Monday, March 31, 2008


The SEC recently sent out letters to CFOs about Fair Value accounting. It seems the SEC wants to be sure that companies are not valuing illiquid securities at too low a price:

Item 303 of Regulation S-K requires you to discuss, in your Management's Discussion and Analysis, any known trends or any known demands, commitments, events or uncertainties you reasonably expect to have a material favorable or unfavorable impact on your results of operations, liquidity, and capital resources. We note that you reported a significant amount of asset-backed securities, loans carried at fair value or the lower of cost or market, and derivative assets and liabilities in your financial statements in your recent Form 10-K. Statement of Financial Accounting Standards No. 157, Fair Value Measurements, defines fair value, provides a framework for you to measure the fair value of your assets and liabilities, and requires you to provide certain disclosures about those measurements.

Fair value assumes the exchange of assets or liabilities in orderly transactions. Under SFAS 157, it is appropriate for you to consider actual market prices, or observable inputs, even when the market is less liquid than historical market volumes, unless those prices are the result of a forced liquidation or distress sale. Only when actual market prices, or relevant observable inputs, are not available is it appropriate for you to use unobservable inputs which reflect your assumptions of what market participants would use in pricing the asset or liability. Current market conditions may require you to use valuation models that require significant unobservable inputs for some of your assets and liabilities. As a consequence, as of January 1, 2008, you will classify these assets and liabilities as Level 3 measurements under SFAS 157.

What this means is that if a large hedge fund is forced to dump securities in a fire sale due to a margin call, you don't have to use those prices to value the same securities on your balance sheet. You can use "unobservable inputs" to determine the value. What are "unobservable inputs"? It's a WAG - Wild A** Guess and CFOs everywhere will be rejoicing now that they have the leeway to value these assets at whatever they need them to.

The Nordic Model

I am generally of the mind that banks and other financial insitutions that make bad investments should just be allowed to fail. Failures purge the system of bad companies and allow the system to heal faster. The very last resort should be nationalization as the UK did with Northern Rock. That's why this report disturbs me:

The US Federal Reserve is examining the Nordic bank nationalisations of the 1990s as a possible interim solution to the US financial crisis.

Are financial institutions somehow different? Shouldn't they be allowed to fail? Maybe if depositors lost money they would be more careful in the future about where they park their cash. Maybe if depositors were responsible for their own money, they would demand banks that actually protect their deposits rather than gamble it away on sub prime mortgages.

I haven't said a lot about the Bear Stearns/JPM/Federal Reserve merger but it seems a bad precedent. Bear Stearns was an important investment bank but if it had failed I suspect the banking system would have survived. Would stock markets have reacted badly? Possibly, but is it the job of the Federal Reserve to protect shareholders? The Fed fulfilled its mission as lender of last resort when it provided the 28 day financing on Friday. If that wasn't enough to keep Bear from failing, that should have been the end of their role. Why should taxpayers shoulder the risk of Bear Stearns?

Lastly, does this mean that things are worse than even the most pessimistic believe? If the Fed is studying nationalization of banks and how to do it with minimal moral hazard, do they know of institutions that may need this option? I hope not, but it certainly can't be ruled out.

SWFs to the Rescue? Maybe Not....

The WSJ economics blog has an interesting entry on the SWF assets. They may not be as much as they seem:

If sovereign wealth funds really have $3 trillion in assets why haven’t they bought even more of the U.S. and Europe?

Christopher Balding, an analyst at the Milken Instititue, a Santa Monica, Calif., think tank, gives an intriguing answer: maybe their wallets aren’t as bulging as people think.

If the estimates of total SWF size were true, he says in a forthcoming paper, “SWFs could currently purchase all national investment brokerages and money center banks listed on U.S. exchanges and still have more than $1.2 trillion left to spend.”

Look at the Middle Eastern SWFs, which are powered by oil revenue. He says some estimates put the combined assets of the SWFs in the United Arab Emirates, Saudi Arabia and Kuwait at $1.9 trillion. That would mean they have assets “nearly 50% greater than all of the foreign reserves in China for a population 2.5% as large,” he says.

Then, Mr. Balding combs through the data. According to the U.S. Treasury, all Middle Eastern oil exporting countries held $300 billion in debt and equities in the U.S. in 2007. The three countries’ foreign reserves were less than $100 billion as of June 2007. Big numbers, but nowhere near $1.9 trillion.

Of course, estimates of assets of SWF vary widely. Some put the assets of the funds from the three nations at about $1.4 trillion. But Mr. Balding’s main point is still interesting. Where’s the rest of the money?

The only way to get to the vastly larger numbers, he says, is to count the domestic assets that the funds have a piece of, which includes national oil companies.

Counting those holdings make the SWFs look immense, he says, but distorts the amount of money the funds actually have to invest overseas. (Abu Dhabi isn’t going to sell its oil company and use the proceeds to buy, say, Exxon Mobil.) Using the same logic, he argues, one could say that France has a $280 billion SWF because of all France’s state owned companies. “Estimates of SWF capital fail to accurately contextualize the numbers by excluding other countries with similar state owned assets,” he writes.

In other words, SWFs may not have nearly as much cash to spend as popular lore suggests. –Bob Davis

The Root of the Problem

Sean Corrigan has a long, but very accurate article at about the banking system and why it is at the root of our current problems. Here's an excerpt but by all means read the whole thing:

With a certain weary inevitability, the cries of pain emanating from those seeing their aspirations ground to dust amid the current upheaval in financial markets have been interspersed with the shrill descant of those all too eager to proclaim a 'crisis of capitalism'.

The implication that it is now time for those far-seeing, disinterested Solons in government to step forward once more and to put right what mere 'market forces' have again so woefully failed to correct.

High finance, we are told, has become a business of 'privatizing profit and socializing losses', a thoroughly inequitable mechanism which the state now has a duty to redress by erecting a whole new framework of Do's and Don'ts in order to rein in the 21st century's version of the Robber Barons.

While the initial diagnosis is fairly unexceptionable - since that is precisely what financial market institutions generally do seek to do - the corollary is not. Nor is this just because politically opportune Witchfinders General tend to be more guilty of fighting the last war than even the most hidebound of generals, nor because the analogy is decidedly unfair to the original Robber Barons, many of whom grew rich by creating genuine wealth and not simply by living, often obscenely high on the hog, off that generated by others.

No, the whole concept of a 'market failure' is a hoary old canard which it is vitally important to dispel for fear that an eager Leviathan will again exploit its subjects' understandable present anxieties in order permanently to increase its power over their lives and liberties.

It's Not Our Fault

I was surprised to find this editorial in Forbes, usually a bastion of free markets and free trade. Peter Morici, a professor at the University of Maryland School of Business (good lord I hope he's not an economics professor) and former Chief Economist at the US International Trade Commission during the Clinton Administration, fills his editorial with attacks on China for everything from high oil prices to the mortgage mess:

Americans need to knock down some false gods.

Globalization is not an unalloyed good. We don't need 300-horsepower cars. And Wall Street is not a citadel of integrity.

The 1990s were the golden age of free trade. The U.S. sealed the North American Free Trade Agreement, launched the World Trade Organization and escorted China into that temple of global commerce.

The idea was simple: Americans would import more T-shirts and furniture and sell more industrial machinery and software to a world hungry for technology. Americans would move into higher-productivity export industries and earn higher incomes in the trade-off.

I don't know of anyone who has said that globalization is an unalloyed good. All economist know that globalization, which is nothing more than a fancy way of saying free trade, produces winners and losers. Economists also know, unlike apparently Mr. Morici, that there are more of the former than the latter. He is right that we don't need 300 HP cars; for people like Mr. Morici that means that we shouldn't want them or be able to get them. As for Wall Street, well anyone who thought that Wall Street existed to look out for ordinary investors just doesn't understand Wall Street. And did Mr. Morici really think the Chinese would not advance beyond T shirts and furniture? Sounds a tad snobbish to me; who do these Chinese people think they are making complicated high tech stuff? They're only supposed to make the stuff we don't want to make.

Imports soared much more rapidly than exports, the annual trade deficit jumped to more than $700 billion and Americans borrowed more than $6 trillion from foreigners to pay for two decades of trade deficits. This math permitted Americans to consume much more than we produced and spend more than we earned.

The trade deficit did not produce the debt; our own monetary policy is more to blame than free trade. Besides if the Chinese want to sell us stuff and finance it too while taking pretty pieces of green paper in exchange, I say we should do that as long they will allow it.

China is perhaps the biggest renegade in the mugging of the American middle class. The U.S. has slashed tariffs on Chinese products from auto parts to TVs, while China maintains much higher tariffs and notorious regulatory restrictions for U.S. exports in its market.

Topping it all, China subsidizes foreign purchases of its currency, the yuan, to the tune of $460 billion a year, making its products cheap on U.S. store shelves. The U.S. annual trade deficit with China is about $250 billion.

So China maintains higher tariffs than we do which means they are punishing their own citizens with higher costs for those goods. Does that mean we should punish US citizens too? And if the Chinese want to subsidize those imports by maintaining a cheap currency, well that just makes Chinese citizens worse off, not us.

Chinese growth has pushed up global petroleum prices nearly five fold in six years, and the U.S. oil deficit is now $350 billion and rising.

I guess devaluing the dollar and starting a war in the Middle East had nothing to do with those high oil prices.

