behind the story, according to the press, was the speculation of when they will stop raising rates. Little covered was the potential for inflation and slowing economic growth.

In my opinion, the biggest danger in front of us is a return to stagflation. It is amazing that it only takes several decades for us to believe a reoccuring phenomena is actually something new.

According to the Fed's statement, "further measured policy firming is likely to be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance." This statement implies that sustainable economic growth and price stability are in contrast to one another. The risks need to be kept in balance.

On the contrary, I believe the Fed has already put us in jeopardy, by being too eager to lower rates and stimulate the economy throughout Greenspan's tenure. This activism has led to what is called the "Greenspan Put", which is the market's belief that Greenspan will come to the rescue with liquidity in the event of an economic and/or market downturn. The realization of the Greenspan Put's existence has created a moral hazard, as market participants have taken more and more risk, and generated more and more credit growth.

This degree of credit growth sustained economic growth throughout the 1990s and for the last five years, but at the expense of the future. Now, with our economy burdened with debt, the Fed will have to either (i) allow for a deep recession, which will cause enough defaults to bring debt levels back to sustainable levels; or (ii) continue to increase liquidity, to generate enough inflation, so that the real levels of debt diminish.

It is my belief that the Fed will choose the path of least political resistance, the latter path, and continue to increase liquidity.

Little commented on by today's journalists was the idea that in taking this path the Fed might have to continue to let inflation rise, possibily eventually leading to stagflation.

Certainly, my viewpoint is not the current market consensus. However, as a taste for posts to come, I will leave you with two thoughts.

One is that during the Clinton era, the CPI index was adjusted to incorporate new techniques, such as hedonics. These techniques were not used in the 1970s and 1980s. Today's measure of inflation is already evelated - at 4.7%. However, if we were to measure it in the same way as we did 20 years ago, it would be whopping 7.0%!

Another point is that I have long thought that as the U.S. raises interest rates, other countries will keep their rates low or even lower rates. THIS HAS TO HAPPEN. Right now, the U.S. Current Account Deficit is well over 6% of GDP, meaning we are consuming $2 billion more a day than we are producing. To bring this deficit into balance, other countries will have to consume more, and we in turn will have to produce more. Another way of saying this is that we will have to raise interest rates to lower consumption, while they will have to lower them. As evidence of this trend, during the latest Fed raising cycle, the U.S. has raised its interest rates 3.25%, Europe has raised its rates 0.25%, Japan has not raised its rates, and this week Mexico lowered its rates! Again, this points to the idea that the U.S. could experience inflation (due to increased global consumption), even as our economy slows (due to decreased domestic consumption). The end result is that domestic-based prices, such as labor and housing, will fall, while internationally-traded commodities will rise in price.

That's why - even at over $60 a barrel - I'm bullish on Oil!

If the mass media writes in awe when Oil crosses $70, you should smile and thank your XOM LEAP Calls!

The housing market

2005-11-28T23:30:00.000-05:00

For four years, I have said housing was overpriced, and for four years, I have been proven wrong by the market.

As Bill Parcells says, "You are only as good as your record says you are." Yet, despite the interventions of friends and family members, I am not willing to admit defeat on this one.

Here's why.

There is something called Fundamentals. When the stock bubble was hitting it's highs of 1999 and 2000, Warren Buffet was sticking to Fundamental analysis, and writing articles in Fortune Magazine firmly stating that stocks were overvalued. Just as Alan Greenspan was being hailed as a Maestro and he proudly accepted the Enron Award from Ken Lay, Warren Buffet was being labeled as a washed-up has-been. But who was right in the end? The "you don't need assets" Ken Lay? Well, you don't need assets in prison. That's for sure.

While Fortune Magazine won't accept my articles, at least there is this blog to express my belief that Fundamentals apply to housing, too.

So, while my brother-in-law states that "housing prices could never go down in this neighborhood" and a good friend here in Boston claims "housing supply is too limited for there to be prices declines", I firmly state: "Malarkey!"

In my opinion, housing prices are driven by two main factors: interest rates and incomes.

