The Darkside of QE2

(A version of this posting was sent out to clients of West Coast Asset Management as a part of the firm's monthly letter)

“The Federal Reserve will buy $110 billion a month in Treasuries, an amount that, annualized, represents the projected deficit of the federal government for next year. For the next eight months, the nation’s central bank will be monetizing the federal debt. This is risky business. We know that history is littered with the economic carcasses of nations that incorporated this as a regular central bank practice.”

-Federal Reserve Bank of Dallas President Richard Fisher (November 8, 2010)¹

The Backdrop

The US financial discourse over the past few months has been dominated by analysis of what has been deemed QE2. For those of you who are unfamiliar with the concept, QE2 is simply an acronym for Quantitative Easing 2. The first round of QE began in March of 2009 when the Federal Reserve embarked on a plan to buy $1.25 trillion in agency mortgage backed securities (those securitized by Fannie Mae and Freddie Mac) and $300 billion of longer term US treasuries. However, with unemployment still uncomfortably high and the perception that there is only a trivial risk of inflation on the horizon, the Fed is at it again; this time vowing to buy $600 billion of US Treasuries over the next eight months.

Specifically, the Fed’s goal is to reduce interest rates available to individuals and businesses even further. Usually, when it wants to achieve that objective, the Fed uses its Fed Funds Rate (FFR) to manipulate interest rates. The FFR is a rate at which depository institutions (primarily banks) lend money to each other (at the Fed) on an overnight basis. During its periodic meetings, the Fed determines the target Fed Funds Rate based on its views regarding the economy. Then, if the Fed wants to slow down growth or contain inflation, the remedy is often to increase the FFR. By making it more expensive to borrow, banks will be less likely to borrow money that they can then lend to customers and excess credit creation will be forestalled. However, if the Fed wants to stimulate growth or prevent inflation from being too low, the protocol is to reduce the FFR. In other words, by making it less expensive to borrow, banks are incentivized to borrow and lend more freely, a dynamic that increases credit availability. However, the current problem is that the Fed can’t lower the FFR any further. Accordingly, as will be discussed more in depth later, the Fed has decided to purchase other assets in an attempt to prompt an incremental reduction in economy-wide interest rates.

For people who are not professional investors or economists and are not following the markets day to day, the Fed’s recent maneuverings likely elicit a lot of questions. For instance, isn’t inflation generally a bad thing? If, so why is it that the Fed thinks inflation is too low and why in the world would it want to create inflation? Additionally, people may be wondering what exactly the Fed is trying to accomplish by buying more Treasuries. If interest rates are near historical lows, what is the benefit of slightly lower interest rates? Finally, another logical question has to do with what the Fed plans to do with all of the Treasuries and mortgage backed securities it has bought over the last year and a half. If it eventually tries to sell them in the open market, won’t that push up interest rates and impact the economic recovery? But, if the securities cannot be sold without affecting interest rates, couldn’t the increased money supply and credit availability lead to inflation when the economy starts picking up again?

Clearly, there is a lot of uncertainty regarding the quantitative easing initiative and the goal of the article is to address some of those concerns. Specifically, by trying to answer the questions posed above, we hope to shed some much needed light on the inner workings and intentions of the Fed.

Why is the Fed trying to create inflation?

The Merriam-Webster online dictionary defines inflation as “a continuing rise in the general price level usually attributed to an increase in the volume of money and credit relative to available goods and services.”² In more simplistic terms, as the money supply increases, prices of goods and services tend to rise as well. On the flip side, deflation is defined as “a contraction in the volume of available money or credit that results in a general decline in prices.”³ Deflation occurred in the US during the 1930’s and many historians and economists believe it was a contributor the length and severity of the Great Depression. The kind of deflation that the Fed worries about is not the falling prices of electronics due to technological innovation. Instead, the Fed is determined to prevent falling asset prices and declining wages that lead business to stop investing, consumers to stop spending and the economy to grind to a halt.

Thus, there are a number of metrics that the Fed uses to monitor the level of inflation, especially the Consumer Price Index (CPI) and the Producer Price Index (PPI). Usually, in a stable and growing economy with a moderately increasing money supply, both these and other metrics reflect the fact that wages and the prices of goods increase a little bit each year. But, as a result of the financial crisis and the ongoing unemployment epidemic, Ben Bernanke and a number of his fellow Fed Governors believe that the inflation rate is too low and that destabilizing deflation is a real possibility.

The Fed has a mandate to foster both maximum employment and price stability. But, when it comes to price stability, the truth of the matter is that Bernanke is much more concerned about deflation than inflation. Therefore, in order to prevent a severe bout of deflation, he is more than willing to take measures that stoke minimal inflation but keep inflation expectations from getting out of line with the current rate. In normal times, the Fed can achieve these goals by adjusting interest rates. However, the current Fed Funds Rate is so low (0%-.25%) that the Fed no longer has the ability to cut interest rates in order to stimulate the economy or cause inflation.

We have nothing to fear though, because the Fed has a number of other tools at its disposal. In fact, long before the financial crisis, Ben Bernanke addressed the issue of what to do when interest rates hit what is known as the “zero bound.” In a speech entitled “Deflation: Making Sure “It” Doesn’t Happen Here⁴,” the future Fed Chairman outlined a number of measures the Fed could take if traditional monetary policy was no longer effective. First, he suggested creating an inflation buffer by officially or unofficially targeting a specific rate of inflation, somewhere between 1% and 3%. Next, he proposed using the Fed’s regulatory powers to make sure the financial system remained both stable and functioning in a normal fashion. And finally, Bernanke presented the following as a potential remedy:

“To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys… For example, the Fed has the authority to buy foreign government debt, as well as domestic government debt.”

As you can see, during this speech way back in 2002, Bernanke telegraphed exactly what he would do if inflation ever got too low for his tastes and interest rate policy solutions were limited. But, the important question is why is he so preoccupied with preventing deflation? Here is a simple example from that same speech that explains the issue:

“To take what might seem like an extreme example (though in fact it occurred in the United States in the early 1930s), suppose that deflation is proceeding at a clip of 10 percent per year. Then someone who borrows for a year at a nominal interest rate of zero actually faces a 10 percent real cost of funds, as the loan must be repaid in dollars whose purchasing power is 10 percent greater than that of the dollars borrowed originally. In a period of sufficiently severe deflation, the real cost of borrowing becomes prohibitive. Capital investment, purchases of new homes, and other types of spending decline accordingly, worsening the economic downturn.”

