Saturday, October 10, 2009

Insightful Weekend Reading

Quote of the week:

I think the crisis came about primarily because people of all stripes did novel, complex and dangerous things, in greater amounts than ever before. In the world of investing, for instance, people made excessive use of borrowed money — “leverage” — and committed too much capital to illiquid investments. It all happened because people believed too much, worried too little and thus took too much risk. - Howard Marks from Oaktree Capital Management

Members of both political parties may need to re-asses why they are in office: In an interesting opinion piece in the NY Times, Thomas Friedman discusses the biases of both parties and the hypocrisy inherent in their policy stances on certain issues. Out of one side of their mouths the democrats say limit carbon emissions or we will destroy our planet; while from the other side they say the government can spend all it wants because there is no looming debt crisis. On the other had the republicans argue that we should continue to pollute as climate change is a hoax but we have to cut spending or a debt bomb will destroy the dollar and our country. While these two topics have nothing to do with one another per se, arguing for one and against the other based on each one’s potential to change our way of life, seems incongruous:

Unfortunately, too many conservatives, who would never risk emitting so much debt that it would tank the dollar, will blithely tell you on carbon: “Emit all you want. Don’t worry. It’s all a hoax.” And too many liberals, who would never risk emitting too much carbon, will tell you on emitting more debt: “Spend away. We’ve got plenty of room to stimulate without risking the dollar.”

Because of this divide, our government has not been able to put in place the long-term policies needed to guard against detonating our mounting debt bomb and climate bomb. As such, we’re in effect putting our kids’ future in the hands of the two most merciless forces on the planet: the Market and Mother Nature.

As the environmentalist Rob Watson likes to say, “Mother Nature is just chemistry, biology and physics.” That’s all she is. You can’t spin her; you can’t sweet-talk her. You can’t say, “Hey, Mother Nature, we’re having a bad recession, could you take a year off?” No, she’s going to do whatever chemistry, biology and physics dictate, based on the amount of carbon we put in the atmosphere, and as Watson likes to add: “Mother Nature always bats last, and she always bats a thousand.”

Ditto the market. The market is just a second-by-second snapshot of the balance between greed and fear. You can’t spin it or sweet-talk it. And you never know when that balance between greed and fear on the dollar is going to tip over into fear in a nonlinear way.

Friedman correctly identifies that without climate change-focused reforms and a move back to fiscal sanity, we are leaving our future basically up to chance. Yeah, maybe our current policies won’t blow up the world, but Mother Nature and Mr. Market (a marriage made in heaven) are both capricious and none of us know exactly where the tipping point lies. Accordingly, as a conservative person I would rather hedge. This is my version of Pascal’s wager. I don’t know if climate change is for real (meaning I don’t have the skills or knowledge to personally verify certain conclusions and data) but I would rather believe it in and act accordingly just in case. The same is true when it comes to the mounting debt load. I don’t know how much debt the US can take on without causing a catastrophe, but I would rather not find out. Let us all hope that the people in Washington come to their senses before it is too late on either of these fronts.

Sprott says be worried about a potential US dollar crisis: Canadian investor Eric Sprott has recently been an unquestionable bear when it comes to the US. His latest report discusses the importance of the USD’s reserve currency status and the implications that the rising deficit could have on the dollar. While he suggests that it is unlikely that the US will see failed bond auctions that lead to a panic, he claims that it does not preclude a dollar crisis from unfolding. He believes that the US is killing the dollar and sooner rather than later the safe haven status that causes people to buy dollars during uncertain times will disappear. I have seen a number of counterarguments that assert that there is no other currency that is liquid enough or strong enough to compete with the dollar. While that may be true now, it does mean that the US can continue down its current path and just hope that a single currency or basket of currencies will not someday become a suitable replacement. I would rather act now (within reason of course) to protect the dollar so we don’t have to find out what a dollar crisis feels like:

The US dollar (USD) is the world’s “reserve currency”. This status is arguably the greatest privilege enjoyed by the US as an economic entity. Most people don’t appreciate its significance. As the world’s reserve currency, the USD is used by other countries across the globe to back up their own respective paper currencies. In some cases, it’s as basic as a country stockpiling US dollars in their central bank vaults. When asked what supports their Pesos, Rubles, or Yen, the powers that be simply point to their pile of US dollars as proof of value. Upon reflection, it’s quite obvious how tenuous it is to back up one’s currency with a pile of paper issued by another country, but this is exactly how the world of international currency has worked for decades. And it has worked quite well…until now.

