Sunday, August 30, 2009

Weekend Leisure Reading

10 Reasons the market has topped:
Hat Tip to Abnormal Returns and The Reformed Broker for posting Doug Kass’s list of reasons the market has peaked for the year:
  1. Cost cuts are a corporate lifeline and so is fiscal stimulus, but both have a defined and limited life.
  2. Cost cuts (exacerbated by wage deflation) pose an enduring threat to the consumer, which is still the most significant contributor to domestic growth.
  3. The consumer entered the current downcycle exposed and levered to the hilt, and net worths have been damaged and will need to be repaired through higher savings and lower consumption.
  4. The credit aftershock will continue to haunt the economy.
  5. The effect of the Fed’s monetarist experiment and its impact on investing and spending still remain uncertain.
  6. While the housing market has stabilized, its recovery will be muted, and there are few growth drivers to replace the important role taken by the real estate markets in the prior upturn.
  7. Commercial real estate has only begun to enter a cyclical downturn.
  8. While the public works component of public policy is a stimulant, the impact might be more muted than is generally recognized. There may be less than meets the eye as most of the current fiscal policy initiatives represent transfer payments that have a negative multiplier and create work disincentives.
  9. Municipalities have historically provided economic stability — no more.
  10. Federal, state and local taxes will be rising as the deficit must eventually be funded, and high-tax health and energy bills also loom.

I think the ones that are most important and impactful are the over-levered consumer, the impending commercial real estate problems and the inability of companies to cut more costs to boost the bottom line. With these substantial headwinds in mind you would assume that at some point the valuation of the market will reflect rational expectations regarding earnings. As such, I would not be surprised at all if the market eventually corrects rather dramatically. As a value investor I sure hope it overshoots so I can get in at a valuation that I am comfortable at.

Don’t forget to calculate the real return when it comes to this recent rally: Hat Tip to The Pragmatic Capitalist for posting the link to this article in Barron’s. What I did not realize is how much value the dollar has lost against a basket of currencies during the current stock market melt up:

The U.S. stock market bottomed and the U.S. Dollar Index peaked almost simultaneously in March. While U.S. stocks are up more than 50% in that time, the Dollar Index (which measures the greenback's value against the euro, the yen, the British pound, the Canadian dollar, the Swedish kroner and the Swiss franc) is down nearly 12%.

With inflation not currently being a problem, it is easy to forget that the real return on an investment also has to include currency fluctuations. In this case the dollars you can sell your appreciated stocks for are worth 12% less than they were in March. While obviously investors holding cash have suffered the same decline in dollar value, investors who put money in foreign equities have been able to realize currency gains and impressive stock market appreciation. The moral of the story?

Since March 9, the value of U.S. equities, as measured by the Wilshire 5000, has increased 54%, or $4.4 trillion. But those dollars have been devalued by nearly 12% in that time. Investors should not mistake asset inflation for real wealth appreciation. And policy-makers should not mistake yet another asset bubble as reason to believe their actions achieved their intended goal.

Is the Fed Insane? Another hat tip to The Pragmatic Capitalist for posting this link. There is no question that the Fed has done everything it can to supply certain entities with an endless amount of liquidity that has been the force behind pushing up a number of asset classes. But, as this author points out, that scheme didn’t work so well earlier this decade when low interest rates helped spark the housing bubble that has so un-apologetically imploded. So, why would we expect a different outcome this time? Maybe if we were being rational, we wouldn’t:

For the Too Big to Fail Bankers at Jackson Hole, who were as thick on the ground as protestors at a town hall meeting, Bernanke has certainly been a savior. He’s cut their funding costs, loaned them money on dubious collateral at rates that would make Santa Claus blush and allowed their competitors to fail. If I belonged to the Too Big to Fail Club for Men, I’d be pretty happy too. For the rest of us mere mortals, the Fed’s actions are not quite as beneficial. CD rates are only high enough to ensure a loss after taxes and inflation, while getting a loan now includes the financial equivalent of a colonoscopy without the benefit of anesthesia…

I can’t help but notice that the Fed’s current policy is eerily similar to the policies that produced the housing bubble and its aftermath. The “considerable period” of low interest rates that convinced one and all that house prices only rise has made an unlikely comeback. The old saying about insanity being defined as doing the same thing over and over and expecting different results certainly applies. (Emphasis mine)

The government smokes green shoots: Hat tip to Zero Hedge for posting this link. There does not appear to be any shortage of irrational exuberance or animal spirits among those in the Obama administration these days. Even though the deficit projections were revised up by a trivial $2 trillion recently, it appears that the move up in the stock market has caused some pretty extreme optimism among government forecasters:

Consider this week's projections of growth of gross domestic product in real terms, exclusive of inflation. The White House projects that GDP will grow by 3.8% in 2011 and climb above 4% a year for the next three years, followed by two years above 3%. This is far higher than historical norms-the economy has not seen such a period of growth since the 1960s.