Fast forwarding to the present, given the severity of the downturn we have already experienced, Bernanke and his cohorts are worried that deflation would damage investment and spending and thus push unemployment even higher and the US into a depression. Unfortunately, what this fear of deflation means is that the Fed is likely to err on the side of inflation, which history has shown can get out of control if the monetary authorities are not extremely careful.

What is the Fed’s goal in reducing interest rates further?

This topic has received a great deal of debate recently. Bernanke’s problem is that rates are already so depressed that much of the stimulative benefits of historically low interest rates have already been felt by the economy. Would another .25% decline in mortgage rates cause a wave of refinancing and home buying? Would another .5% decline in Treasury rates lead businesses to start investing and hiring again? Someone skeptical of the Fed’s intentions would argue that the impact of QE2 might be very subdued given the uncertainties regarding the housing market, consumer spending, and the viability of business investments. One such critic is John Hussman of the Hussman Funds, who stated the issue quite eloquently in one of his latest missives⁵:

“With no permanent effect on wealth, and no ability to materially shift incentives for productive investment, research, development or infrastructure (as fiscal policy might), the economic impact of QE2 is likely to be weak or even counterproductive, because it doesn't relax any constraints that are binding in the first place. Interest rates are already low. There is already well over a trillion in idle reserves in the banking system. Businesses and consumers, rationally, are trying to reduce their indebtedness rather than expand it, because the basis for their previous borrowing (the expectation of ever rising home prices and the hope of raising return on equity indefinitely through leverage) turned out to be misguided. The Fed can't fix that, although Bernanke is clearly trying to promote a similarly misguided assessment of consumer "wealth."”

What Hussman is saying is that by reducing interest rates even lower, the Fed actually has the peripheral goal of inflating asset prices with the hope that the associated “wealth effect” will cause widespread confidence to increase and eventually lead people to start spending and businesses to start hiring. One could also argue that the Fed is enticing investors to take more risk. With yields on government and corporate bonds so low, investors who are looking for returns are forced to buy riskier assets such as stocks. Given that backdrop, it is no surprise that the S&P 500 is up so much since Bernanke signaled the QE2 was likely during his Jackson Hole speech at the end of August. But, just focusing on the S&P obscures the fact that just about everything is up in price. If you are curious, take a look at the price charts for gold, silver, corn, cotton and copper over the last year. For example, gold is up about 23%, silver is up 64% and cotton is up an amazing 75.6%!⁶

Not only is the Fed helping to inflate stock market prices and to push people into riskier assets, but the near zero Fed Funds Rate and the buying of other assets is forcing people to buy hard assets as an inflation hedge. So, while the Fed believes that inflation is too low, at some point the dramatic price increases in commodities are going to flow through to consumers. And, with stagnant wages, unemployment clearly not declining fast enough and fiscal stimulus winding down, the people who spend a disproportionate percentage of their income on daily necessities (food, clothing, household items) are going to really feel the pain when prices begin to rise.

We also should point out that zero interest rate policy has been a godsend for the banks. First off, the banks can borrow at basically 0% from the Fed and immediately turn around and buy 10 year US Treasuries that yield north of 3%. In essence, the banks can choose to receive a risk free spread of 2.6% on their money as opposed to lending it to consumers and businesses to help jumpstart the economy. In addition, by holding interest rates down the Fed has induced large corporations to issue billions of dollars of long term debt at very attractive rates. Obviously, this is great for shareholders of these companies but it has also led to huge revenues for the banks who underwrite these debt offerings. In summary, it certainly appears that the Fed’s asset purchases have benefited those with large investments in stocks, large banks, and big corporations at the expense of the rest of America.

How is the Fed going to sell all of the assets it has bought?

This, ladies and gentlemen, is the million dollar question. To accurately assess the situation, it is necessary to analyze the Fed’s balance sheet. As of the most recent data available on the Fed’s website, the dollar amount of assets on the Fed’s balance sheet was just about $2.35 trillion⁷. To that number, you can at least add the $600 billion of Treasuries that will be purchased over the next eight months, bringing the total near $3 trillion. Compare that to the $914.8 billion in assets the Fed held at the end of 2007 and it is possible that the Fed will have more than tripled its balance sheet in three and a half years⁸. The liability side of the balance sheet consists mostly of balances that banks hold on reserve with the Fed. At the end of 2007 these deposits amounted to $20.77 billion and are now about $1.26 trillion. This is what John Hussman meant when he said that that there are over $1 trillion in idle reserves in the banking system. In other words, banks are hoarding money and leaving it with the Fed instead of lending it out.

In any case, the Fed is going to have to sell assets unless it wants to see the money supply explode when the economy starts to improve on a sustainable basis and banks start lending out those reserves. As a hypothetical, let’s say the Fed wants to get its balance sheet back to where it was at the end of 2007. This would entail selling somewhere around between $1.5 and $2 trillion in assets, assuming the Fed follows through on its most recent promises and then refrains from more quantitative easing (the latter being a very dangerous assumption). Clearly, if the Fed tried to sell these assets all at once the market would not be able to absorb the sale and interest rates would likely go through the roof. So, unless inflation had accelerated to very uncomfortable levels, the Fed would probably try to wind down its balance sheet over a number of years in order to avoid killing a nascent economic recovery and to ensure a somewhat orderly rise in interest rates.

Bernanke did actually hint at the unwinding issue in his speech from 2002. Specifically, he indicated that “[b]ecause some of these alternative policy tools are relatively less familiar, they may raise practical problems of implementation and of calibration of their likely economic effects.” So, it appears that Bernanke was aware of the potential pitfalls at the time of his unfortunately prescient speech. However, the magnitude of the necessary asset sales was likely not even a possible outcome in Bernanke’s mind but unquestionably needs to be addressed sooner rather than later.