What has changed significantly in this boom is interest rates, allowing people with the same income to afford larger principle payments and therefore more expensive houses.

However, if interest rates go up, principal payments will fall, as will housing prices. Already, the housing market is slowing, even as long-term rates have barely gone up.

The other part of the equation is incomes. There are several components to income: number of incomes in a society, amount of those incomes, and amount of those incomes being devoted to housing. Since the 1700's, housing expenditures as a percentage of income have not changed. I don't think they have in this boom, and I don't think they will in the future.

Nor have the number of incomes nor the amount of those incomes changed so significantly since 2000, 1995, 1990 or even 1980 to warrant a multi-fold increase in the price of houses. Certainly the incomes in America are not twice what they were in 2000.

So, what, I ask, has so fundamentally changed?

Interest rates. Of course, there is the very real possibility that the housing market will "correct" by simply staying at these prices for 5 to 10 years, while a politicized Fed keeps interest rates low and let's inflation go through the roof. Although Ben Bernanke says he believes in "inflation targeting", I find it hard to believe that he will continue to raise interest rates if the economy slows down and unemployment worsens, even if inflation continues to accelerate.

In either case - whether the Fed raises interest rates and housing prices decline significantly, or the Fed let's inflation go while housing prices stagnate - one thing is clear: there will be a correction in inflation-adjusted housing prices.

"Fine, but that won't affect this neighborhood!"

Imbalances at a critical juncture

2005-11-15T23:45:00.000-05:00

Across both old and new media, there is a war of words raging about the direction of the market.

On one hand, you have the optimists, who are jetting around the world from party to party, claiming this time is different (see http://www.safehaven.com/article-4104.htm). This time Current Account Deficits and Inflation don't matter. There is a new world order that explains why the dismal scientists, the economists, are wrong.

On the other hand, the economists are locked away in their sanctuaries of study, claiming all is not right in the U.S. of A., and that we face a unprecedented set of imbalances, that either threaten to throw us into a surge of inflation or a contraction of deflation - but either way, threaten the fabric within which we have wrapped our wealth.

In my humble opinion, we are at a critical juncture in the market that will test the various hypothesises that are being put forth, and thereby help us to divine the direction in which we may be headed. In short, $55 Oil, $500 Gold, and 1250 S&P are key lines that the market has drawn in the sand. If those lines are crossed, I believe, a clearer trend will emerge.

Going back for a second to the concerns of the economists, the basis of their discomfort stems from the massive imbalances in the economy, the most pronounced of which is the U.S. Current Account Deficit. Today, that deficit is greater than 6% of U.S. annual GDP. That is tremendous. To put it in perspective, it means we have to import more than $2 billion in investment capital per day just to keep the U.S. Dollar valued where it was the day before. To date, foreign investors have been happily lending us these amounts, and then some. The concerning question is: for how long will they do so? According to Alan Greenspan's comments today, the answer is "not indefinately."

The other source of concern for some is somewhat related to the U.S. Current Account Deficit: the level of indebtedness of the U.S. consumer and the U.S. government. In total, the U.S. consumer has over $11 trillion in debt. The federal government has about $4.5 trillion in debt, while state and local governments owe another $1.7 trillion (not to mention all the Social Security and medical liabilities the government has!). The worry is that there are two paths out of this indebtedness: (1) to have the federal government print a lot of money to pay for it, which of course has the unwanted consequence of inflation; (2) to slow consumption and increase savings, which has the unwanted consequence of a slower economy, with less growth, fewer jobs, and possibly deflation.

To the optimists, all this worry is silly. Debt is at a record high, but so are assets. The net worth of individuals (assets minus debt) in fact has never been higher. The counterpoint is that asset prices have been inflated by low interest rates, and once interest rates go up, the true overwhelming nature of the debt will be revealed. Who is correct? It is difficult to say.

With such complex arguments being put forth, how can an individual investor know which extremity will win out - or whether we will just muddle along with moderate growth and moderate inflation. To make matter worse, the level of complexity described above is just the beginning. In this globalized world, to truly understand the trends in an economy, one must also examine competing economies and currencies. How Japan sets its interest rates or how fast China decides to grow its money supply, all will effect the economy in the U.S. For now, let's just stay with the simple case, and we'll explore the other factors in future posts.