This is self-serving optimism. By assuming higher economic growth, the forecasters can show more tax revenue and lower estimates of future deficits.

Excessive Obama optimism is not limited to economic growth. Despite the enormous monetary stimulus pumped out by the Federal Reserve in 2008-2009, bank credit that is widely regarded as potentially inflationary, the administration assumes that inflation will actually decline from 2.1% in 2008 to 1.5% in 2009 and then to 1.3% in 2010 and 2011, and not rise above 1.8% through 2019.

Well above average growth and incredibly tame inflation? I guess it could happen. But these projections sure look like best case scenarios. The combination of an over-levered consumer and far too much capacity in the system should limit growth a tad, even though we are coming off of a depressed base. Plus, whether you think the US is Japan, Zimbabwe or neither it is hard to argue that a doubling of the Fed’s balance sheet at least does not have the potential to be inflationary. The more I think about it, the more I fear that the projections for GDP and inflation are both too high. Despite all the ramblings about hyperinflation, the more likely scenario may be minimal growth and deflationary pressures, similar to what Japan has experienced. In any case, what nobody wants are government forecasters who are like sell-side analysts who believe that the companies in their coverage universe can prosper despite the fact that the world is falling apart around them. I would much rather see realistic assumptions that take into account the magnitude of the headwinds the US is facing.

George Bush- the gift that keeps on giving: I certainly don’t approve of the comments coming out from members of the Obama camp that consistently reference how they inherited this current financial mess. I think this rhetoric is nonsensical partisanship. Let's blame Bush and Paulson (but not Bernanke or Geithner). It may be their fault to some extent, but honestly, who cares? It doesn’t change the fact that our current leaders have to figure out ways to help the economy get out of its current malaise without causing a revolt among our foreign creditors. Having said all that, when we evaluate how the Obama administration is performing, we can’t forget the lasting legacies of the Bush years. From Paul Krugman:

There were two big-ticket Bush policies. One was the tax cuts, which cost around $1.8 trillion in revenue; add in interest costs, and we’re presumably talking about more than $2 trillion in debt. The other was the Iraq War, which has cost at least $700 billion, and will cost more before we finally extract ourselves.

Without these gratuitous drains on the budget, it seems fair to assert that we’d be coming into this economic crisis with a federal debt around 20 percent of GDP ($2.8 trillion) smaller than we are. And that, in turn, means that we’d be looking at projected net debt in 2019 of around 50 percent of GDP, not 70.

And that would definitely not be a scary number. Net federal debt was 49 percent of GDP in 1993, at the end of the Reagan-Bush years; Bill Clinton did move to reduce that number, and succeeded, but the nation wasn’t facing imminent crisis.

The bottom line, then, is this: the irresponsibility of the Bush years has left us poorly positioned to deal with the current crisis, turning what should have been an easily financed economic rescue into a more difficult, anxiety-producing process.

The ghost of George W. just never goes away. The point is to remember the hand that Obama and his cabinet members were dealt as a result of the choices made by his predecessor. In my eyes these circumstances will never be an excuse for the failure to implement smart policies and reforms. However, an unbiased observer should be willing to give Obama some time and maybe even the benefit of the doubt when the next set of elections comes around.

The guys who set the fire are now charged with putting it out: In this piece from Simon Johnson of the Baseline Scenario, he compares Ben Bernanke (who continues to receive accolades for saving the US from a Depression) to some real firefighters who were found to be the original arsonists. The implication, of course, is that Helicopter Ben had a hand in starting this fire, so why in the world are we dumping so much praise on him for helping to protect some of the few remaining buildings from being burned down. It’s kind of like giving a terrorist a medal of honor for disarming a second bomb seconds before it goes off after letting the first one explode.

But what if the financial crises in recent decades – you can add the dotcom bubble, the S&Ls fiasco, and various emerging market debt crises to our recent housing and banking disaster – is not a sequence of random unfortunate events, but rather the product of a dangerous financial system? Given that today’s firefighters also previously held responsibility for overseeing this system, both recently and as long ago as the early 1990s, this question is relevant – particularly as the very same team, in various combinations, repeatedly pronounced on the system’s fundamental soundness.