Let me try to explain why. As of December 1st, 2010 the Fed had a net worth (total assets minus total liabilities) of $56.02 billion. In addition, the majority of the Fed’s assets base consists of securities held outright, which total about $2.088 trillion. Now, let’s say the Fed wants to sell $1.5 trillion of those assets to reduce the size of its balance sheet. This is not the forum to dive into a deep discussion of bond math and the duration of the Fed’s security holdings. However, the important thing to understand is that if market forces cause interest rates to rise, the value of the previously purchased assets on the Fed’s balance sheet will fall. The Fed likes to claim that it has the ability to hold assets to maturity, a fact that implies that the Fed should not have to mark its balance sheet to current market prices. However, in the event that the Fed was forced to sell in order to combat potential inflation, it could realize losses on those sales. Specifically, with about $56 billion in equity, the Fed would only have to realize a 3.7% loss on the sale of the $1.5 trillion in securities to wipe out 100% of its equity. And you thought Bear Stearns and Lehman Brothers had a lot of leverage.

Smart people can argue about whether or not the Fed can actually be insolvent, but the idea that America’s central bank could have assets worth less than its liabilities does not inspire a lot of confidence. There is no way to know how much interest rates will have risen when the Fed wants to unwind its balance sheet, but the truth remains that a 3.7% realized loss on asset sales is certainly not that farfetched. Thus, the Fed may be unable to sell securities when it wants to increase interest rates unless it wants to realize substantial losses. Then, the fact that the Fed’s balance sheet could be locked in at the current size is very troubling, especially given the implications for inflation.

Will quantitative easing work?

The purpose of this piece is to illuminate some of the risks of quantitative easing. Many talking heads have taken the stock market rise that came about after rumors of QE2 emerged to mean that most investors approve of what the Fed is doing. But recently, two luminaries of the investment world, Bill Gross of PIMCO and Jeremy Grantham of GMO, have published scathing critiques of the Fed’s policies (see link’s below).

However, we should all be careful to not underestimate Ben Bernanke and the Fed. As a group, the members have a lot of influence and a number of tools at their disposal. As such, I am certainly not saying that quantitative easing will unequivocally not work or that the US is on a dangerous path that cannot be reversed. I am also not implying that the stock and bond markets are poised for large declines. Specifically, what I do believe is that the Fed’s attempts to inflate assets may not be sustainable unless the economic fundamentals improve as well. Accordingly, my humble advice is to watch the developing situation very closely, especially when it comes to commodity inflation and rising interest rates.

America is in uncharted territory. It looks as though we will live through at least a tripling of the central bank’s balance sheet in just a few short years. Such a circumstance is unprecedented in modern US history. As such, whether or not QE2 is “working” may depend on who you are and what you are invested in. Therefore, it is the job of investment managers to understand the risks and position their clients in a way that protects them from both the intended and unintended consequences of QE.

3^rd Quarter Letter for Jeremy Grantham of GMO: http://www.gurufocus.com/news.php?id=110465

November letter from Bill Gross of PIMCO: http://www.pimco.com/Pages/RunTurkeyRun.aspx

References:

1. http://www.dallasfed.org/news/speeches/fisher/2010/fs101108.cfm
2. http://www.merriam-webster.com/dictionary/inflation
3. http://www.merriam-webster.com/dictionary/deflation
4. http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm
5. http://www.hussmanfunds.com/wmc/wmc101108.htm
6. http://money.cnn.com/data/commodities/
7. http://www.federalreserve.gov/releases/h41/current/h41.htm
8. http://www.federalreserve.gov/monetarypolicy/files/BSTFRcombinedfinstmt20072008.pdf

What Political Gridlock in Washington Means to You

(A version of the follow post was included in a newsletter sent out to clients of West Coast Asset Management.)

Just about every media outlet imaginable has reported the widely held belief that Republicans (or anyone who is not an incumbent) are going to have a very good day this coming November 2^nd. While it may be true that the current Democrats inherited an economy that was falling off a cliff, the common refrain is that voters want change. This desire may come from any number of initiatives and events that have apparently been damaging to the White House and Congressional Democrats. Whether the topic is ObamaCare, the continued pandering to large banks, the Dodd-Frank legislation or the increasing size and importance of the US government, suddenly the Democrats who now hold a majority have become very unpopular, at least according to the polls. Specifically, Gallup’s website shows Obama’s approval rating at an uninspiring 48%¹. Additionally, among likely voters, Gallup reports that Republican candidates look to be favored by a very large 11-17% margin in the upcoming election².

What this means is that there is likely to be even more gridlock in Washington in the coming years. Regardless of whether or not the Republicans take over the majority in the House and Senate, it appears that they will gain some seats. Consequently, Congress will likely be unable to pass meaningful legislation that does not command the ever-elusive and increasingly rare bipartisan support. Thus, when this inconvenient fact is combined with an increasingly less powerful and popular President, chances are the kinds of reforms that the country really needs are not going to pass in the near future.

Now, we are probably not saying anything that most people do not already know. But, what is important are the specific details regarding which issues may remain unaddressed due to the impending logjam in Washington. As such, the purpose of this piece is to outline three specific items that may unfortunately not be resolved and then pontificate on the subsequent effect on investors and markets. The goal is not to offer policy solutions; we will leave that to politicians and those who run macro hedge funds. We also have no interest in blaming either party; we are just interested in the effect of a political stalemate on investors globally. In fact, our main objective is to highlight some of the risks and opportunities for our investors if there is to be a prolonged impasse when it comes to legislation in Congress.

The Bush Tax Cuts

To extend or not to extend? That is the question. The Obama administration wants to extend the cuts to those who make less than $250,000 a year. To that the Republicans contend that any tax increase, even if just for the wealthy, will deter consumption and investment and thus delay economic recovery. But, therein lies the conundrum. What if the Democrats are only willing to vote to extend the tax cuts to some and the Republicans will only accept a full extension of the current rates? In that case no legislation is likely to pass and the tax cuts will just expire on their own. What happens then?

Well, marginal income tax rates will increase, the estate tax will come back in full force, and capital gains tax rates will rise. In other words, investors will be faced with the trifecta of reduced income after taxes, having to re-think or adjust their estate plans and lower profits on successful investments that have yet to be realized. Additionally, if capital gain taxes are going to increase, the stock market may see a significant amount of selling at the end of the year as investors move to lock in the 2010 rates. Clearly, for an economy struggling to find its footing, the impact of an expiration of the Bush tax cuts could be quite destabilizing. As such, while the Bush tax cuts may have increased the government’s deficit problem (since they were not “paid for” by a reduction in government spending), the unfortunate truth is that any tax increase of this scale could derail the recovery and have a detrimental impact on the equity markets.