The banks came up with more creative and risky mortgage products that permitted Americans to live beyond their means. We went from 10% down to 5% down to nothing down, with banks lending home buyers closing costs through second trusts.

Some loans that required no payback for five years even let folks dig deeper in their pockets on the premise that home prices would always go up. The banks sold these risky loans, bundled as bonds, to foreign investors like the Chinese government and foreign pension funds, as well as to U.S. insurance companies and corporations with cash to park. The bank executives paid themselves like royalty for the privilege of bilking trusting clients.

When the worst of the bonds--those backed by risking adjustable rate mortgages-- collapsed, the banks got stuck with billions of unsold bonds.

Most recently, Bear Stearns collapsed, and the U.S. Federal Reserve is lending the banks $600 billion against shaky bonds on a 90-day revolving basis. That essentially socializes the banks' losses on bad bonds.

I'm not sure why Mr. Morici transitioned to this bit about bankers, sub prime and Bear Stearns, but apparently these problems were caused by China too. I guess if those dastardly Chinese hadn't bought the mortgages the problem would have been avoided. Again, the problem was created by the Fed by leaving monetary policy too loose for too long. As for Bear, well there aren't any losses yet; what will Mr. Morici say if the Fed actually turns a profit off the Bear bailout? I'm not a fan of these kind of bailouts either but in this case, I think the Fed faced a decision of bailing out Bear or watching the entire debt besotted system collapse.

Getting out of this mess is going to require Americans to live within their means--a.k.a. cut the trade deficit--and throw out the rascals on Wall Street.

Living within our means has nothing to do with the trade deficit. Living within our means will require that the Federal Reserve stop making credit so easy to obtain - and that is already happening. It may reduce the trade deficit if we have a recession but that is an effect not a cause. If we close the trade deficit by raising tariffs we will just get inflation. I guess in a weird way that would cause us to live within our means as interest rates would no doubt go a lot higher, but it would seem a drastic means of achieving the desired end.

Cutting the trade deficit requires burning less gasoline and balancing commerce with China.

Americans must either let the price of gas double to force conservation or accept cars with tougher mileage standards. Fifty miles per gallon by 2020, instead of the 35 required by current law, is achievable, but that means more hybrids and lighter vehicles.

Okay, this is just nonsense. Americans should let the price of gas double? Are Americans doing something to prevent that? I can only guess that he advocates higher gas taxes since the market would double the price if demand were sufficient.

The U.S. government should tax dollar-yuan conversions at a rate equal to China's subsidies on yuan purchases until China stops manipulating currency markets. That would reduce imports from China, move a lot of production back home, raise U.S. productivity and workers incomes, and reduce the federal budget deficit.

I guess he can't bring himself to say the word tariff but this is just a tariff in disguise. And boy is this a magical tariff! It reduces the trade deficit, increases US manufacturing, raises productivity and workers incomes and reduces the budget deficit. Wow! I guess he forgot about the part where everything from production to consumption costs more too. I guess that doesn't matter. And who gets to decide how much China is subsidizing the Yuan? Mr. Morici? What is the appropriate rate of exchange for the Yuan?

Mr. Morici seems to believe that everyone is to blame for our problems except ourselves. We are in this mess primarily because of lousy monetary and fiscal policy, over which we have complete control. It's just so much easier to blame China than actually do what's necessary to resolve these problems on our own. Shame on Mr. Morici and shame of Forbes for publishing this tripe.


Generally, I don't think we should enjoy the misfortunes of others - it seems like bad Karma to me - but if ever a group deserved a comeuppance, it is hedge fund managers. They are overpaid and arrogant and no doubt I would be too if I could convince rich people to pay me 2 and 20 on several billion dollars. Fortunately, I don't have this problem; my fees are low and I'm always worried that I'm charging too much, especially when we go through a period of negative returns as we have recently. And I worry more when we're up because maybe I've just been lucky and it could all go away tomorrow. Anyway, hedge funds run by supposedly very smart people are blowing up right and left and it's hard not to feel a little schadenfreude (via The Telegraph):

The leverage that magnified gains in the rising markets has had the same impact on the way down. Weaker funds were the first victims. But now the squeezing by the lenders has meant that a far bigger number have had no cushion or protection against short-term swings.

Beller wrote to his investors: "Because of their own well-publicised issues, credit providers have been severely tightening terms without regard to the creditworthiness or track record of individual firms, which has . . . made it impossible to meet margin calls."

In the aftermath, others have a different view. One observer says: "The only way to generate 90 per cent returns off AAA-rated bonds is if you are taking too much risk. Simple as that."

Another friend says that he often boasted that Peloton was sailing close to the wind. "I once asked Beller how he would cope if the market suddenly turned and he was forced to mark to market. He said he'd be in trouble but that would never happen."

Focus Capital, the fund that liquidated two weeks ago, was managed by Tim O'Brien and Philippe Bubb, who formerly worked at Pictet & Cie in Geneva. Focus won a EuroHedge industry award after returning more than 100 per cent in 2006. O'Brien and Bubb told investors that they had been the victims of the credit crunch and short selling. But observers disagree: "Focus took large stakes in very small, illiquid companies. In these markets that's a dangerous position to be in."

Two weeks ago funds were caught out when the so-called "box trade" - betting that 20-year bond and swap spreads would widen as seven-year spreads narrowed - moved against them. Endeavour Capital, run by former Salomon Smith Barney fixed-income traders, told investors that 27 per cent of the value of the $3bn fund had been wiped out. The fund is thought to have been 18 times leveraged.

Meanwhile, Platinum Grove, the $5.5bn New York-based hedge fund set up by former Long Term Capital Management co-founder Myron Scholes, fell 7 per cent when Japanese prices moved suddenly. Investors said that London-based London Diversified had lost between 4 per cent and 5 per cent, too. The fund's founders, led by David Gorton, famously took £55m in management fees after the fund's first year in 2004.

So, our returns so far this year are beating a Nobel Prize winner. That doesn't mean that Myron Scholes is no longer smart or that I'm smarter; it does mean that owning a Nobel Prize for theoretical work in economics does not make you a good fund manager. And that very few fund managers are worth the price they charge.

Sunday, March 30, 2008

This Internet Thingy Will Never Last

From the Paleo-Future blog (via Adam Smith):

Every voice can be heard cheaply and instantly [on the Internet]. The result? Every voice is heard. The cacophany more closely resembles citizens band radio, complete with handles, harrasment, and anonymous threats. When most everyone shouts, few listen.

. . . Nicholas Negroponte, director of the MIT Media Lab, predicts that we'll soon buy books and newspapers straight over the Intenet. Uh, sure.

These expensive toys are difficult to use in classrooms and require extensive teacher training. Sure, kids love videogames--but think of your own experience: can you recall even one educational filmstrip of decades past?

We're promised instant catalog shopping--just point and click for great deals. We'll order airline tickets over the network, make restaurant reservations and negotiate sales contracts. Stores will become obselete. So how come my local mall does more business in an afternoon than the entire Internet handles in a month? Even if there were a trustworthy way to send money over the Internet--which there isn't--the network is missing a most essential ingredient of capitalism: salespeople.

That is from a 1995 article in Newsweek. I wonder if the author still has a job....

Saturday, March 29, 2008

Why Commodity Prices are High

The commodity price boom has been attributed to Asian (specifically Chinese) demand, but I include commodities in our portfolios for a different reason. Commodities are the canary in the coal mine of inflation and our mandate for our portfolios is to protect purchasing power. This article at by Jeffrey Frankel ( explains why commodities have been rising so dramatically since the Fed started slashing interest rates:

How to explain commodity prices go up while the economy turns down? If strong economic growth is not the explanation for the large increases since 2001 in prices of virtually all commodities, then what is?

One wouldn’t want to try to reduce commodity markets to a single factor, nor to claim proof of any theory by a single data point. Nevertheless, the developments of the last six months provided added support for a theory I have long favoured: real interest rates are an important determinant of real commodity prices.

High interest rates reduce the demand for storable commodities, or increase the supply, through a variety of channels:

by increasing the incentive for extraction today rather than tomorrow (think of the rates at which oil is pumped, gold mined, forests logged, or livestock herds culled)

by decreasing firms’ desire to carry inventories (think of oil inventories held in tanks), by encouraging speculators to shift out of spot commodity contracts, and into treasury bills.

Commodity prices are rising because of monetary factors, not because of growth or peak oil or any other explanation. And that monetary policy is inflationary.

Peak Oil My A**

The Malthusians who claim that we are running out of oil just don't get it. There is plenty of oil in the world and technology will find ways of extracting it:

America is sitting on top of a super massive 200 billion barrel Oil Field that could potentially make America Energy Independent and until now has largely gone unnoticed. Thanks to new technology the Bakken Formation in North Dakota could boost America’s Oil reserves by an incredible 10 times, giving western economies the trump card against OPEC’s short squeeze on oil supply and making Iranian and Venezuelan threats of disrupted supply irrelevant.

In the next 30 days the USGS (U.S. Geological Survey) will release a new report giving an accurate resource assessment of the Bakken Oil Formation that covers North Dakota and portions of South Dakota and Montana. With new horizontal drilling technology it is believed that from 175 to 500 billion barrels of recoverable oil are held in this 200,000 square mile reserve that was initially discovered in 1951. The USGS did an initial study back in 1999 that estimated 400 billion recoverable barrels were present but with prices bottoming out at $10 a barrel back then the report was dismissed because of the higher cost of horizontal drilling techniques that would be needed, estimated at $20-$40 a barrel.