Despite falling 36% since 2001 (as measured by the US Dollar Index (DXY)), it is only recently that the US dollar’s ‘world reserve currency’ status has been seriously questioned. The media pundits haven’t spent much time discussing this of course, but during the week of September 8th to 11th, the DXY actually fell to new 2009 lows every single day that week. Over the last six months there has also been a substantial increase in anti-US dollar rhetoric from China, Japan, Russia, France, Brazil, and even the United Nations. Reading between the lines, it appears the US dollar hegemony has finally broken, and what happens next will have major consequences for the global economy…

Chairman of the Federal Reserve, believes that the rising budget deficits in the United States are “unsustainable”. Because the US Government is printing dollars to fund their liabilities, it is highly unlikely that we will ever see a failed bond auction similar to that of Poland. The far more likely outcome, therefore, will be a US dollar crisis. It is for this reason that we have positioned our hedge funds and mutual funds so heavily in precious metals. At the end of the day, when the world finally realizes what the US has done to the world reserve currency, international investors will shift into an asset that no government can print. In our opinion the US dollar’s status as a ‘port’ in the financial storm has officially come to an end.

Hester of Hussman Funds on margins and earnings: Some of the best writing regarding the current state of the stock and bond markets has recently been coming from the men at Hussman Funds. This past week, Bill Hester delved a little deeper into the theme that John Hussman discusses just about each week in his posts. The idea is that at the peak the S&P was discounting highly levered and unsustainable company margins. But now according to Hester and Hussman, in the new normal and after the trauma our entire economy has suffered, a return to pre-crisis margins is very unlikely. However, based on Hester’s analysis, if one is to dig into the implied margins of sell side estimates, this return to past levels of profitability is precisely what is being baked into earnings projections. Companies have definitely been boosting margins and earnings by cutting costs (especially workers), but eventually they will need to achieve some top line growth to see sustained earnings growth. With consumer so stretched, unemployment continuing to increase and credit so tight, it is had to imagine a return to spending that will help facilitate a realization of what look like historically high margins. The takeaway? The market is not cheap at these levels. (Not that I had to tell you that)

For operating earnings to get back to their peak levels, analysts have penciled in earnings growth of more than 40 percent over the next year, and then another 22 percent between 2010 and 2011. These expectations sit far above what is expected from overall economic growth, where growth forecasts are more modest. There's a couple of ways companies could deliver strong operating earnings growth amid tepid economic growth. One is through a decoupling of the relation between sales growth and economic growth. If companies could grow their top lines in spite of anemic economic growth, then earnings could grow at higher rates than is typical when compared to the overall growth in the economy…

If sales are expected to grow modestly, and in line with economic growth, but earnings are expected to rise far and above what can be explained by economic growth or sales growth, then analysts must be assuming aggressive expansion in profit margins…

What's noteworthy in this analysis is not simply that margins are expected to recover. Margins typically do expand following recessions as sales pick up and businesses are slow to hire and invest because of continued uncertainty. What is worth highlighting is that analysts expect that the typical company will soon achieve the same level of profit margin that they were able to deliver in the years leading up to 2007 – a period where leverage was preferred over balance sheet strength, a preference by company managements to focus on equity shareholders, during a political climate where labor lacked bargaining power, where consumer spending was fueled by mortgage equity withdrawals, and leverage ratios increased broadly because business and consumer credit was easy to come by. To assume a return to peak profit margins is a bet that the economic and political landscape that emerges over the next year or two will match the pre-panic landscape perfectly.

Roubini lays out Bernanke’s to do list: In an op-ed piece in the Wall Street Journal this week, NYU professor Roubini and author Ian Bremmer present a sobering list of potentially arduous and often conflicting tasks that the Fed could be forced to take up in the coming years. Here is the list:

Ben Bernanke and the Federal Reserve face a number of very difficult challenges in the years ahead. They include:

• Resisting pressure to monetize deficits, which would eventually cause high inflation.

• Implementing an exit strategy from the massive monetary easing of the past year.

• Maintaining the Fed's independence, which has been compromised by the direct and indirect bailout of financial institutions and congressional attempts to micromanage the central bank.

• Properly calculating asset prices and the risk of asset bubbles according to the Taylor rule, an important guideline central banks use to set interest rates.

• Supervising and regulating the financial system more effectively, particularly in the role of "systemic risk" regulator…

In other words, avoid keeping rates so low that it causes another asset bubble while simultaneously not stifling a recovery by taking the punch bowl away too soon. When you add to that the need coerce Congress and the President to create a path toward fiscal responsibility without provoking a backlash that could threaten the Fed’s independence, Bernanke and crew are likely to have a rough few years. Not to say that they did not have a hand in creating the mess they subsequently have to help clean up. But, when you look at the above list it is hard to imagine that the Fed will be able to use the blunt monetary instruments at its disposal adeptly enough to fight deflation now without stoking inflation down the road. I wish them luck but the goldilocks scenario of just right monetary policy seems about as likely to play out as Bernie Madoff being released from prison.

One other point that Roubini makes that I think needs to be stressed over and over again is that we can never forget the depth of the Fed’s ties to the financial institutions it is supposed to regulate. As Simon Johnson has said, the Fed is certainly not immune to being captured just like the other regulators that were supposed to be watching various corners of our financial system:

The Fed is currently resisting a Treasury-led effort to review how it is organized out of concern it might forfeit its independence. Yet the governance structure of the New York and other regional Federal Reserve banks left them effectively controlled by large financial institutions last year, so such a review is necessary. While congressional interference in the Fed's jurisdiction is a danger, the recent quasi-fiscal activities of the Fed bear a review.