The Burgeoning Deficit

Of course, the flip side to extending the Bush tax cuts is that government needs revenue to help bring down the deficit. Specifically, the budget deficit for fiscal year 2010, which ended September 30^th, came in at an astounding $1.29 trillion³. Therefore, by forgoing the opportunity to increase taxes, the powers that be in Washington are basically guaranteeing that the shortfall will remain at $1 trillion levels. For some, this is necessary given the malaise in the economy. In fact, many of those who believe in the policy prescriptions developed by John Maynard Keynes continue to suggest that even greater government spending is needed to get the economy humming again. However, even the Neo-Keynesians agree on the un-sustainability of the fiscal path the US has embarked upon since the beginning of the financial crisis.

Specifically, an ongoing deficit could impact financial markets down the road. For example, if the politicians in the nation’s capital are unable to agree on and effectuate a credible plan to reduce the deficit, there could be some severe consequences for those who have flocked to fixed income securities over the last year or so. Even though long term Treasury rates remain near historical lows, this situation is not guaranteed to last. If the US’s creditors begin to believe that Washington’s spending has gotten out of control and that inflation is likely as a result, they may start to demand higher rates to compensate them for the risk of accumulating and holding US Treasuries. If this happens, interest rates are likely to rise across the board. That means that mortgage rates, corporate borrowing rates and even rates on consumer credit could increase. Also, as rates rise, investors who bought fixed income securities could see the value of those investments drop. Furthermore, higher interest rates are likely to impact already strained consumers and eat into the profit margins of businesses. As such, it is unlikely that these developments would be seen as positive by stock market investors and the equity markets could see some near term selling pressure.

However, individuals and corporations holding cash or short term fixed income securities could be beneficiaries of an increase in interest rates. Currently, when inflation is factored in, the real yield on most cash accounts is slightly negative. Accordingly, savers are being punished in the low rate environment that persists today, especially retirees who live off of income produced by their savings and investments. But, in a perverse sort of way, if fears regarding the deficit serve to push rates up, millions of people who have limited exposure to the risky assets that have been rising in price and are sitting on cash will be the beneficiaries (at least in the short run).

Unemployment Blues

The recent September unemployment data was rather dismal. The headline unemployment rate remained stubbornly high at 9.6% as the economy shed an estimated 95,000 jobs in September. Even more troubling was the fact that the U-6 unemployment rate, which captures the under-employed as well, jumped to 17.1% in September. Further, 41.7% of unemployed people had been out of work for 27 weeks or more⁴. As a response to this specific problem, Congress has passed extensions of unemployment benefits a number of times over the last year. However, the votes are becoming more contentious. The most recent bill that passed in July saw support from 272 House members while 152 opposed the bill⁵. But, even though the final Senate vote was 59-39 in favor of the extension, it took months to pass the bill in the Senate as a result of bickering between the parties regarding how to pay for the benefits⁶. Accordingly, if the Republicans were to gain seats, there is certainly the risk that future extensions would not be feasible. Regardless of one’s views on the merits of unemployment benefits, the truth remains that as people’s benefits lapse, they are unable to spend, invest or make rental or mortgage payments. Unfortunately, the population at risk includes 2.5 million people so the impact of their reduced income could have a meaningful impact on the economy, especially since the unemployment situation does not look like it is bound to improve anytime soon.

The question Americans must ask themselves is whether the government is doing enough to help stimulate the economy and create jobs? Unemployment benefits are clearly just a temporary solution to what looks like a structural problem within the economy. If it is true that certain financial services, retail, and construction-related jobs are not going to come back for many years, how are we going to reduce the unemployment rate? Infrastructure investment by the government to replace the US’s crumbling roads and bridges has been suggested as an option. Also, clean energy is often cited as a source of many new jobs in the coming years. The problem seems to be that the leaders in Washington cannot figure out how to agree on a way forward. Accordingly, virtually nothing is being done to either spur job creation in the private sector or create government work programs. This is at least partially a function of the gridlock in D.C. that may only become more pronounced if the Republicans win big in early November. But, in addition, there is no denying the fact that the huge number of manufacturing jobs that have been outsourced to lower labor countries has contributed to the current unemployment problem.

The Light at the End of the Tunnel

Given the circumstances cited above, it is hard to see much of a silver lining for equity investors. However, it is times of heightened and seemingly insurmountable uncertainty that provide unique opportunities to make long term investments. Many investors are extrapolating the current economic troubles years into the future. This has caused the stocks of world-class companies with fortress-like balance sheets and durable competitive advantages to trade at prices that imply a perpetual state of turmoil. Accordingly, while many people view the previously discussed problems as intractable, long term investors believe that global economies and markets are very dynamic and adaptable. Therefore, we believe in reversion to the mean and that a strategy of investing with a sufficient margin of safety and a multi-year time horizon is the best way to generate excess returns for our investors. So, while the media and politicians myopically focus on the next few months or weeks, we will continue to build positions in companies that we believe have the ability to excel and prosper in just about any economic environment.

Sources:

1. http://www.gallup.com/poll/113980/Gallup-Daily-Obama-Job-Approval.aspx
2. http://www.gallup.com/poll/143777/GOP-Holds-Solid-Leads-Voter-Preferences-Week.aspx
3. http://www.dailyfinance.com/story/taxes/federal-budget-deficit-below-expectations/19675849/
4. http://www.bls.gov/news.release/empsit.nr0.htm
5. http://www.washingtonpost.com/wp-dyn/content/article/2010/07/22/AR2010072203825.html
6. http://www.washingtonpost.com/wp-dyn/content/article/2010/07/21/AR2010072105650.html

Must Read Interview with Alice Schroeder

Readers,

I usually refrain from shameless promotion, but my good friend Miguel Barbosa of the world-class site Simoleonsense just released the first installment of his lengthy interview with Buffett biographer Alice Schroeder. Anyone who has read her book, The Snowball, knows that it provided readers with an intimate depiction of Warren Buffett's relationships that had not been available elsewhere. We had long known Buffett the investor and thanks to Ms. Schroeder, we now better understand Buffett the man, father and husband.