It was not until 2007, when EOG Resources of Texas started a frenzy when they drilled a single well in Parshal N.D. that is expected to yield 700,000 barrels of oil that real excitement and money started to flow in North Dakota. Marathon Oil is investing $1.5 billion and drilling 300 new wells in what is expected to be one of the greatest booms in Oil discovery since Oil was discovered in Saudi Arabia in 1938.

The US imported about 14 million barrels of Oil per day in 2007 , which means US consumers sent about $340 Billion Dollars over seas building palaces in Dubai and propping up unfriendly regimes around the World, if 200 billion barrels of oil at $90 a barrel are recovered in the high plains the added wealth to the US economy would be $18 Trillion Dollars which would go a long way in stabilizing the US trade deficit and could cut the cost of oil in half in the long run.

Friday, March 28, 2008


From Steve Pearlstein at the WaPo:

Well, isn't this rich: Max Baucus of Montana and Chuck Grassley of Iowa, chairman and ranking member, respectively, of the Senate Finance Committee are suddenly in a lather that taxpayer funds might be implicated in the Federal Reserve's rescue of Bear Stearns.

Would that be the same Max Baucus and Chuck Grassley who have made careers out of protecting and enhancing the lavish system of import restrictions, price supports and other subsidies that have transformed American farming and ranching into a vast socialist enterprise? You betcha.

Whatever you want to say about the sharpies on Wall Street, they are pikers compared to Max's and Chuck's friends down on the farm when it comes to picking the pockets of taxpayers and consumers, or concocting a system in which the farmers get all the gains while the government assumes most of the risk.

Politicians have no shame.

McCain Reaps What he Sows

In my opinion, the McCain/Feingold campaign finance law was the greatest infringement on free speech in recent history. I can't help but chuckle now that McCain himself finds himself in the middle of a campaign finance problem:

Last year, when his campaign was floundering and nearly broke, McCain applied for public financing. Candidates who opt into the system get portions of their privately raised donations matched with taxpayer dollars, but agree to abide by an overall campaign spending limit. This year, the cap for the presidential primaries is about $54 million.

But earlier this month, after he became the GOP front-runner and donations began pouring into his campaign, McCain decided to withdraw from the public financing system, even though he had not yet received any public money and his campaign has already spent nearly $50 million. Staying in the system would be crippling. His campaign would not be able to pay for ads, mailings, polls, or travel until September, when the primary campaign officially ends with the party convention.

And the Democrats have an ace in the hole. They have been holding up nominations to the FEC and without a quorom on the FEC they can't rule on this:

But the commission is unable to vote because an impasse in Congress has left it with too few members for a quorum.

As a result, McCain is in a bind. His campaign says that he has a right to declare himself out of the system without an FEC ruling and that he will feel free to spend more than the cap allows in coming months. But the dispute has cast a cloud over the self-styled election-finance reformer.

I'm guessing that the Democrats are not in a hurry to remedy the situation.

Auction Rate Mark Down

I wondered how long it would be before brokerage firms finally faced reality and marked down the value of auction rate securities on customer statements. It looks like UBS is the first to bite the bullet:

TORONTO -- In the first confirmation that problems in the auction-rate securities markets has eroded the principal holdings of individual investors, UBS AG is marking down the value of the securities in its brokerage customers' accounts.

Until now, customers who were unable to sell securities in regularly scheduled auctions were told that the securities retained full value and would receive higher interest rates.

UBS, however, using an internal model to value the securities, will mark them down this afternoon and inform clients via their online statements shortly thereafter, people familiar with the matter said. The markdowns will range from a few percentage points to more than 20%, the people said.

I wonder how you model the value of a security with no market? These auction rates are worth only what someone else is willing to pay and if you have one that no one will buy it's value is....nothing.

By the way, the Massachusetts Secretary of State has issued subpeonas to three brokers in his investigation of the auction rate market:

Massachusetts Secretary of State William F. Galvin said today that he has issued subpoenas to business units of three large financial services companies as he seeks more information for his investigation into auction rate market securities.

Galvin's office said he has issued subpoenas to UBS Securities LLC; Merrill, Lynch, Pierce, Fenner & Smith Inc.; and Bank of America Investment Services Inc., all of which are registered as Massachusetts broker dealers.

Galvin wants to know if clients were warned about the risks of investing in auction rates. I can answer that question with a resounding NO.


Michael Zhuang has a post at the Seeking Alpha blog about the AAII market sentiment poll that I've written about here in the past.

Investor sentiment is at its lowest since 1990 and second lowest since the American Association of Individual Investors [AAII] sentiment indicator began in 1987. On 2/7/08, the 8-week moving average bull/bear spread reached the low of -25% and has since hovered below -20%. What does it mean for investors that the bull/bear spread stands at -25%? And what is the bull/bear spread?

Current low investor sentiment is significant because there were only six instances (excluding this one) when it was below -15%. And only two instances when it was below -20%.

Zhuang looks at stock market returns when the spread reaches these extremes. The results are what a good contrarian would expect. Markets tend to rally after extremes such as this. Zhuang uses a moving average to smooth out the volatility of the poll. What I look for are a low number of bulls that stays low when the market rallies. At the January lows the bulls were in the low 20s but when the market rallied off those lows the bulls quickly jumped into the mid 30s. The bottom was not in. We'll have to see how this indicator plays out over the next few weeks, but if we get a rally and the bulls don't budge, the bottom is probably in.

Bogle and Siegel on ETFs

I do my best to avoid The mostly because I can't stand Cramer, but sometimes they have informative articles. This article on the proliferation of ETFs features comments from John Bogle and Jeremy Siegel.

With their low fees, all-day trading and tax efficiency, exchange-traded funds (ETFs) have captivated investors. There were no ETFs before 1993, and only 80 in 2000. By the end of 2006 there were 359. Today, there are nearly 700, including 280 launched in 2007 and 30 through mid-March this year. They hold about $600 billion.
While most experts think ETFs were a good innovation -- built like index-style mutual funds but traded like stocks -- some worry that the increasingly specialized ETFs introduced in recent years stray from the faith, encouraging too much risk-taking.

I use a lot of ETFs in our portfolios but I generally stick with the broad market or large sector ETFs. The original idea behind the ETF was to construct a better index fund and Barclay's IShares have done a great job of that, but even they have started to drift from the original purpose by developing ETFs that track ever smaller slices of the market. That's okay for folks who want to speculate but as a long term investor, I tend to agree with John Bogle:

That concern is heightened for some by recent Securities and Exchange Commission proposals to let new funds come to market with less oversight, and to invite proposals for introducing actively managed ETFs. Like actively managed mutual funds , these would employ teams of stock pickers and analysts trying to beat the market's gains rather than simply match them, as today's ETFs do. "I can't imagine anything more absurd than an ETF that is [actively] managed," says John C. Bogle, retired founder of The Vanguard Group, the leader in index-style mutual funds and ETFs.

Bogle is equally critical of the now-prevalent class of narrowly defined ETFs, which typically focus on stocks of specific industries or countries. "They are great for brokers," he adds, noting that narrow ETFs appeal to speculators who buy and sell frequently and pay lots of sales commissions. "The question is, are they any good for investors?" Most small investors, Bogle argues, do best by choosing a handful of broad-market index investments and holding them for the long term.

This article is also a great primer for anyone who wants to gain knowledge about ETFs. Read the whole thing by clicking on the title of this post.

More Auction Rate News

The auction rate security market is still not working and as I noted here before, the issuers are trying to find ways to provide some liquidity to the now long term owners of these securities. Legg Mason is apparently trying to work this out for the preferred stock investors in their closed end funds:

NEW YORK (MarketWatch) -- Asset manager Legg Mason said Friday it is urgently trying to generate liquidity for shareholders of seven closed-end funds it manages that collectively own more than half a billion dollars of unsellable auction-rate preferred securities
"Legg Mason is fully aware of the urgency to resolve this situation, and of the uncertainty, frustration and difficulties these failed auctions have caused for shareholders of these securities, and is committed to explore any and all possible solutions that are equitable to both the preferred and common shareholders of these funds," the company said in a press release.

The problem for the funds is that alternate funding sources are scarce right now. The funds do not want to just redeem the preferreds because that would mean selling bonds in their portfolio to fund the redemptions. With a steep yield curve there is still an advantage to adding leverage to a muni bond portfolio so they don't want to do that unless they absolutely have to. Some other fund families have found bank financing to replace the auction rate funding but I suspect the rates are not as good as what they got from the auction rate market. That will likely mean dividend cuts for some of these funds.

The municipalities have had an easier time redeeming their auction rate securities. There are always buyers for long term municipal bonds. The funds will take longer as the funds will need to line up alternate financing to continue their leveraged portfolios. There is not a lot of appetite for funding leveraged investment vehicles at the moment. Ultimately, I expect all of the securities from the major participants in the auction rate market to be redeemed. That may not be true of some of the smaller players; if you own an auction rate from an issuer you've never heard of, you might have a problem. I have been contacting some fund companies about their plans so if you have auction rates that you are not sure about, send me an email ( and I'll try to get some information for you.

WaPo on Candidates Tax Plans

The Washington Post has an article about the various candidates plans for taxes. While it is marginally positive in that the candidates are talking about keeping some of the existing tax rates, the WaPo analysis is rife with economic fallacies.

