Wednesday, September 30, 2009

Wednesday is link day

Reasons to like the China story, but not the investment opportunity: Hat tip to Yaser Anwar for giving us access to the latest comments from Dylan Grice at SocGen. In his latest piece, he discusses both why investing in China could be lucrative and why it could be dangerous at the current levels. The investment thesis on China is not so dissimilar from the case for investing in tech stocks in the late 1990’s. Yes, the internet changed our lives in an incredible way. But, in terms of an investment, especially after the story had become well known, betting on tech stocks turned into a nightmare. The reason, of course, was valuation. No matter how good a story is and how likely it is to come true, if the stocks are extremely overvalued it is very tough to make money on them. Similarly, the emergence of the Chinese may change the world forever. China may well become the most powerful nation on the planet. There are certainly risks (as Grice points out) but the bull story for China over the long run probably is pretty compelling. However, as Grice so eloquently says, “Value should always get in the way of a good story.” In other words, investors need to distinguish between a good story and an invetsment that is priced to provide excess returns. Below is a bullet point summary from Grice of his views on China:

-Any investment contains risks, and investing in China may contain more than most. But the price Mr Market is currently offering appears to offer little compensation for taking them. There are many reasons to be strategically bullish on China, but valuation isn’t one of them.

-Last week I argued that China could become the most spectacular bubble, sorry, bull market, the world has ever seen. Financial history shows that large geopolitical swings frequently coincide with manias, while financial deregulation acts as the catalyst for rapid credit growth. Both are likely to exert increasing sway in coming years.

-Miyamoto Miyashi, the legendary Japanese Samurai, said that in strategy it was important to see distant things as if they were close, and to take a distanced view of close things. So as a long-run story, the Chinese super-bubble theme is worth keeping in mind.

-But a good story isn’t an investment case. Anyone investing in the late 1990s into the story that the internet was going to change the world, for example, likely lost a fortune, even though the story was 100% correct. Value should always get in the way of a good story.

-Prospective investors in China today face significant risks: the quality of the data and the inflation of bank credit cloud the near-term outlook, while water shortages, or China’s apparent historical propensity to take the wrong policy turn when seemingly poised for greatness pose longer-term investment risks too.

-Price is what you pay, value is what you get. Using a simple Graham and Dodd type valuation approach, the Chinese market trades at around 23x cyclically adjusted earnings, marginally higher than its recent average. It’s not obvious that the market’s current pricing offers much in the way of a margin of safety.

Confusing competitiveness with profitability: During the recent G20 meeting, there apparently was a lot of discussion regarding the need for higher capital levels at banks. So far there have been some whisper numbers but nothing concrete. While it is not hard to see that higher capital levels could potentially make the entire banking sector less prone to nasty blowups, the specific details will make or break whether or not reforms are effective. The level clearly needs to be high enough that a financial institution can withstand unexpected losses. The problem is that if the percentage of capital is set at a level unacceptable to financial institutions, they will use their strong lobby to stymie any reform movement. I think even the most defiant CEO understands that at least some changes are forthcoming. However, we know that these people will do anything they can to water down the impact of new regulations. These actions are justified by arguing that if capital standards are too onerous, certain institutions will become uncompetitive in the global market place. Don't believe it. What they are really saying is that if one country has more stringent rules than another, the banks located in the more regulated environment will not be as profitable. Less leverage means a lower return on equity and could mean smaller bonuses for the banksters. If competitiveness is measured by the ability to pay out exorbitant bonuses then maybe the opponents to leverage caps or larger capital buffers have a point. But, as Simon Johnson points out below, the rest of us should not shed any tears for these people. The US should act to make the entire financial system more secure regardless of what other countries do:

It’s time to get past the thinking that our economic prosperity is tied to the “competitiveness” of the financial sector, when that means doing whatever finance wants and keeping capital standards low.