Miguel has promised me that this interview will provide even more insight for those who are interested in what makes the world’s greatest investor tick. Please take this opportunity to read the interview linked below. I personally am looking forward to the rest of the series as well.

http://www.simoleonsense.com/simoleonsense-interviews-warren-buffetts-biographer-alice-schroeder-part-1-the-forging-of-a-skeptic-from-accountant-to-buffetts-voice-on-wall-st/

America's New Risk: Regulatory Risk

With the elections only a few days away, it seems to me that the US political system has reached an important crossroads. The question that many people are currently asking themselves is: what will happen if the Republicans take a number of seats in the House and Senate? Will the logjam in Washington D.C. just get worse?

The following piece examines the uncertainty surrounding future regulations that would only be exacerbated if we end up with with a Congress that refuses to be on the same page as the President. As always, my point of view is that of an investor. As such, my concern is that many companies currently have no way to plan for potential new regulations and as a consequence, investors have little ability to price in the changes that may be coming. My thesis is that this nebulous future many companies are facing is only holding back the economic recovery because investment and hiring decisions are being postponed. In highlighting three industries that I feel are uniquely susceptible to being hit by further regulations, I hope to illustrate that point. Let me know what you think.

(Disclaimer: The opinions expressed in this article are my own and do not necessarily reflect those of West Coast Asset Management or any employees of the firm.)

America’s New Risk: Regulatory Risk

When assessing the stocks of companies domiciled in emerging markets, the risk that the home government will take monetary, fiscal, legal or even military actions that undermine the value of the equity market is usually called country or regime risk. This concept comes with the implication that investors should demand a higher rate of return to compensate them for the risk that the government will do something capricious, misguided, or even unethical. For example, if you run an oil company with assets in Venezuela you are concerned about regime risk because the government might nationalize your assets. Or, if you are investing in the nascent equity market in a war-torn African country, you should price in the risk that war breaks out once again or that there is some sort of coup. The point is that investors and companies who are familiar with regime risk can act appropriately by making sure the potential returns are worth all of the uncertainty.

Fortunately, over the last number of decades, investors who focus on the US have not needed to price in any regime risk. The US hasn’t experienced a Civil War since the 1860s. Aside from the impact of going off the gold standard during the Nixon administration and intentionally devaluing the dollar versus gold in the 1930s, the US has never defaulted on its debt obligations. Furthermore, what has made the US the safest country to invest in over the last 60 years is the strict adherence to the rule of law. When all of this is combined with the economic stability that the US has enjoyed, many investors have rightfully not felt the need to demand a premium return for country risk. In most people’s minds, such considerations only applied to “frontier” or “emerging” markets.

Unfortunately, a new risk is emerging in the US that investors should take note of. It is my position that it is not as severe as country risk or regime risk. However, I do believe that there is more potential for what is known as regulatory risk to affect equity markets than in recent history. For a simple definition of regulatory risk, we turn to Investopedia.com¹:

“The risk that a change in laws and regulations will materially impact a security, business, sector or market. A change in laws or regulations made by the government or a regulatory body can increase the costs of operating a business, reduce the attractiveness of investment and/or change the competitive landscape.”

Could it be that this risk has become a real threat to companies and investors in the US? Sadly, I believe it has. Let’s look at three very distinct industries to illustrate the uncertainty caused by increased regulatory risk: (Examples of potentially affected companies are included in the adjacent parenthesis)

1. Retail Pharmacies (CVS, WAG, RAD): Just about no one questions the need to reduce health care costs and expenditures in the US. With an aging population, health care spending will represent a larger and larger percentage of US GDP and this increase threatens to put states and the US government in very difficult fiscal positions due to their responsibilities to Medicaid and Medicare patients. Unfortunately for retail pharmacies, they have been caught in the crossfire even though they do not appear to be part of the cost inflation problem. Specifically, pharmacies are reimbursed based on their cost of acquiring drugs. They are paid a slight premium to their cost along with a flat fee for dispensing the drugs. However, reimbursement rates are under pressure as many states are now unable to cope with prescription drugs needs of Medicaid patients.

As such, there is a battle looming over reimbursement rates that unfortunately could lead the pharmacies to stop filling prescriptions for Medicaid patients. This is exactly what happened in Washington state in January of this year when rates were reduced to a level that no longer covered Walgreen’s cost. Not only is the uncertainty regarding reimbursement bad for patients, but it is also a problem for pharmacies in that the ambiguity makes hiring and expansion decisions very difficult. This is on top of the fact that a change in reimbursement rates could decimate the already low operating margins for these companies and likely cause a further drop in their stock prices.

Finally, an important question for these companies has to do with which party has the power to influence and pass legislation in Congress. If the Republicans gain enough seats in the House and Senate to repeal the Obamacare initiative, then 32 million people who were going to have access to prescription drug coverage will no longer have that luxury. No matter what your beliefs are about the merits of the health care reform bill, the potential for it to be reversed makes pharmacies unable to forecast demand or execute their expansion policies. Cleary, this is not a recipe for job creation in the industry.

2. Oil and gas-related companies (XOM, APC, DO): The damage done by the BP oil spill has clearly affected the environment and the local economy of the Gulf of Mexico region. What is also noteworthy is the impact it has had on the offshore drilling (especially deepwater) and oil and gas exploration industry. As a result of the government’s response to the spill, the companies that operate in this space have no idea how to budget for the coming year. Probably the most important question is: are there going to be moratoriums on offshore drilling? To that question I recently came across a comparison to the airline industry that I thought was interesting. The idea is that enacting a moratorium on offshore drilling is like grounding all the airline flights in the US because one plane crashed. Said another way, while the images of the oil spill were horrifying, a moratorium looks like an attempt to indiscriminately punish an entire industry for one company’s apparent negligence.

Additionally, what happens if the Republicans win the House or the Senate in the November elections? Could they find a way to eliminate the potential for a prolonged moratorium? Would a windfall tax on oil profits be off the table? As you can see, the uncertainty makes it impossible for companies to know how much to invest, what to do with idle equipment, or how to make hiring decisions. Unfortunately, in an environment in which the US economy desperately needs businesses to start investing and hiring once again, this regulatory risk could serve to postpone a legitimate recovery.