The Prudent Bear says Fed should raise interest rates now: Hey, the Australian Central Bank just did it. Why not the US? Although I am skeptical of the negative derivative effects that easy monetary policy inevitable leads to, I am not sure it is quite time to raise rates in the US. Martin Hutchinson does make the a few valid points though. First, with after tax returns on cash not much higher than 0%, by keeping rates so low the Fed is making consumer saving look like a very poor option. How can you rebuild your balance sheet if you get nothing for the money you save? No wonder people are throwing money into the stock and commodity markets. This is his second point. A sharp rise in interest rates would likely curb the speculation and euphoria in the stock and commodity markets that may be fueling another unsustainable bubble.

On the one hand, raising interest rates sharply, perhaps to a 2% federal funds target rate in the initial step (while maintaining high liquidity) but with the announced intention of moving rapidly towards 5% or more if inflation takes off, would appear to offer only benefits. Since interest rates paid by small business borrowers are far above those paid by the government, an increase in fed funds rates and Treasury bond yields will have minimal effect on small businesses, provided liquidity remains high. Small business loans will still offer the highest interest margins to lenders, so if liquidity remains available and lenders are not concerned about their own funding, they will be made.

On the other hand, a sharp increase in interest rates would knee-cap stock, bond and commodity markets, aborting the rapidly inflating bubble that is threatening to produce yet another orgy of resource misallocation. In the stock market, casinos would no longer be able to bail themselves out of bankruptcy through initial public offerings (IPOs). Internationally, a drop in oil prices would shove Messrs. Chavez, Ahmadinejad and Putin at least partly back in their boxes, while a fall in the gold price would short-circuit inflationary psychology before it really takes off.

Higher short-term interest rates would give U.S. savers at least a zero real after-tax risk-free return on their money, thus ending the odious Keynesian “euthanasia of the rentier” that Fed Chairman Ben Bernanke and his predecessor, Alan Greenspan, have been undertaking since 1995.

Most important, a really frightening crisis in the Treasury bond market would bang the heads of Congress and the Obama administration against the wall, and force them to start getting the budget deficit under control.

Once higher interest rates have deflated the various bubbles, pushed the housing market down to a sustainable bottom and forced the government to rein in the budget deficit, liquidity can be gradually removed from the market, as the government’s financing needs and the bubbles’ demands on liquidity will no longer be so excessive.

Maybe we should raise rates like Volcker did even if it does push the economy into a much deeper recession. Take a little bit (more likely a lot) of pain now in order to avoid suffering some kind of quality of life changing calamity in the future. The problem is that there is no way to be sure how likely this Armageddon scenario really is and we have to remember that politicians’ main goal is to get re-elected. If the Fed raised rates to 2% tomorrow I would bet anything that Ron Paul’s bill to audit the Fed would be passed the next day, including some extra clauses that virtually stripped the Fed of all of its powers. So, while taking short term pain to make sure our children have a dynamic place to live may be the most prudent course, there is no will in Washington, on Wall Street, or even on Main Street to do so.

Simon Johnson says don’t blame China: Sounding like the kids from South Park singing “Blame Canada,”many financial commentators like to blame China for our current housing woes. The refrain goes something like this: the Chinese funneled money from their massive current account surplus and reserves into the US housing market, keeping rates unnaturally low and eventually causing a housing bubble. While this may have been a portion of a toxic cocktail, it was certainly not the only element that impacted housing values. As Simon Johnson points out, there were many other culprits who should share blame: banks, regulators, the Fed, rating agencies, etc. Coming up with a convenient scapegoat (especially a non-American one) is attractive to politicians who don’t want to get blamed for being on the job when the world fell apart. But, according to Johnson, this use of revisionist history is nothing more than an attempt to avoid fixing the many problems inherent in our economy and financial system:

This may seem like an obscure point, but basically it means that even with the low rates of the Greenspan FFed, and even with all that cheap money from overseas, we couldn’t get it where we needed it to go because it was being sucked up by the housing sector. And it was being sucked up by the housing sector because lenders earned fees for making loans that could not be paid back, and banks earned fees for packaging those loans into securities, and credit rating agencies earned fees for stamping “AAA” on those securities, and all sorts of financial institutions — including those same banks — loaded up on these securities because they offered high yield and low capital requirements. In short, we had a dysfunctional financial system that failed at its most fundamental job — allocating capital to where it benefits the economy the most.

Encouraging productive investment by businesses and preventing the next bubble go hand in hand — both require fixing the financial system. Blaming global imbalances — a consequence bereft of either a subject (an actor) or a verb (an action) — is only a way of avoiding our real problems.

(Picture courtesy of