When President Bush pushed big tax breaks through Congress in 2001 and 2003, Sen. John McCain (R-Ariz.) joined Sen. Hillary Rodham Clinton (D-N.Y.) and other Democrats in opposing them as fiscally reckless. But now that McCain and Clinton are running for president, neither is looking to get rid of the cuts. Instead, they are arguing over which ones to keep.

The same is true of Clinton's rival for the Democratic nomination, Sen. Barack Obama (Ill.), who recently blamed the Bush tax cuts for driving the nation toward recession. But he, too, wants to preserve about half the cuts, and pile on new ones.

Fallacy #1: The Bush tax cuts are not to blame for the potential recession. The idea that depriving the government of tax revenue could cause a recession could only be uttered by a politician, all of whom believe that what they do in Washington is more important than what happens in the real world.

The direction of the tax debate is frustrating deficit hawks in Washington, who worry that none of the candidates is charting a course toward a balanced budget. Meanwhile, Bush and other politicians are telling voters alarmed by a sagging economy that keeping the cuts past their 2010 expiration date can help revive the nation's fortunes, a claim many economists say is nonsense.

Fallacy #2: Who are these "many economists" who say this is nonsense? How about some names and political affiliations. If the tax cuts are allowed to expire, tax rates will rise. If that is so, isn't it obvious that this would have a negative economic impact? I suppose an economist could argue that if tax rates rise, the result will be higher tax revenues and a lower deficit and that would have a positive effect, but higher revenues and a lower deficit are far from a certainty in that scenario.

Conceived during Bush's 2000 presidential campaign as a means to return what were then huge government surpluses to taxpayers, the cuts were approved by Congress in the midst of a recession, which worsened after the Sept. 11, 2001, terrorist attacks. Though the recession was mild, the recovery was sluggish and hampered by a deep decline in employment. Productivity ultimately rebounded robustly, but national savings plunged, and the country racked up a large trade deficit.

Fallacy #3: "The recovery was sluggish and hampered by a deep decline in employment."

Here's a chart of the unemployment rate:

Unemployment rose in the last recession but the rise was not dramatic or particularly bad compared to past recessions.

Why would tax cuts hurt the economy? Because their one very clear effect was to increase the budget deficit. Combined with spending on the wars in Afghanistan and Iraq, and a huge new prescription drug benefit for Medicare recipients, the cuts helped drive the annual deficit to a peak of nearly $413 billion in 2004. Last year, it dwindled to $162 billion. But the nation's cumulative debt has nearly doubled since Bush took office and now exceeds $9 trillion.

Fallacy #4: The tax cuts "one very clear effect was to increase the budget deficit". That is not clear at all. Tax revenues between 2003 and 2006 increased by 35%. As a percentage of GDP tax revenues increased from 16.5% to 18.4%. Unfortunately, spending rose even faster. So what is the cause of the budget deficit? Tax cuts or excessive spending?

Government spending is the problem. As I have written about here before, lower tax rates can support spending that is in the historical range of the US withoug budget deficits. Hong Kong spends a similar amount as a percentage of GDP, has much lower tax rates and runs a budget surplus. Again, the problem is spending, not tax rates.

Wednesday, March 26, 2008

Freedom From Markets

One of my pet peeves is the pork ladled out to US farmers. I have nothing against farmers; I grew up in the south where farming is a way of life, but the largess shown to farmers in this country is obscene. Farm subsidies distort markets and support businesses that should by all rights fail. And these subsidies are not going to a bunch of poor subsistence farmers. They are going to wealthy individuals and large agriculture businesses:

The goal was to target more benefits at farmers who work the land and need financial assistance, while weaning benefits away from the well-to-do. Recent recipients include 92-year-old David Rockefeller, heir to oil-baron John Rockefeller. He received $554,000 in subsidies from 1995 to 2005 for farm operations and land conservation in New York, according to a spokesman for Mr. Rockefeller and government data compiled by the Environmental Working Group, which is lobbying for an overhaul of farm programs. The spokesman says Mr. Rockefeller has reinvested about $600,000 into the community where his farm is located, and that his late wife Peggy loved to farm and raised cattle. "She was on the tractor and everything," he says.

Well if that doesn't warm your heart. I'm paying taxes so a Rockefeller can ride a tractor. The income limit to receive these subsidies is $2,000,000 per year. This is not about helping poor farmers. When will taxpayers finally wake up and realize that the federal government is nothing more than a criminal enterprise that rewards the few at the expense of the many? Damn......

Obama and the Oil Market

Since we're on the topic of the government solving problems caused by governemnt, this story from the Obama campaign seems appropriate:

WASHINGTON (Reuters) - Democrat Barack Obama would take an active role in U.S. oil markets as president, tackling concerns about the dominance of large oil companies and eyeing the Strategic Petroleum Reserve as a potential weapon to combat high prices, his top energy adviser said.

Another politician who wants to repeal the law of supply and demand. Geez, don't any of these guys take economics classes? From carbon trading to a windfall profits tax, Obama hits all the right notes:

Grumet, head of the Washington-based Bipartisan Policy Center in addition to advising the Obama campaign, said the oil industry had "concentrated incredible market power in a small number of companies" in a way that caused alarm.

"Senator Obama has a deep concern that the consolidation of the industry -- these national mergers, you know, that were allowed under both Clinton and Bush administrations -- are a cause for some concern," he said.

He said an Obama administration would examine "whether these mergers and consolidations have decreased competition in a way, concentrated market power in a way, that is undermining to consumers."

The power in the oil industry is not concentrated in the hands of private oil companies. The power in the oil industry is in the hands of governments - mostly ones that are not friendly to the US. Approximately 80% of the world's oil reserves are controlled by governments. Why would Obama single out the private companies for punishment?

With oil prices at record highs, Grumet said Obama would seek to tax the "windfall" profits that oil companies are making - a threat that Clinton has also made.

The oil industry has profit margins of less than 10%. Our governments (federal, state and local) make more off a gallon of gasoline than the oil companies. Why not reduce the tax on gasoline if you are worried about the price? How will taking profits from oil companies increase the supply of oil?

Oil prices are high primarily because the Federal Reserve has devalued the dollar. Oil producing countries will not just accept a lower price for their goods so they take actions to raise the price in dollars. Another consequence of excessive monetary pumping is that more money is available for speculators to spend in the oil market. The price of oil can be brought down by raising the value of the dollar.

Another reason oil prices are high and we have to depend on the kindness of foreigners for oil is that government will not allow US oil companies to exploit the resources we have here. We haven't built a new refinery in this country in over 30 years; of course gas prices are high.

The law of supply and demand cannot be repealed by politicians. If you want the price of oil to fall, increase the supply of the stuff (or alternatively, decrease the supply of dollars). You can't do that by taking money from oil companies and wasting it on government sponsored alternative fuel programs. We tried that back in the 70s with Synfuel which turned out to be a giant waste of tax dollars. And it won't work now.

Think Audaciously

Alvaro Vargas Llosa has an article at TCS Daily that explains, once again, why government is the problem:

The Federal Reserve recently announced new measures to tackle the current financial crisis. They include helping J.P. Morgan Chase acquire Bear Stearns, lowering the discount rate and offering short-term loans to about 20 investment banks-- and they came only days after the government said it would inject $200 billion into the financial system.

These are the latest steps taken by the U.S. government to solve a problem created in large measure by the government itself. We have seen this movie before.
As a reaction to the bursting of the dot-com and telecom bubbles at the end of the 1990s, the Fed inflated the currency through the actions of its Open Market Committee. By June 2003, the policy of easy money was reflected in the drop of the federal funds rate to 1 percent. The loose monetary policy was maintained, with variations, for almost five years. The result was a fiction economy in which millions of people borrowed and consumed too much. The fact that mortgage loans were turned into sophisticated securities traded internationally made the fiction global.

Vargas Llosa places the blame where it belongs - at the Fed:

The history of the boom-bust cycle since the creation of the Federal Reserve in 1913 has been the deliberate increase of the money supply, the misallocation of resources due to the perverse incentives of inflation, and eventually the bursting of the bubble. It is the consequence of the Federal Reserve system, a central bank that confers upon a chosen elite -- the Federal Reserve governors -- the monopoly of money creation and the power to decide what amount of money is appropriate for an economy in which millions of people are making decisions they cannot anticipate.

Vargas Llosa believes, as I do, that the answer is to abolish the Fed, but he acknowledges that is unlikely:

It is time to think more boldly. If abolishing the Federal Reserve is politically inconceivable right now, there are less dramatic measures that can be taken on the road toward a definitive solution. The most obvious one is to simply stop using the Federal Reserve to inflate the currency.

If a crisis in which at least $400 billion has already been lost and millions of people have been badly hurt is not enough to set minds thinking audaciously, nothing will.

Politicians will never advocate that the Federal Reserve be abolished. Through inflation the Federal Reserve allows profligate politicians to spend more, expand the role of government and accrue more power over their constituents. Ultimately, the system will collapse due to excessive debt as all fiat money systems have in the past. I don't think we are there yet, but that day will come. The response of government when that happens will not be one that enhances freedom.