3. Financial institutions (GS, JPM, BAC): The financial regulation bill that just passed was widely seen as a victory for the major commercial and investment banks as the most draconian proposed measures were not included into the final bill. However, what must not be forgotten is the fact that much of the rules of the industry are going to be set by (unelected) regulators in the coming years. Specifically, the bill left an incredible amount of discretion in the hands of the FDIC, the consumer protection agency and the Federal Reserve. In fact, law firm Davis Polk counted 243 rulemaking decision and 67 studies that the bill authorizes regulators to be involved in². I will spare you most of the details of what actually is left to be decided, but how to approach the threat created by derivatives, appropriate capital levels, and exactly how to handle the risks of too big to fail institutions will be figured out over the next few years. In other words what we got was a framework for a financial regulation bill (with many exclusions and exemptions embedded in it) without a whole lot of additional certainty as to the eventual details.

Financial institutions can adjust to bad news. They can shut down operations, sell assets, and fire people if necessary. What they cannot plan for in prolonged uncertainty. So, if you are wondering why banks are not lending to consumers and businesses, you can be sure that their inability to predict what the eventual legislation will entail has caused them to be very cautious. Unfortunately, there will be no sustainable recovery until the banks re-start the credit intermediation process. Making the situation even worse, in addition to the impediments listed above, there is also the risk that whoever controls Congress or White House will try to influence the regulators to make decisions that are favorable to their constituents. The fact that the rules could change dramatically depending on who voters favor at any given moment means that financial institutions will have to continuously adjust their operations in order to comply with the shifting regulations. Given the lack of stability in the financial sector over the last few years, increasing regulatory risk just makes it harder for companies to figure out what their “new normal” reality will be.

These are just a few examples among many. Credit rating agencies, for profit education firms and utilities trying to figure out if Cap and Trade is a reality, all are facing similarly uncertain circumstances. It should be noted that I am not arguing the regulation is not necessary. In fact, I believe that many industries were long overdue for legislation aimed at protecting customers, investors and taxpayers. My point is that the gridlock in Congress and the number of companies that could see their industries undergo dramatic changes have created ambiguity that no company can properly plan for. While this is not the first time in US history companies have had to be prepared for major shifts in regulation, I feel as though the number of sectors and companies that could be impacted is larger than it has been anytime in the recent past.

As an investors, I just want to know what the rules are going to be so I can figure how to play the game. I am not used to and do not liking discounting the value of the companies I research just because of some lingering regulatory risk. I know that this situation will eventually be resolved and that American will hopefully get back to its prosperous ways. However, I believe that it is imperative that regulators decisively set policies and the let the private sector get back to focusing on reinvigorating the economy through prudent investment and hiring. Excessive government intervention is inefficient and costly, especially when the US is facing strained economic circumstances. I look forward to a time when regulatory risk and regime risk is more prevalent within the usual emerging market suspects, not at home in the US.

Sources:

1. http://www.investopedia.com/terms/r/regulatory_risk.asp
2. http://www.zerohedge.com/article/davis-polk-summarizes-fin-reg-reform-130-pages

High Frequency Traders are Stealing from You

Readers,

I would like to provide a brief update on my life and post an article I wrote for clients of West Coast Asset Management. I am back in school but have luckily been able to continue my relationship with WCAM. I am working a few days a week from LA doing research and creating content for quarterly letters and blogs.

However, what takes up most of my time is this field study I am performing with a number of my colleagues on the Student Investment Fund at Anderson. We are attempting to come up with a proposal to improve the investment management (IM) program at Anderson. We are contemplating a number of suggestions, including a yearly speaker series, an IM conference (like the one Columbia hosts each year), a stock pitching challenge, a curriculum refresh that includes more practical investing classes and maybe even a separate track for IM like those offered by Columbia and Kellogg. Additionally, we are looking for support from UCLA alumni and any asset managers in the LA area. So, if you or anyone you know would like to be involved, please email me.

Without further ado, the following is an article I wrote about high frequency trading (HFT). The subject was getting a lot of press until ForeclosureGate started dominating the newswires. But, despite the lack of headlines, mini flash crashes continue to happen in certain securities on a weekly basis. This is a warning sign that the system itself is very unstable and that we may be at risk of another crash like the one we saw in May of this year. For those who are still unclear on what HFT is and what risks it may pose, I tried to put together a simple primer on the subject. I am not an expert on this subject but I hope this adds to people's understanding of what I believe is an undesirable trend towards more computer control of the stock market.

High Frequency Traders are Stealing from You

The history and backdrop

Most people are well acquainted with the stock market crash that occurred on October 19^th, 1987 in which the Dow Jones dropped by 508 points or 22.61%. After the fact, the largest one day percentage decline in the market’s history was mainly blamed on portfolio insurance. This was a risk management tool that employed stop losses through automatic, computer-based selling. Unfortunately, the prevalent use of this strategy caused a cascade of selling once the market started to drop. Hindsight being 20/20, commentators who opined on the events of the day of course claimed that the outcome was obvious and predictable. Clearly it should not have been a surprise that indiscriminate selling by computers could cause the market to plunge. How could anyone have believed that thoughtless machines controlling the most important stock market in the world was a good idea?

Now, here we are almost 23 years later and apparently we have learned nothing from our past mistakes. In fact, computer trading programs, or algorithms if you will, now dominate the day-to-day trading on the major exchanges. While it is difficult to quantify precisely, most estimates suggest that what is known as high frequency trading (HFT) makes up between 50% and 75% of all trades¹. Let us say that again: Robots trading shares in between one another now accounts for anywhere between half and three-quarters of market activity on a daily basis. So much for fundamental, bottom’s up investing.

What is HFT? (Moved to the top from the bottom)

We understand that we are attempting to tackle a difficult topic. In fact, we are in the process of trying to understand it better ourselves and are certainly not experts. However, if we did not think that the emergence of HFT was an incredibly important development or that we could not present our analysis in approachable manner, we would not be stressing the issue. The truth is that HFT potentially affects all investors, not just those who are involved in the daily trading of the markets.