Some of today’s firefighters pushed hard for deregulation of derivatives markets in the 1990s, and this now proves to have been an important cause of the crisis (Summers and others). Others had responsibility for the solvency of Wall Street over the past half decade, yet disguised all potential warnings in layers of impenetrable opaqueness (e.g., Geithner; see p.91 in David Wessel’s bestselling In Fed We Trust, Crown Business, 2009). Still others pronounced that there was no housing bubble exactly as things spiraled out of control and the potential costs to taxpayers rose (Bernanke and his colleagues at the Fed; again, pick up Wessel’s book, p.93 is among the most damaging).

This theme is becoming more and more prevalent among market commentators. People from Taleb to Marc Faber to Simon Johnson are asking the simple question of why we trust our firefighters when they either ignored the fire as it got out of control or actually started it themselves. All of these men have a valid point.

More confirmation of a purely speculative rally: Hat tip to Zero Hedge for posting this link. It is not often that I get to use data from Fama and French of EMH fame to further one of my arguments so I am going to milk this as much as I can. As the following commentary from MarketWatch indicates, this has been the rally most driven by small cap growth companies as compared to solid, large cap value firms:

Perhaps the most revealing historical dataset in this regard is the one maintained by University of Chicago finance professor Eugene Fama and Dartmouth professor Ken French, which dates back to the mid 1920s. The accompanying table reports the returns of their small-cap growth and large-cap value sectors over the first six months of recent bull markets.

(A) Small-cap growth

(B) Large-cap value

First six months of bull market that began on...


Ratio to (A) to (B):







To put these historical ratios in context, consider that the corresponding ratio for the recent rally would be 3.2-to-1 if we were to focus on Ford Equity's quality ranking, and 2.32-to-1 if we were to segregate stocks according to market cap.

Tough to know exactly what to make of this but it is definitely a cause for concern regarding the sustainability and legitimacy of this rally.

AIG stock price increases have gotten out of hand: I am continually baffled by the moves that we have seen in the stocks of supposedly distressed companies such as AIG, Freddie Mac, Fannie Mae and Citigroup. What disturbs me even more is that the trading volume of the above 4 stocks has made up more than 30% of total volume recently. Aside from some bullish comments made by the new CEO of AIG (that he actually seemed to contradict a few days later), nothing but wild speculation and day trading seem to be fueling these gains. From the NY Times:

Yes, the company has named a new chief executive, who comes from a solid background at MetLife, and yes, he has said that A.I.G. will pay back the government for its bailout sooner rather than later. The giant insurer has been moving to change the names of key business units and working to disentangle its bewildering structure. It even reported a profit in its latest quarter.

But none of that really explains the recent gains. Speculation swirls daily that some deal may be in the works, that short sellers are being squeezed out of their positions, or that the company’s former chief executive, Maurice R. Greenberg, may be poised to make a comeback in the role of consultant. The new chief executive, Robert Benmosche, has been fueling some of the interest, as he talks about seeking advice from Mr. Greenberg and slowing the breakup of A.I.G. so it is not a fire sale.

[Optique Capital analyst] Mr. Fitzpatrick said he thought the likelier explanation for the increased share price was that speculators looking to profit from a distressed stock had pounced on A.I.G.

Looks like some run of the mill illegal insider trading in Dell shares: Hat tip to Karl Denninger for posting the chart below. It shows the ramp up in shares of Dell well before the earnings news was officially released around 4pm EST. You can see a big move up in price and a huge spike in volume at 3:43pm EST, a fact that suggests that the news was leaked and those who received the information had no qualms about using it to their advantage. This would never happen if the SEC were still alive. Wait, they are? You're kidding. I wish someone would tell me these things. Well, we know they move REALLY slowly so maybe sometime in 2011 a retail investor trading shares through his E*Trade account will get charged with insider trading.

We have no one to blame but ourselves: Hat tip to James Kwak of The Baseline Scenario for posting this link. The authors of this piece from the University of Wisconsin conclude that the US has borrowed itself into a debt crisis. Yes, China may have been a facilitator of our excesses, but the real blame lies in the consumers and government institutions that used leverage to finance consumption and spending. You can also try to blame opaque financial products and greedy bankers but the root cause of our current conundrum is still good ole fashioned excessive leverage. The other thing the authors point out is that this debt fueled consumption not only pushed up the prices of non-tradable goods such as housing, but also of other services for which I think pricing may prove to be somewhat sticky. If I am right, this is a form of inflation that just decreases purchasing power further.