Economic Hysteria

The economy may be in recession or heading for one. Or it may not. As anyone who reads this blog regularly knows, my view is that we aren't in a recession now and probably won't have one this year. It's a minority view and becoming harder to defend as the official economic stats continue to deteriorate. I may end up being wrong, but based on what I see in my community, I don't think so. When I go to the mall I still have to park further away from the entrance than I'd like. The place is packed. Now, as the Economics Babe recently remarked, a lot of the people in those cars might just be window shopping rather than actually buying anything, but my guess is that if things were really bad, people would just stay home. The bottom line is this: we haven't even had one down quarter of GDP growth yet and we need two consecutive negative quarters to call a recession. We may get there, particularly if people believe too much of what they read in the press, but we aren't even close yet. Robert Samuelson says pretty much the same thing today in the Washington Post (HT Greg Mankiw):

WASHINGTON -- Regarding the economy, it's hard not to notice this stark contrast: The "real economy" of spending, production and jobs -- though weakening -- is hardly in a state of collapse; but much of today's semi-hysterical commentary suggests that it is. Financial markets for stocks and bonds are described as being "in turmoil." People talk about a recession as if it were the second coming of Genghis Khan. Some whisper the dreaded word "depression." Meanwhile, Americans are expected to buy about 15 million vehicles in 2008; though down from 16.5 million in 2006, that's still a lot.

There's a disconnect between what people see around them and what they're told is happening. The first is upsetting (rising gas prices, falling home prices, fewer jobs) but reflects the normal reverses of a $14 trillion economy. The second ("panic," "financial meltdown") suggests the onset of something catastrophic and totally outside the experience of ordinary people. The economy, said The New York Times last week, may be on "the brink of the worst recession in a generation" -- an ominous warning.

Perhaps, but so far the concrete evidence is scant. A recession is a noticeable period of declining output. Since World War II, there have been 10. On average, they've lasted 10 months, involved a peak monthly unemployment rate of 7.6 percent and resulted in a decline of economic output (gross domestic product) of 1.8 percent, reports Mark Zandi of Moody's If the two worst recessions (those of 1981-82 and 1973-75, with peak unemployment of 10.8 percent and 9 percent) are excluded, the average peak jobless rate is about 7 percent.

He also points out that despite all the talk about how bad the stock market is, we haven't even reached the 20% decline that is the benchmark for bear markets. The drop we've had so far only qualifies as a correction. We've had much worse markets in the past, and this one may turn out to be as bad as those, but it hasn't happened yet. A lot of people have asked me why I seem so calm about what is going on; my answer is that panicking will do no good and the economy, if left alone, will recover. The biggest fear I have is that our government will attempt something truly stupid and stall the natural process of recovery. The best we can hope for is that while the politicians are arguing about the best way to "stimulate" the economy, it recovers on it's own and they do nothing.

Durable Goods

Orders for durable goods declined 1.7% in February, as business demand for machinery and capital goods unexpectedly fell. Economists were expecting a rise in orders of 0.5% for the month. It is the second straight monthly decline, a sign that domestic demand is weakening at a faster rate than the growth of exports.

Orders for capital goods fell 2.6%, while orders for machinery dropped by a record 13.3%. Excluding machinery orders, total orders rose 0.3% for February. Civilian aircraft orders and computer orders both had gains for the month, rising 5.4% and 10%, respectively.

See Full Report.

Tuesday, March 25, 2008

Consumer Confidence

The Conference Board consumer confidence index fell to 64.5 from 76.4 in the month of March. Economists were expecting a reading of 73.3. Consumer confidence is at its lowest levels since 2003, during the Iraq War.

The expectations index fell to 47.9 from 58.0 in the month of March. That is the second lowest level ever, hitting a 35-year low.

See Full Report.

Friday, March 21, 2008

When Will People Learn

Repeat after me: My broker is not looking out for my best interests. My banker is not looking out for my best interests. Repeat this as long as it takes to never forget it.

March 20 (Bloomberg) -- How can any state or municipality possibly use swaps and derivatives again?

No, I'm not referring to how such things blew up on Jefferson County, Alabama, which is trying to extricate itself from $3 billion in variable-rate debt and $5.4 billion in swaps. I'm not even talking about how so many other municipalities are finding that the financial stuff they bought is costing them money instead of saving it.

I instead refer to two class-action complaints filed on March 12 by seven municipalities, including Fairfax County, Virginia, the city of Chicago and the state of Mississippi, one against Bank of America Corp. and another against 35 securities firms for bid-rigging in municipal derivatives.

Get this: The issuers are already working on a settlement with Bank of America.

The lender copped a plea and is ratting everyone out. In February 2007, the bank announced it was cooperating with the federal government in its investigation into anticompetitive practices in the municipal bond industry.

The bank at the time also said it had entered into a ``leniency agreement'' with the Justice Department. This means that Justice won't bring criminal prosecutions against the bank for its role in the scandal surrounding the reinvestment-of- proceeds business.

Bankers and brokers are looking out for themselves and you should too. Or hire a fiduciary to do it for you. But never, ever just take their word for it that they are doing what is best for you. They aren't now, never have and never will.

Most Volatile Market Since '37

The volatility of the stock market this year is the worst since 1937:

March 20 (Bloomberg) -- The U.S. stock market is the most volatile in 70 years, according to a Standard & Poor's study of daily price swings in the S&P 500.

The benchmark for American equities has advanced or declined 1 percent or more on 28 days this year. That's 52 percent of the trading sessions so far, which is the highest proportion since 1938, said Howard Silverblatt, S&P's senior index analyst. The S&P 500 lost 12 percent in 2008 through yesterday following $195 billion in bank losses related to subprime mortgages.

I didn't need S&P to tell me that; this market has been absolutely emotionally exhausting since last August. I needed today off to recharge. Hopefully things will calm down soon, but I'm not counting on it.

Thursday, March 20, 2008

MZM Goes Vertical

Money Supply, in the form of MZM, has gone vertical:

I don't know where all this money will go, but the last 2 times we had growth like this we ended up with asset price bubbles. The correction in commodities this week has many saying that the bull market there is over. With money supply growing like this, I doubt it.

Financial Stocks

There's been a lot of talk this week about the possibility that the financial stocks have finally found a bottom. That may be true, but a look at the charts tells me that it is far from clear that the sector is ready for investment.

US Broker Dealer ETF

US Insurance ETF

US Regional Bank ETF

US Financial Sector ETF

US Financial Services ETF

It is possible that the bottom is in but these are not pretty charts. Caveat Emptor.

Leading Indicators

The composite index of leading indicators is used to predict the direction of the economy's movements in the months to come. The index is made up of 10 economic components, whose changes tend to precede changes in the overall economy. The ten components are:

1. the average weekly hours worked by manufacturing workers
2. the average number of initial applications for unemployment insurance
3. the amount of manufacturers' new orders for consumer goods and materials
4. the speed of delivery of new merchandise to vendors from suppliers
5. the amount of new orders for capital goods unrelated to defense
6. the amount of new building permits for residential buildings
7. the S&P 500 stock index
8. the inflation-adjusted monetary supply (M2)
9. the spread between long and short interest rates
10. consumer sentiment

For the month of February, the Conference Board reported a decline in the US index of 0.3%. The index declined for the fifth straight month, continuing its downward slope from its high back in July 2007. Over the past six months, the leading indicator index is down 1.5%.

Four of the ten indicators were positive for the month- real money supply, interest rate spread, and new orders for both capital and consumer goods. The rest were negative, led by weekly initial jobless claims and building permits.

See Full Report.

Initial Jobless Claims

First-time jobless claims rose to 378,000 for the week ending March 15, up 22,000 from a upwardly revised 356,000. The four-week moving average gained 6,000 to 365,250. Economists were expecting a number closer to 360,000.

See Full Report.

Wednesday, March 19, 2008

Bottom Indicators

Kiplinger has an article about indicators of a bottom in the stock market. Their conclusion is that we aren't there yet:

We stand by the old adage that nobody rings a bell when stock markets hit bottom. In fact, Jim Stack of InvesTech Research, who has a pretty good track record of calling bottoms, admits: "You're doing a good job if you recognize the bottom two months afterward. And even then you don't know if it's an interim bottom, or a new market low."

Nonetheless, Stack and other gurus have a handful of favorite indicators they like to watch for a heads-up on market turns. So far, most of those indicators suggest the market hasn't hit the bottom yet.

The only thing I would add to this is that indicators like this do not help us predict the level of the bottom. In other words, we may not be at the end of the bear market in time, but we still could have seen the lows in price.

Markit Distortions

The writedowns on mortgage debt at the major banks and brokers has garnered a lot of headlines. How do the banks decide how much to write down? Are they being conservative or aggressive in valuing these securities? I have believed for some time that the amounts being written off were probably more than the actual losses. In this environment, when everyone is expecting a write off it makes sense to just throw out the baby with the bathwater. I suspect many of these writeoffs have valued these securities at close to zero. That may be accurate in some cases but not all. Now comes some evidence that the write offs may have been excessive:

THE credit crunch has been good to Markit Group. The company, spun off from Toronto Dominion, a Canadian bank, in 2003, has built a commanding position in the credit-derivative indices used to value fiendishly complex assets—hence the name. As trading in such products has dried up, investors have come to see those indices—such as the ABX (for subprime mortgages), the CMBX (commercial mortgages) and LCDX (leveraged loans)—as oases in a liquidity desert. Banks use the indices to help them calculate write-downs, or to hedge their exposures. The ABX is popular with hedge funds keen to take a view on the housing market.