While it will take years for the true path to reveal itself, in the short run the three previously mentioned indicators should be helpful. The first and probably most important is Oil. Oil has been on a long run-up. It is hard to believe a barrel of Oil was trading in the low teens in the 1990's. Since reaching that low, it has skyrocketed, exceeding almost all analysts' projections. Several weeks ago, Oil set a multi-decade high of just over $70 a barrel. Since then, it has come down to around $58 a barrel, where it is today.

Because Oil is such a vital and worldwide commodity, some, including me, see it as a possible indicator of larger trends, such as how fast inflation is growing in the U.S., and what effect foreign economic and money supply growth will have on U.S. inflation. In other words, if Oil is in an even longer term run-up, the more dire predictions of massive inflation are more likely to come true.

To determine the long-term trend of Oil, it is important to see over the next two months whether Oil breaks below $55 a barrel, or stays above it. If it breaks below $55 a barrel, then the trend has been broken. This is no guarantee that the trend will not resume, but a fairly strong indicator that at least for the medium term, the price of Oil will remain somewhat contained. If, however, it fails to go below $55 a barrel, then it will likely retest its high of $70, and at that point, we should all watch the $70 mark carefully. If it can break that, then we may be in for real trouble.

Any comments that aren't spam or obscenities are much appreciated!

Where to Invest

2005-11-13T16:18:00.000-05:00

If you're into investing these days, you have to be very careful.

The world is awash with liquidity, which has driven up lots of asset prices, from housing to bonds. While stocks have come down somewhat, they still trade at a slightly elevated historical price-to-earnings ratio.

There are lots of places to make money, you just have to look a little harder these days.

To start with, here are my high-level thoughts on the state of the market, and where I'm focusing my research.

1. Housing. No way. Don't touch it with a 10-foot pole. Housing is way over-extended, and is already starting to come down a little. http://www.benengebreth.org/housingtracker/ Housing prices depend a lot on interest rates, and interest rates are still going up. Until it is clear we are at the top of an interest rate cycle, I'd stay away from investment properties, REIT and other housing investments.

2. Bonds. Stay short-term and high quality. While there are some really nice high-yield bonds out there (I'll cover this later), the Fed is still raising rates. It is unclear exactly where long-term rates are going, but in my humble opinion, I think inflation is not only underreported, but underestimated going forward. Europe and Japan are talking about raising rates, so we could be in for a cycle of rising interest rates. Stay in short-term, high quality bonds and wait until it's clear interest rates are topping out. Only then will it be profitable to extend to longer term maturities.

3. Stocks. There are a few good plays out there. Price-to-earnings ratios are still a little high, but even so one can almost always find some real values in any environment. My personal favorites right now are:

UNAM - $9.49 - a small insurance company that trades just above book value and under 9 times P/E. They got into new lines of business in the late 1990's and lost lots of money. They got out of those businesses around 2000 to focus on their well-understood and profitable California P&C business, but the market is still treating them as if they had the bad businesses. A good value.

GLGC - $4.02 - also trading just above book value, this pharma research and services company is finally getting its two core business to be profitable, and getting into a 3rd, very exciting business. They are very undervalued on a metrics-basis, because the market doubts their ability to get profitable. I think the market is wrong, plus, I think the downside is minimum give their quality assets and high levels of cash.

4. Beware the Fed. I think the Fed is going to pump money into the system via the Repo markets, even as they raise interest rates. This should keep everything humming along, and we may see a holiday rally as is typical of this time of year. Looking into 2006, things are a little more scary, as increased liquidity and strong global growth may continue to generate inflation and force the Fed to continue to increase interest rates. A key metric to watch in the coming weeks will be if Oil stays above $55. The long-term trend in Oil is up, but if it breaks below $55, it will have pushed through it's downside support line. This could signal inflation is not as bad as I have been thinking. If Oil does stay above $55, however, and begins to rally, it could spell bad news for inflation and interest rates in 2006.

That's all for now!