Investopedia.com defines HFT in the following manner²:

“A program trading platform that uses powerful computers to transact a large number of orders at very fast speeds. High-frequency trading uses complex algorithms to analyze multiple markets and execute orders based on market conditions. Typically, the traders with the fastest execution speeds will be more profitable than traders with slower execution speeds.”

So far, not so complicated. Basically, companies engaged in high frequency trading use trading speed and sophisticated computer programs to create an advantage over other traders. The specific strategy of many of these programs it to use their superior technology to make pennies or fractions of pennies on every trade. This process, which is kind of like collecting pennies in front of a steamroller, may not seem particularly lucrative until you realize that there are billions of trades executed on US stock markets each day. A billion pennies sure adds up over time.

If it sounds like these firms profit from an unfair and uneven market structure, it is because that is precisely the case. But why is this inequity tolerated and often cited as a positive thing? Well, the common defense of HFT is that these firms who run these algorithms are providing liquidity, a measure of the degree to which a stock can be bought and sold without affecting the price. Generally, the more liquid a stock is the easier it can be traded without causing huge swings in the price. As long as the liquidity is real and those who provide it are committed to it, greater liquidity can be very beneficial to investors. Specifically, it can lead to lower bid-ask spreads (which can lead to lower costs of trading) and a greater ability to move into and out of cash when investors so desire.

However, we believe that the problems created by HFT are twofold:

1. Increased volatility and the risk of extreme moves in the markets
2. Increased trading costs through predatory activities

The market roller coaster

First off, all of the evidence we find suggests that HFT creates unusual volatility in the markets. Let’s go back to the so called “Flash Crash” on May 6^th, 2010. The Dow Jones dropped 600 points in a matter of minutes, shares of Accenture (ACN) dropped from over $40 to a penny, and shares of Apple (APPL) rose to over $100,000 each. Even though the exchanges eventually cancelled these outlier trades, how is it possible that share prices can fluctuate so dramatically? The initial reaction to this dramatic move in the price of market indexes was the “fat finger” theory. This is the idea that some incompetent trader who meant to sell one thousand shares inadvertently added three extra zeroes and sold one million shares. However, we believe that such explanations are created in an attempt to obscure the fact that the markets are broken. Actually, these are not our words but basically what Larry Leibowitz, the COO of NYSE Euronext (owner of the New York Stock Exchange), said during his testimony in front of a House Financial Services Subcommittee five days after the Flash Crash ³. Specifically, this is what he said about the impact of technology on the functioning of our stock markets:

“The May 6 market drop certainly should inform the SEC’s [Security and Exchange Commission’s] current examination of the changes in the markets, and in particular how certain recent advances in technology may have fostered trading practices that negatively impact the entire market…As regulators seek to determine whether regulatory action is necessary to address the shifts in market structure resulting from technological change, the events of May 6 make it clear that the regulators also need to consider steps to avoid the types of extreme volatility our markets experienced that day.”

This indictment of the recent technological revolution in trading came from a man whose company thrives on market volatility since fees go up as volume increases. Additionally, NYSE Euronext jus opened a huge new $500 million data center in order to take advantage of co-location (where exchanges like NYSE allow traders to plug directly into their servers and increase their trading speed dramatically) revenue that is derived solely from firms who want quicker speeds for their electronic trading. So, despite his vested interest in the increased proliferation of HFT, Mr. Leibowitz is clearly concerned that the practice is a threat to the integrity of the U.S. stock markets.

Liquidity dries up

The problem arises when other market participants depend on liquidity that will only be present when the market is going up or trading sideways. Unfortunately, as we believe the Flash Crash proved, when the market declines rapidly the liquidity dries up as the algorithms shut down to avoid catching a falling knife. Essentially, our concern is that when the market plunges the HFT algorithms are programmed to stop trading so that the firms are not caught holding assets that are falling in value. But, this just exacerbates the drop in the market as there are subsequently fewer buyers remaining. A true liquidity provider would remain in the market in order to bid on assets even if they are declining in price and make an active market (one with both buyers and sellers) in stocks. But, if the HFTs flee the market at the first hint of weakness, the market can stop functioning. When this happens, stocks such as Accenture, which usually trade close to 4 million shares a day but saw volume spike to 10.3 million shares on the Flash Crash day⁴, can fall from over $40 to $.01. Unfortunately, this type of volatility can make stocks stray far away from their intrinsic values and cause retail investors to leave the market because they are unable to stomach the price swings.

The hidden HFT tax⁵

The following is the most technical portion of this analysis. However, we think that if you are willing to stay with us, you will understand why HFT likely costs you money. The best way to explain the HFT tax is through an example. Let’s say you are a mutual fund that wants to buy one million shares of Microsoft (MSFT). This is such a large order that you are worried that you may move the market up with your trade. Therefore, in order to make sure you don’t pay more than you want per share you put in a limit order. Let’s say the stock is trading at $24.95 but you put in a limit order (i.e. the most you are willing to pay) of $25. Many mutual funds use what are known as VWAP (Volume Weighted Average Pricing) trading algorithms to execute these large trades. The problem with these algorithms is that even if they break up the buy orders in smaller batches (i.e. not all one million shares in a single trade) they create patterns that the HFT algorithms can sniff out.

Think of a VWAP kind of like an 18-wheeler trying to switch lanes on the highway. It takes a long time to move and therefore a quicker vehicle has the opportunity to outmaneuver it. This is what the HFTs do when they sense a VWAP-based order. By exploiting the predictable patterns created by the VWAP, the HFT algorithm is fast enough to sense the limit order of $25 on the MSFT shares, buy the shares at $24.95 and then sell them to the mutual fund at $25. No harm, right? The mutual fund got its trade executed at $25 and no one ever thinks twice. Wrong! The problem is that the HFT basically engaged in what is known as front running by jumping in front of the VWAP and causing the mutual fund to pay $.05 too much for each share. If this only happened every once in a while it might not be a big deal. But imagine the costs to mutual fund shareholders if this dynamic played out each and every day with thousands of stocks. We are talking about billions of dollars in potential profits for the HFTs. If you are wondering why the NYSE pre-sold ALL of its co-location spots for its new data center within a short period of time, you now have the answer.

Want to know who the major players are? Well, according to NASDAQ’s website, the top five liquidity providers for the NYSE as of July 2010 were Wedbush Morgan Securities, GETCO, Citadel Securities, Merrill Lynch and UBS Securities⁶.