The indices' relentless fall (see chart) has added to pressure on banks, such as Merrill Lynch and Citigroup, with big mortgage-related holdings. Citi's shares slid to a nine-year low this week on talk of a further, $18 billion write-down. Banks that mark assets far from where the indices trade incur the ire of their auditors.

The indices are undoubtedly useful, but some people think banks are putting too much emphasis on them. They capture only a narrow slice of the market: the ABX references 20 securities, for instance. And they are prone to distortion (mostly downwards) by heavy speculation. “They are not liquid enough to take the weight of short-selling heaped on them,” says one fund manager, who adds that the ABX “will probably be remembered as one of the most crowded hedge-fund trades in history.” One version of the CMBX implies losses more than 30 times greater than those suffered to date, a multiple that strikes some people as implausible. Dick Bove, a veteran bank-watcher with Punk Ziegel, recently denounced Markit's indices as “fallacious”. He expects to see write-ups as their flaws become apparent.

The CMBX is trading at a level that implies massive defaults in the commercial mortgage market. A bad recession would certainly result in a rise in the default rate but will it be this bad? My guess is no.

More Liquidity for the Mortgage Market

WASHINGTON (MarketWatch) -- The federal government loosened strict capital requirements on Fannie Mae and Freddie Mac on Wednesday, allowing them to inject billions of dollars into the nation's sagging mortgage market by buying more loans.

The Office of Federal Housing Enterprise Oversight said it is reducing Fannie Mae's and Freddie Mac's capital-surplus requirement to 20% from 30% previously. The companies will be clear to invest the freed-up capital in mortgages and mortgage-backed securities.
The move is expected to add up to $200 billion of immediate liquidity to the market for mortgage-backed securities. Wednesday's move by Ofheo, combined with other actions, should enable the two companies to buy or guarantee about $2 trillion in mortgages this year.

The government is pulling out all the stops in the mortgage market. I'm sure the Fed asked for this; they have been facing major pressure to start buying mortgages directly and permanently rather than just taking them as collateral for short term loans. For obvious reasons they didn't want to do that so Fannie and Freddie will fill the gap. Between the Fed and the agencies a lot of money has been thrown at the mortgage market in the last three weeks. Only time will tell if it is enough.

Tuesday, March 18, 2008

More Consequences of a Weak Dollar

I've blogged here before about the consequences of a weak dollar, but this is something I hadn't really thought about (via Mises):

The slowdown of the American economy and the ensuing devaluation of the US dollar deliver gloomy headlines as timely as weather forecasts. The weakening currency may excite entrepreneurs anticipating increased exports. As well, it might have a stimulating effect for American professionals who are paid in return for our services.

However, the total effect is negative insofar as it will curb the trend toward the expansion of the international division of labor. Less outsourcing means higher labor costs for American business, which means less productivity overall.

I'm not sure this is completely correct. The article doesn't really quantify the change in producitivity or cite much in the way of statistics, but anecdotally it makes sense. Certainly there must be some marginal effect after the recent devaluation. Just another consequence of inflation.

Housing Starts

Housing starts for the month of February fell 0.6%, to a seasonally-adjusted annual rate of 1.065 million. The number was better than expected, as analysts were expecting a number in the range of 990,000.

New construction on single-family homes declined by 6.7%, the lowest level in 17 years. Starts on single-family homes have dropped 62% from the peak over two years ago and have fallen 28.4% in the last year.

Starts on multi-family units increased 14.5% in the month and are up 23% in the past year.

Regionally, total starts fell 28% in the Northeast and were flat in the Midwest. Starts rose 3.9% in the South and 5.1% in the West.

Building permits, an indicator of future construction, fell 7.8% in February, to a seasonally-adjusted 978,000 annual rate. Building permits are at its lowest level since late 1991.

See Full Report.

Producer Price Index

Prices paid at the wholesale level increased by 0.3% in February, after a 1.0% gain in January. A worrisome trend of higher prices may be developing, as two months of data indicate. Core prices also increased, posting a hefty 0.5% gain. The PPI number was in line with economists expectations, while the core number was above the 0.2% estimate.

Over the last 12 months, producer prices have increased by 6.4%. Core prices over the same time climbed 2.4%.

See Full Report.

Monday, March 17, 2008

Contrarian Indicator

In what may be contrarian signal on the market, Goldman Sachs has politely asked Abby Joseph Cohen to shut up about the S&P 500:

March 17 (Bloomberg) -- Abby Joseph Cohen, among the most bullish investment strategist on Wall Street this year, will stop making Standard & Poor's 500 Index forecasts for Goldman Sachs Group Inc.

She was succeeded in the role by David Kostin, Goldman's U.S. investment strategist, spokesman Ed Canaday said in a telephone interview. Kostin today predicted the S&P 500 may fall 10 percent to 1,160 before rebounding to 1,380 by year's end.

The 56-year-old Cohen now has the title ``senior investment strategist'' and contributor to the portfolio strategy team, according to Canaday. She was Goldman's chief investment strategist.

I remember back in 1999 when I was at Oppenheimer and Mike Metz was "reassigned" for being too bearish. Of course, he got moved out within a few months of the top and he was proven correct about the market. He is now back as the strategist at Opy. If Abby Cohen has now lost her job (well she hasn't actually lost it; it just that when she goes there, someone else is doing it) and she's the most bullish on the Street, we may just be getting close to that elusive bottom. Food for thought anyway...


$2? That's what JP Morgan will pay for Bear Stearns in a bailout pursued, financed and strong armed by the Federal Reserve. When we look back on this years from now, people will wonder how Jamie Dimon was able to gain control of so much in assets for so little. The Fed's got his back on the riskiest stuff and JPM gets Bear's prime brokerage, asset management and investment banking businesses basically for free. Dimon will go down in history as one of the greatest negotiators to ever walk down Wall Street.

There are some unanswered questions surrounding the deal. What are the terms of the Fed loan being provided to JPM? Do they have any risk from the assets on Bear Stearn's balance sheet? Who bought all those puts last week on BSC? Were the put buyers counterparties to BSC? Would it be legal for a counterparty to hedge their risk buy purchasing puts? Was there insider trading? How much did the option market makers lose? Did Goldman Sachs and JP Morgan withdraw financing from BSC knowing that it would give them an opportunity to make money and buy the assets on the cheap? Will GS buy any of the assets from JPM? Will shareholders approve the deal? What if they don't? Can the Fed force the deal through?

The stock market, at least for now, seems to be taking the news in stride. After a swift 200 point loss, the Dow has recovered, trading down just 3 points as I write this. Of course, it's only 10:45 so who knows how we'll close, but I am encouraged by the action so far. The VIX spiked over 35 this morning which is very near the highs seen in the August and January sell offs. The AAII sentiment poll over the weekend showed just 20% bulls, so sentiment is decidedly negative. Is this the bottom? I don't know, no one does, but it's beginning to feel like it. Bottoms are often marked by a specatacular bankruptcy and while BSC didn't actually file Chapter 11, they certainly would have if the Fed and JPM didn't step in.

At this point the biggest problem with being a bull on stocks is that it is hard to see what would be the catalyst for a move higher. The economic news hasn't been as bad as the headlines suggest but it certainly hasn't been good. The credit markets just seem to get worse by the day. The dollar is still falling and inflation is higher than anyone at the Fed is willing to admit. Having said all that, it would seem that, based on today's action so far, the bad news is losing it's punch.

One thing that we can learn from looking at past bear markets and recessions is that the market will likely bottom before the economy does. If past recessions are any guide, the market will bottom at the trough of the recession when things are the bleakest. Can things get worse? Are we at the bottom yet? All I can say at this point is maybe.

Empire State Manufacturing Index

The New York Fed's Empire State Manufacturing Index, which measures manufacturing activity in the New York area, hit record lows for the month of March. The index fell to -22.2, down from -11.7 in February. The previous low was -19.6, back in November 2001. Economists had been expecting the index to rebound slightly, to -5.0.

Despite the horrible number, expectations for future business conditions improved slightly, with the future index increasing to 25.8 from 22.7. The new orders index also improved for the month, jumping to -4.7 from -11.9.

The prices-paid index rose to 50.6 in March, up from 47.4 in February.

See Full Report.

Friday, March 14, 2008

Inflation? What Inflation?

The Bureau of Labor Statistics released its monthly consumer price index for February, and to everyone's surprise(and I mean everyone), it came in flat. There was no increase in consumer prices in the last month. Hard to believe, but for the time being, we'll treat it as great news.

Core CPI, which excludes volatile food and energy prices, was also flat for the month. Economists were expecting an increase in prices of 0.2% for both the CPI and the core. Over the past year, the CPI is up 4.0%, down from 4.3% in January. Core is up 2.3%.

Report Breakdown- Apparel prices fell 0.3%, while transportation costs fell another 0.7%. Food prices rose 0.4%, offsetting a 0.5% drop in energy prices. Recreation and medical care costs both rose 0.1%.

See Full Report.

Thursday, March 13, 2008

The Great Recession of 2010

Betting on future tax rates is now available at Intrade. It isn't a pretty picture (HT Mankiw):

P(top rate equals or exceeds 38 percent) = .87
P(top rate equals or exceeds 40 percent) = .33
P(top rate equals or exceeds 42 percent) = .18

Notice that there is a one in three chance the rate will exceed the level that prevailed under President Clinton.