The United States has borrowed and spent itself into a foreign debt crisis. Between 2001 and 2007, Americans borrowed trillions of dollars from abroad. The federal government borrowed to finance its budget deficit; private individuals and companies borrowed so they could consume and invest beyond their means. While some spending went for physical commodities, including imports, much of the spending was for local goods and services, especially financial services and real estate. The result was a broad-based, but ultimately unsustainable, economic expansion that drove up the relative price of goods not involved in foreign trade—things like haircuts, taxi rides, and, most important, housing. The key “nontradable” good was housing; that boom eventually became a bubble. And, when that bubble burst, assessments of assets and liabilities across the board became unbalanced.

The debt crisis of 2008 would have occurred in the absence of credit default swaps and other exotic financial instruments (such as collateralized debt obligations, the sliced and diced securities based upon other securities backed by mortgages). But these factors greatly magnified the impact of the debt crisis and significantly complicated the policy response to the ensuing events.

Unpaid property taxes are leading to more foreclosures: According to this piece in the NY Times, struggling municipalities are now selling their claims to unpaid property taxes to third parties who try to collect. The problem is that these firms just care about getting their money. They don’t care at all about whether or not their collections lead to foreclosures that further depress housing prices:

The Times’s Jack Healy reported the other day that in recent years, some cities and counties that are strapped for money have sold their delinquent tax bills to private firms. The firms, which typically charge double-digit interest rates and steep fees, get to keep what they collect. They also get the right to foreclose on the homes, taking priority over mortgage lenders.

Debt collection is always tough. But it is especially fraught when private firms go after unpaid taxes, because private collection distorts the public interest. For example, governments can also foreclose for unpaid taxes, but they are less likely to do so out of concern for property values and quality of life. The auditor in Lucas County, Ohio — which sold more than 3,000 tax liens for $14.7 million — said that the cost to the community from abandoned and foreclosed properties has been greater than the short-term benefit from selling the liens.

Mark this as just another subtle, incremental headwind facing the housing market. Unfortunately, I feel like I read about another such impediment just about every day.

Guess what? Stocks aren’t cheap: One more hat tip to The Pragmatic Capitalist for posting the link to this article in the Wall Street Journal. Even with James Montier gone, Albert Edwards and crew at Soc Gen continue to look for Ben Graham type stocks. I don’t think it will surprise you that there are VERY few out there now:

What still looks cheap to hard-core value investors?

Oil major Chevron, pharmaceuticals giant Merck, and contract oil and gas drilling company Patterson-UTI are the only U.S. stocks that passed the most brutal value tests run by analysts at Societe Generale, the investment bank, in London.

Three stocks isn't much.

Societe Generale's screens were heavily influenced by Benjamin Graham, the famous father of value investing. They looked for shares where the earnings yield is at least twice that of top-rated corporate bonds, and where the dividend yield is at least two-thirds of the bond yield…

Bottom line? In the MSCI World Index, which covers the stock markets of the major developed economies, just fourteen stocks passed, says SG's global quantitative strategist, Andrew Lapthorne. That includes the three U.S. stocks mentioned. (Energy stocks were heavily represented: Others that passed include BP, Total, ENI and Royal Dutch Shell.)

At the end of February, as the market was nearing its lows, Societe Generale found 44 stocks that passed the tests, including seven in the U.S.

So you can keep buying this rally if you want. But don’t be surprised if what you find are not bargains but lemons disguised as good companies.

Bob Shiller on the feedback loop of economic confidence: In this piece Yale economist Bob Shiller discusses how both negative and positive confidence in the economy can spread and be self fulfilling. He believes that animal spirits are at work at all times; a view shared by most value investors as well. We know that the pessimism present at the beginning of the year has turned into wild bullishness, but exactly where are we now in terms of confidence?

I have been collecting survey data since 1989 on public opinion about the stock market; since 2001, the surveys have been conducted under the auspices of the Yale School of Management. We compute a “Crash Confidence Index,” which measures people’s confidence that there will not be a stock market crash like that of Oct. 28, 1929, or Oct. 19, 1987. The index reached its all-time high in 2006, as the market was still soaring. It reached its low at the beginning of this year.

Recently, the Crash Confidence Index has been on an upswing again. Stories about market crashes are less frequent and are being crowded out by a wide variety of other, more normal narratives. The markets have repeatedly been shrugging off bad news because people have a different mind-set.

Contrary indicator alert! Investor complacency alert! This is becoming a crowded trade. That might be fine if there were a lot of good news in the short run or news that indicated a brighter future. Maybe there just aren’t many green shoots where I am, but it sure feels like the coming quarters are going to be as difficult for real people as the past 18 months have been.

(Picture of Doug Kass courtesy of