As we discovered over the past 12 months, undercapitalized finance is not a good thing – it is profoundly dangerous and expensive. Other countries should be encouraged to raise capital standards also, but if they can’t or won’t, then their financial institutions will (a) not be allowed to operate in the United States, and (b) be allowed to interact in any way with a US bank only to the degree that the US entity carries an extra (big) cushion of capital in those transactions. Any US entity found circumventing these rules will be punished and its executives subject to criminal penalties.

Of course, this process needs to be WTO-compliant and the G20 is as good a place as any to manage the high politics of that. But stop worrying about what other countries might or might not do. Establish high capital requirements in the US, and make this a beacon for safe and productive finance.

And prepare for the crises that will sweep undercapitalized parts of the world financial system in the years to come.

Forbearance and “extend and pretend didn’t work in Japan and it won’t work here: In his latest missive, John Hussman discusses how the leaders and regulators in the US have refused to force banks to recognize their losses and restructure their debts. Of course, this type of inaction is reminiscent of the attempts of the Japanese to emerge from its real estate crash by allowing banks to earn their way out of the cycle. We now know that policy did not work and in fact created numerous zombie banks. That begs the question of whether or not the US is in actuality doing anything different. I understand that the US is not Japan and that times are different. But from a broader perspective, if the definition of insanity is doing the same thing over and over and expecting different outcomes, what does that say about global policy makers?

Historically and across countries, according to the IMF, 86% of systemic banking crises have ultimately required government restructuring plans that included closing, nationalizing and merging banks. Yet the policy response of the U.S. has been akin to putting a band-aid on an untreated infection. Worse, not only has the underlying infection been overlooked, but thanks to the easing of FASB mark-to-market rules early this year, we have at least temporarily stopped reporting on the status of that infection.

After the bubble burst in Japan in 1990, Japanese banks were not compelled to properly disclose their losses either. The predictable result is that the problems resurfaced later, but worse, because they had not been addressed…

Forbearance only works, however, if you're buying time to do something to restructure debt. Instead, we've celebrated bailouts and the easing of reporting requirements as if they are a substitute for restructuring. In my view, this is a mistake that will haunt us…

With the financial markets cheerily celebrating the end of the recession, credit spreads back to 2007 levels, and analysts referring to the mortgage crisis as largely a thing of the past, it is natural to ask why I would start pounding the tables again about debt restructuring. Old news. Problem solved. Why even bring it up?

The simple answer is that we have not solved the mortgage mess. We have temporarily buried it under a pile of public money, bailing out bank bondholders at public expense. As I've noted before, the best time to panic, in the financial markets, is before everyone else does. Similarly, the best time to consider responses to credit strains is before they surface. My sincere hope is that if, and I believe when, financial trouble resurfaces, we will be wise enough as a nation to prevent policy makers like Geithner and Bernanke from making the same bailout mistakes twice, protecting irresponsible lenders, and further burdening the nation with debt in the process.

Why we should to continue to be worried about US housing: Hat tip to The Pragmatic Capitalist for posting the link to this article in Fortune. If you read my blog or follow Whitney Tilson’s housing crusade or keep track of what Mark Hanson is writing about, nothing in this article will be news to you. There are still many structural headwinds facing the housing market that somehow continue to get overlooked by the media and government pundits (is that an oxymoron by the way?). In fact I was listening to a speech by Philly Fed President Plosser in which he specifically highlighted that housing had turned around. (I do give him credit though for being very candid about the risk of inflation and how hard it will be for the Fed to turn of the liquidity spigot.) Accordingly, I feel it is my duty to continue to articulate the reasons that housing prices may not yet have bottomed. My goal is not to turn each and every one of my readers into housing bears. The aim is to make people aware that there is still some risk to the downside and to hint that it might be prudent to take the mass media’s accounts with a grain of salt. In terms of this particular article, I think there are two items that are worth noting specifically:

Prices Are Still High

Although home prices have plummeted from their stratospheric levels of 2005 and 2006, they are still well above their historical norms. The Case-Shiller Home Price Indices, for example, shows that home prices in 20 major cities are still 41% above the level of January 2000 (at the peak in July 2006 they were 106% above that level). A report from the Census Bureau this month shows that incomes have not grown this decade. How are Americans supposed to afford 41% more house with no increase in income? While home prices may not revert all the way back to their long-term average, by at least this measure, prices are still very high.