How does HFT affect the price of stocks?

West Coast Asset Management engages in bottom’s up value investing. Our belief is that if you buy shares of a company at a price less than their intrinsic value, the market will eventually appreciate the fundamentals of the company and bid the price up near the stock’s true value. But what does it mean if 50% to 75% of trading comes from predatory robots trading shares back and forth? It means that shares are not necessarily trading based on economic or company-specific factors in the short term. The irony is that this dynamic may actually create opportunities for value investors. We invest based on the notion that markets are often inefficient in the short run but that the market’s pricing mechanism functions properly in the long run and allows us to profit from our contrarian strategy. Accordingly, if the presence of the HFTs causes temporary dislocations in price of individual securities, we may be able to take advantage and generate excess returns for our clients. Additionally, if the HFT algorithms begin to focus on a stock that previously had not been particularly liquid, investors who own that stock could benefit from the increased tradability of the security.

What should be done about HFT?

Unlike many of the problems we face as investors, this one seems easily solvable. Specifically, it is our position that HFT should be banned. By disallowing co-location the regulators could level the playing field in terms of speed and thus limit the ability of the HFTs to outrun other investors. The SEC is currently looking at the issue and we hope they come to the conclusion that the increased clout of the HFTs is not good for our markets. As we have illustrated in the preceding discussion, HFT does not appear to serve any purpose from an overall public welfare perspective. In fact, it seems as though these algorithms extract rents directly from smaller investors who do not have the same technological advantages. We also can’t forget the violent swings in market prices that the HFT facilitates and the associated potential for a severe market crash. When all of these issues are combined it becomes unambiguous that high frequency trading presents a real threat to the vitality of our stock markets and to investor confidence. Therefore, we hope that the U.S. regulators do something proactive to protect the investing public as opposed to catering to the powerful financial “services” industry. Let’s stop this practice before we all are forced to look back at a debilitating market crash and say, “we knew this was going to happen all along.”

For more information on the subject of HFT we highly recommend reading the second quarter shareholder letter from Iridian Asset Management ($7.1 billion assets under management) available here: http://www.zerohedge.com/article/more-are-waking-hft-terrorism-iridian-asset-managements-latest-investor-letter-blasts-high-f. We would also like to thank the authors, Jeff Silver and Ben Hunt, as their explanations helped frame our analysis.

Sources:

1. http://www.nytimes.com/2010/05/07/business/economy/07trade.html
2. http://www.investopedia.com/terms/h/high-frequency-trading.asp
3. http://www.house.gov/apps/list/hearing/financialsvcs_dem/leibowitz_5.11.10.pdf
4. http://www.google.com/finance?q=NYSE:ACN
5. http://www.zerohedge.com/article/more-are-waking-hft-terrorism-iridian-asset-managements-latest-investor-letter-blasts-high-f
6. http://www.nasdaqtrader.com/trader.aspx?ID=topliquidity

Give Us Back Our Cash

The following is my latest piece (in Scribd to preserve formatting) about the large amount of cash on the balance sheets of US corporations. Based on the number of proposed M&A deals announced recently, it appears that companies are starting to put their cash hoards to work. But, is this good news for shareholders? Given the dismal performance of many big mergers you will forgive me if I do not trust the majority of US CEOs to allocate capital in a way that is optimal for shareholders. For this reason and a number of others, it is our position at West Coast Asset Management that companies with huge net cash positions should begin returning cash to shareholders as opposed to letting it languish on their balance sheets.

A version of this article was posted on WCAM's website at: http://wcam.com/newsroom. If you are looking for a value-biased, long only manager for your assets, feel free to contact former TV star Andrew Firestone at afirestone@wcam.com to inquire about WCAM's investment philosophy.

Give Us Back Our Cash!

Summer Update and Double Dip Analysis

Readers,
It has been a little while since I last had the opportunity to post and I thought I would provide a brief update on how my summer is progressing. But first, I want to thank everyone for the overwhelming outpouring of support after I created the post that asked for help in finding a summer internship. I literally received emails from people all over the world offering their assistance and guidance. I really appreciate all of the support and I hope that I can continue to create content and research that is both valuable and informative.

Thanks to my good friend Marcelo Lima, I was able to secure an internship position at West Coast Asset Management (WCAM) in Santa Barbara, CA. WCAM is a long only manager of separate accounts focused on high net worth individuals, institutions and charitable foundations. The firm was founded by Lance Helfert and Kinko’s founder Paul Orfalea. Anyone who attended the 2008 Value Investing Congress sessions in New York or California will probably remember the presentations made by Lance and CIO Atticus Lowe. Furthermore, Atticus was profiled in the April 2007 and May 2008 editions of Value Investor Insight and Lance makes regular appearances on Fox Business News and CNBC. Finally, Lance, Atticus and Paul are co-authors of the book, The Entrepreneurial Investor: The Art, Science and Business of Value Investing which has sold thousands of copies and has recently been translated in Korean.

If you would like to learn more about WCAM, I encourage you to check out the website at www.wcam.com. Additionally, if you are looking for a manager who is capable of handling both equity and fixed income separately managed accounts feel free to contact me or Andrew Firestone (of The Bachelor fame) at afirestone@wcam.com.

My role at WCAM is to find new investments for the equity separately managed accounts. So far this summer I have extensively researched a number of companies, including two exchanges, a power transmission company and a couple of data processing and outsourced services firms. We are specifically looking for companies with a market capitalization greater than $1 billion which possess robust moats, resilient business models, strong and recurring cash flow generation and preferably a consistent dividend. If this sounds like a relatively defensive stance, that is precisely because it is. As a team we continue to believe that the US is at risk of falling back into a recession and prefer to be invested in companies that will prosper even in stressed economic circumstances.

It was in this context that I was asked to contribute to the quarterly letter that recently went out to clients. Given our outlook, my goals were to shed some light on the risks that we see brewing in the US economy and explain to clients why we are positioned cautiously. There are clearly a number of people talking about the risks of a double dip recession. However, I decided to highlight those that I thought were most relevant to equity investors and our clients. I hope you enjoy my updated analysis (in Scribd format to maintain the formatting) and will stay tuned for additional posts in the near future.

5 Reasons to Fear a US Double Dip