Newsletter Article

I contribute articles for newsletters and other local publications. Here's the latest for the Coral Gables Bar Association:

As I write this the U.S. stock market, as measured by the S&P 500, is down over 10% since the beginning of the year. The U.S. economy is widely believed to be either already in or entering a recession. Home prices are falling and foreclosures are rising. The municipal bond market has seen yields rise (prices fall) so much that long term tax free bonds are now yielding more than taxable Treasury bonds (see our blog for a more complete explanation of what is going on in the muni market: Consumer confidence is at an all time low.

Amidst all this doom and gloom the easy course is to give in and join the crowd. It is natural to be tempted to sell stocks and seek the safety of a money market or savings account. It is natural to want to avoid the pain of a bear market and wait for economic conditions to improve before doing any buying. Unfortunately, the easy, natural thing to do is not always the right thing to do.

Economic data tends to lag and the stock market tends to anticipate. Recessions do generally coincide with stock market downturns, but because of the lag time of economic statistics, they take a while to diagnose. On average the National Bureau of Economic Research announces a recession six months after it began. Furthermore, because the stock market anticipates, stocks often hit their bottom at the trough of the recession, not when it ends. If you wait until the end is announced, you could miss a large move in stock prices. In two of the last four recessions the entire stock market decline took place before the recession announcement. In the 1990 recession, which seems most like the current downturn, the recession and the market decline were over before the NBER even announced the recession.

Successful investing requires that one act as a contrarian. It is trite to say that investing requires one to buy low and sell high but that is what is meant by acting as a contrarian. How can you buy low if you don’t buy when the market is down? How can you sell high if you don’t sell when the market is up? It sounds simple, but does your natural instinct say buy right now?

So what should you be doing now? Well, that depends to some degree on your circumstances, but there are some common things that every investor should be at least considering right now. The most obvious and important task is to check your asset allocation. If you read my column from March of last year, Commodities as a Strategic Investment, and included some commodity exposure in your portfolio, you’re looking at a sizable gain by now. That means that commodities are probably a larger portion of your portfolio than you originally intended. Also, after the recent stock market decline, the portion of your portfolio dedicated to stocks has probably fallen. Consider taking some of the profit from the commodities (sell high) and using the proceeds to purchase stocks (buy low).

If you purchase individual stocks, you should review all your holdings. What seemed like a good idea a year ago may not seem as good now. If you own stocks that have declined in value, review them as if you were considering them for a new purchase. If you wouldn’t buy it now, you should consider taking the tax loss and moving on to something else. If the original rationale for buying the stock is still valid, consider buying more to lower your average cost. And if you’re stock picking doesn’t produce market beating results, consider using a low cost index fund as we do for most of our stock market exposure.

Finally, if you don’t have an asset allocation plan, it is time to get one. A well diversified portfolio allows you to weather the storms that are inevitable in markets. Consider that while the stock market has declined roughly 10% since the beginning of the year:

1. REITs are down 3-5% not including dividends. Yes, I mean Real Estate Investment Trusts. All real estate is not created equal.
2. The Goldman Sachs Commodity Index is up 17.6% and the DJ AIG Commodity index is up 19.1%.
3. Treasury bonds are up about 1.5% not including interest payments.
4. Foreign stocks (as measured by the EAFE index) are down 8.7%. Even Emerging Market stocks have outperformed the S&P 500, falling 9.5%.

We don’t know yet whether the current economic slowdown will develop into a full blown recession, but we do know there have been significant changes in our portfolios. Make changes now with an eye on the long term and always act as a contrarian. Buy low, sell high!

Initial Jobless Claims

New jobless claims held steady for the week ending March 8th, holding at 353,000. The 4-week moving average fell by 1,250, to 358,500.

Jobless claims still remain above the threshold of a healthy labor market. Readings consistently higher than 350,000 would signal significant weakening in the labor market.

See Full Report.

Retail Sales

Retail sales fell 0.6% in February, after rising 0.4% in January. Auto sales accounted for most of the drop, as retail sales excluding automobiles fell only 0.2%. Both numbers were below estimates. Economists forecast a flat month for sales, and a slight gain of 0.1% excluding autos.

Rising energy prices, a housing slump, and the credit crunch have, as the report suggests, weakened consumer spending and confidence. It is becoming increasingly possible, depending on the March retail sales number, that real consumer spending will fall for a full quarter for the first time in 17 years.

See Full Report.

Wednesday, March 12, 2008

Jim Rogers Slams the Fed

Jim Rogers is one of the most succesful investors of all time. He was partners with Soros back in the day but left because he thought he was smarter than Soros - and he probably still is. He was interviewed on CNBC Europe today and had some harsh words for the Fed:

Federal Reserve Chairman Ben Bernanke should resign and the Fed should be abolished as a way to boost the falling dollar and speed up the recovery of the U.S. economy, investor Jim Rogers, CEO of Rogers Holdings, told CNBC Europe Wednesday.

Asked what he would do if he were in Bernanke's shoes, Rogers, who slammed the Fed for pouring liquidity in the system and accepting mortgage-backed securities as guarantees, said: "I would abolish the Federal Reserve and I would resign."

If this happened, "we don't have anybody printing money, we don't have inflation in the land, we don't have a collapsing U.S. dollar," he told "Squawk Box Europe."

He also gave some investment advice:

He said he had a short position on all investment banks and is buying agricultural commodities such as cotton, wheat, coffee and sugar and was also buying the Chinese yuan and the Japanese yen.

"Buy agriculture. Agriculture is one of the few places where you're going to make a fortune in the next years," Rogers said.

If he's right at least my commodity positions will make some money.

Unintended Consequences

Jeff Jacoby tells us how government makes things worse in the Boston Globe (HT: Mankiw):

WHAT DO ethanol and the subprime mortgage meltdown have in common? Each is a good reminder of that most powerful of unwritten decrees, the Law of Unintended Consequences - and of the all-too-frequent tendency of solutions imposed by the state to exacerbate the harms they were meant to solve.

Take ethanol, the much-hyped biofuel made (primarily) from corn. Ethanol has been touted as a weapon in the fashionable crusade against climate change, because when mixed with gasoline, it modestly reduces emissions of carbon dioxide. Reasoning that if a little ethanol is good, a lot must be better, Congress and the Bush administration recently mandated a sextupling of ethanol production, from the 6 billion gallons produced last year to 36 billion by 2022.

But now comes word that expanding ethanol use is likely to mean not less CO2 in the atmosphere, but more. Instead of reducing greenhouse gas emissions from gasoline by 20 percent - the estimate Congress relied on in requiring the huge increase in production - ethanol use will cause such emissions to nearly double over the next 30 years.

It seems to me that ethanol subsidies have had exactly the effect that the politicians expected - Charles Grassley is still the Senator from Iowa, right?

On to subprime:

The crisis has its roots in the Community Reinvestment Act of 1977, a Carter-era law that purported to prevent "redlining" - denying mortgages to black borrowers - by pressuring banks to make home loans in "low- and moderate-income neighborhoods." Under the act, banks were to be graded on their attentiveness to the "credit needs" of "predominantly minority neighborhoods." The higher a bank's rating, the more likely that regulators would say yes when the bank sought to open a new branch or undertake a merger or acquisition.

Jacoby ends with a quote from Mark Twain that is as true today as when he first wrote it:

"No man's life, liberty, or property is safe," warned Mark Twain, "while Congress is in session."

Rogoff on Inflation

Ken Rogoff thinks the world's central bankers (and particularly the US Federal Reserve) need a reality check on inflation (HT: Greg Mankiw):

Many central bankers and economists argue that today's rising global inflation is just a temporary aberration, driven by soaring prices for food, fuel, and other commodities. True, prices for many key commodities are up 25 percent to 50 percent since the start of the year.

But if central bankers think that today's inflation is simply the product of short-term resource scarcities as opposed to lax monetary policy, they are mistaken.

The fact is that around most of the world, inflation ― and eventually inflation expectations ― will keep climbing unless central banks start tightening their monetary policies.

The U.S. is now ground zero for global inflation. Faced with a vicious combination of collapsing housing prices and imploding credit markets, the Fed has been aggressively cutting interest rates to try to stave off a recession.

But even if the Fed does not admit it in its forecasts, the price of this ``insurance policy" will almost certainly be higher inflation down the road, and perhaps for several years.

That's not a pleasant thought, but it's probably accurate. Inflation is created by central banks and they have been inflating their butts off for the last 9 months trying to avoid a recession. And it's not working.

The Oil Bubble

Crude oil prices are hitting new highs just about every day. Is the oil market in a bubble? Well, looking at the fundamentals of the oil market would seem to point in that direction. Oil and gas inventories have been rising for a while even as we make new highs in price. Consumption in the US is falling and the growth rate in places like China are lower than they were a year ago. And yet, Goldman Sachs recently suggested that oil prices could reach $200/barrel. Ronald Bailey at Reason has a good article about the reasons oil is continuing to rise:

So supply is up; relative demand is down and yet, the price of oil is soaring. What's going on? Last week, Exxon Mobil CEO Rex Tillerson blamed a third of the recent run up in oil prices on the weak dollar, another third on geopolitical uncertainty, and the rest on market speculation.

I'd say the weak dollar is the main culprit but I suppose those other items could be having an effect too. The more important question for us is whether the entire commodity complex is in a bubble. We always maintain a position in commodities in our portfolios and that is a major reason our portfolios have performed so much better than the market recently.