Shadow Inventory

The market has been terrible for three years. Many Americans who might like to move have simply been waiting things out. Banks have put so many homes into foreclosure that they are backlogged in actually releasing the homes onto the market. And homebuilders are still bleeding money as they sit on vast tracts of undeveloped land that they'd like to slap homes on as soon as they find some buyers. Every time things start to look good, this shadow inventory starts to come back on the market, keeping prices low.

It is important to remember that even with the recent drop in prices, housing (on average) is still way up during this decade. The problem with this is that household income has not grown. So, if you think of housing price to household income kind of like a price to earnings ratio, this would imply a high P/E relative to the 2000 period. (I am aware that a better measure of a house’s P/E ratio is the price to equivalent rent. I am just trying to illustrate a point.) The takeaway is that people should be careful not to get anchored to the recent fall in prices when they measure the value of a home. Just because the price is down does not mean it is cheap. To understand value, people need a baseline from which to compare and the data from 2000 provides a sobering reminder of what a debt fueled bubble can do to prices.

The slow crawl back to financial reality: In his weekly article, Martin Hutchinson of The Prudent Bear takes readers through the recent fantasies that investors have been caught up in. He starts with the fantasy that sophisticated models could protect investors from risks and potential blowups. The crash of 1987 and the implosion of LTCM should have put this fallacy to rest. He also discusses the tech bubble and how the idea that all of these dot coms could be profitable at the same time (based on the size of the market and global GDP) was completely ludicrous. Then, as a result of the burst of the tech bubble, the Fed was under the delusion that deflation was on the horizon and subsequently took interest rates to incredibly low levels (well, at least back then) and left them there for too long. Finally, he discusses the current period and the plethora of foolish beliefs held by the Fed, regulators, the banks and even homeowners.

The problem is that while some of these fantasies look silly to most people in hindsight, very little is being done to get us back to reality- based capitalism. Maybe I am being too harsh and behind closed doors the people creating fiscal and monetary policy understand what must be done, but it sure seems as though many are trying to re-create the bubble that just exploded. Hutchinson suggests that all of the liquidity and stimuli being pumped into the market are preventing the necessary corrections from happening. In other words, the Fed and Treasury are not letting the markets regulate and punish those who made foolish decisions based on convenient fantasies. While allowing the natural process to occur without distortion may be quite painful in the short run, we would all likely be better off if excesses were cleared away and those who deserved to fail were actually allowed to:

A new webzine, CFOZone, has highlighted a study showing that companies which declare "pro-forma" earnings (dolled up by management to reflect the most favorable assumptions) suffer increased attention from short sellers, about $1.3 million worth initially after the pro-forma earnings declaration – just north of 1% of trading volume. This is good news; it suggests that the market is becoming hostile to attempts to fool it. The sooner we move to a reality-based capitalism, the better – but it may take some considerable time…

As the bubble that has developed since March is showing, the bailout of the world's financial system has stymied the normal bear-market correction mechanism that restores reality to the markets. Further nonsense like the declaration by the Federal Open Market Committee Wednesday that "economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period" only encourages the unreality – if good quality borrowers can borrow short-term at a cost well below the rate of inflation (let alone the likely future rate of inflation), then fantasy continues to be subsidized…

A reality-based market seems almost like Nirvana. A market that punishes dodgy accounting rather than rewarding it. A financial system that rewards savers adequately. A capital market that selects only sound borrowers and rational projects. A banking system that imposes no costs on taxpayers, and treats even its retail customers with respect and integrity.

It's a goal well worth striving for, and may well begin restoring U.S. prosperity when it arrives. But it will very likely require a horrendous period of downturn and destruction before it can be attained, as the costs of fantasy manifest themselves.

(Map of China courtesy of