Mike Metz, one of the most literate and clear thinking analysts on Wall Street, has suggested in his recent commentaries that commodities and Treasury bonds may both be in bubbles. On commodities he recently stated:

This search for higher returns is being reflected in the current surge in commodity prices, which has reached bubble proportions in that levels do not reflect supply demand considerations of producers and consumers. The arena has attracted hoards of momentum traders and speculators, resulting in parabolic moves in most soft and hard commodities.

So are commodities in a bubble? I don't think so yet; if commodities were in a bubble one would expect the stocks of commodity producers to also inhabit bubble land. But the valuations on commodity producers like oil companies are quite modest. I expect that we will see a major correction in commodity prices sometime soon, but it will be that - a correction.

Auction Rate Redemptions

One of my fears about the Auction Rate market was that closed end funds that issued auction rates to buy long term munis would be forced to call the auction rates and sell the municipal bonds. Well, here's some good news:

BOSTON, March 10 /PRNewswire-FirstCall/ -- Eaton Vance Corp. (NYSE: EV)announced today that three closed-end equity funds managed by its affiliate Eaton Vance Management have secured committed financing totaling approximately $1.6 billion that the funds intend to use to redeem all of their outstanding auction preferred shares ("APS"). The three closed-end funds are: Eaton Vance Tax-Advantaged Dividend Income Fund (NYSE: EVT); Eaton Vance Tax- Advantaged Global Dividend Income Fund (NYSE: ETG); and Eaton Vance Tax- Advantaged Global Dividend Opportunities Fund (NYSE: ETO)(collectively, the "Funds"). With the new financing, the Funds intend to
change their method of leverage from APS to debt. The Funds expect to redeem in full their outstanding APS, subject to completion of their new financing arrangements and satisfying the notice and other requirements that apply to APS redemptions. It is expected that each series of the Funds' APS will be redeemed at the next dividend date after March 28, 2008.
See under closed-end fund press releases to view the Funds' announcement. To receive a hardcopy of this information call (800)225-6265.


March 7 (Bloomberg) -- Aberdeen Global Income Fund Inc. plans to buy back all its auction-rate debt, the first closed- end fund to take the step since the market seized up in mid- January.

The fund will redeem $30 million of auction-rate securities known as preferred shares, replacing them with loans from a major financial institution, the fund said today in a statement.

This is double good news. The investors stuck in these auction rate preferreds will be able to get their money back and the funds have found financing that will allow them to avoid a forced liquidation of their bonds. Maybe the muni market will survive after all.

Friday, March 07, 2008

About that Recession....

The employment report today provides a splash of cold water on those, like me, who believe that the economy will avoid recession. This is the second consecutive month of job losses and we have never experienced that without a recession. The losses were small - 85,000 jobs total over two months - but it is two consecutive declines. Of course, in the last recession we were shedding jobs at the rate of 200,000 per month at the bottom, so if this is going to be worse - and many say it will - we've got a long way to go.

The Fed announced new additions to the liquidity pool this morning. The TAF auctions will be raised to $50 billion - there are two scheduled for March - and they'll make another $100 billion available through weekly repurchase agreements. The repurchase agreements are arguably more important right now as they will accept mortgage backed paper for the repos. The implosion of the mortgage market this week obviously got the Fed's attention.

Stocks had another tough day as no one apparently wants to be long over the weekend. Who knows what hedge fund or bank will announce bad news before the opening bell Monday? It does seem that sellers are starting to get exhausted though. The market action seems lethargic; there's been no panic selling climax, just a steady drip of sell orders.

I'm not sure where this ends. This week is the first time since this started last July that I really felt worried. The selling in the muni market last week and the AAA mortgage market this week is really worrisome. These securities are not sub prime - Fannie Mae and Freddie Mac are AAA - and if investors are unwilling to hold these, then Houston we have a problem. The banks that lend to hedge funds and mortgage REITs through repos are demanding more collateral which leads to selling which leads to demands for more collateral. If this continues we have to consider the possibility of Fannie Mae and Freddie Mac going under. If that happens we will finally find out if the US government will really guarantee this agency paper. Given a choice between economic collapse and adding to the national debt, I think we can all rest assured that politicians will be falling all over themselves to spend our tax dollars bailing out FNM and FRE.

Making money as an investor requires that one be optimitic when everyone else is pessimistic. You have to be a buyer when everyone else is a seller and vice versa. It is hard to do when it seems that there is no end to the bad economic news but I guarantee you that the bad news will end. And when it does, those who have been able to preserve capital will be the winners. We have performed much better than the stock market because of our exposure to commodities and bonds, so I expect to be in that group, but to paraphrase Thomas Paine, "These are the times that try investor's patience".

It is always tough to see past the valley when the economy is not clicking on all cylinders, but every recession in history has been followed by an expansion. During times like this, I spend my time picking through the debris of the previous boom to see if any bargains exist. Obviously, that has led me into the real estate related securities and this week I spent considerable time working on the mortgage reits. My interest was spurred by the Carlyle Capital and Thornburg blow ups. Both of these entities had relatively good mortgages in their portfolios; that wasn't the problem. The problem was leverage. Carlyle was leveraged 32 to 1 and Thornburg was about 15 to 1. As the value of their mortgages fell their banks demanded more collateral and in both cases, it appears they have been unable to come up with the money.

These failures drove down the price of all mortgage backed securities, including agency paper. Obviously, the market is anticipating that the two portfolios will be liquidated and the lower prices put pressure on all the mortgage reits. Mortgage reits with more reasonable levels of leverage saw their stock prices get hammered over the last two days. Are there opportunities here? I suspect there are and what I learned this week about these companies was very enlightening.

First of all, there is no guarantee that the portfolios will be liquidated. When E trade got in trouble last year, Citadel came along and bought the portfolio. And Citadel has been buying up smaller mortgage companies (they bought Res Mae and Sowood) so they would be a natural buyer of Thornburg. There have also been rumors that JPM and Citadel forced this issue with Thornburg so they could buy the assets on the cheap. I really don't buy that but it will be interesting to see if Citadel emerges as a white knight. The point is that those selling in anticipation of these portfolios being liquidated may be disappointed.

Second, most of the mortgage reits operate with a lot less leverage than these two. Analy, MFA and Anworth all have leverage ratios between 8 and 10 times. That is much easier to deal with and I wouldn't expect these companies to go Thornburg's way. But with all the Black Swans around these days, it can't be ruled out.

There is a reason that smart outfits like Citadel are getting in the mortgage business. With good credit and permanent financing, the mortgage business is very profitable. Using reasonable leverage, returns on equity in the mid teens and even in the twenties is pretty easy to obtain. And the balance sheets of these mortgage reits are not as bad as they appear. The accounting rules used to adjust the balance sheets of these companies has produced some weird results. I am not done with my analysis yet, but I expect to see some major changes in the balance sheets of these companies when this crisis finally passes. I'll be posting on these balance sheet issues when I finish and fully understand the implications.

Here's a timely example of what I mean by balance sheet issues. Crystal River (CRZ) (I bought CRZ today for my personal portfolio) reported earnings today and the results were eye opening. CRZ stock is down from 29.48 last May to 10 now so they've had some problems. But does the stock price really reflect the reality of the situation? CRZ reported a loss of $10.10/share for the quarter and that sounds awful but the reality is somewhat different. Net Investment Income was $.80/share and operating income was $0.72/share. Everything else that contributes to the GAAP loss are balance sheet items that don't affect cash flow. Evidence of that is that CRZ declared a dividend today of $0.68/share. Of course, we don't know what will happen in the future; the dividend could be cut, but at least for now, this looks like a relatively healthy company with a balance sheet that is being whipsawed by the accounting rules.

I'm not nearly done with trying to figure out all the accounting rules that are affecting these companies but it appears there may be some major bargains. This is what every investor should be doing while we wait for the recovery. Every panic produces opportunity; you just have to find it.

Thursday, March 06, 2008

Mortgage Market Meltdown

The credit crisis got serious today. The mortgage market has been a big part of the credit problem all along but in the last few days the problems have become more acute. When the sub prime market first started unraveling last summer, it was just sub prime that was a problem. It became obvious that so called Alt A mortgages would have similar problems and the implosion of Thornburg this week confirms that.

But what happened over the last two days is the most worrying. Now mortgages backed by Fannie Mae and Freddie Mac are falling. A London hedge fund, Peloton, had its portfolio seized by creditors last week. And this was a fund that made a killing last year shorting sub prime. This week Carlyle Capital failed to meet margin calls on a portfolio of Fannie and Freddie paper. These guys were leveraged 32 to 1 so it doesn't take much price movement to trigger a margin call, but that portfolio will now be coming on the market so the supply will just increase and prices will probably keep falling.

Even worse is that Fannie Mae and Freddie Mac themselves own vast amounts of these mortgages. And they are highly leveraged. If you look at the official debt/equity ratios, they are leveraged about 25 times. That actually seems low but even if it's right it's still a lot of leverage. It would not take much of a fall in the value of their mortgage portfolios to completely wipe out the equity.

This situation is more serious than anything the market has faced since this started last summer. The market believes there is an implicit US government guarantee on Fannie and Freddie debt. We may find out soon whether implicit can become explicit.


In the right hand column of this blog you'll find a poll about the stock market. We are trying to get some data on market sentiment. Please take the time to vote.