Venetian Pool

The family is headed to historic Venetian Pool today.




I've never actually been swimning there, but I've been for some charity events. Thanks to our friend Cha Cha for coming up with the idea.

Dollar drives Sub Prime Mess

John Tamny has an article at TCS that looks at the correlation between housing prices and the value of the dollar:

Greedy capitalists are increasingly blamed for the moderation of real estate prices that has led to the subprime meltdown, but a more realistic culprit is our own Federal Reserve. Dollar mismanagement there drove lenders and individual consumers into the housing market; both understandably chasing the rising returns that always result when the unit of account (in our case, the dollar) is cascading downward. History has once again repeated itself.

This of course makes perfect sense. It'll be interesting to see what happens to the dollar - and real estate - when the Fed starts to cut rates. Tamny argues that the dollar and stocks will rally. I'm not so sure.

Bard Analysis

An interesting research technique based on Much Ado About Nothing:

Next time you read a newspaper, I want you to try the Much Ado about Nothing Analytical Tool. In the left column you put sentences with stats based on an actual count of something real - jobs, dollars, interest rates, prices. Quotes, if they are substantial, go in the left column too. Actual events like hurricanes, elections, wars and terrorist attacks are definitely left column material.


Your right column is for sentences with words like 'worries', 'concerns', 'expectations' or 'believes'. Unattributed quotes go on the right, as do short quotes. Opinion polls go on the right. This includes opinion polls masquerading as economic stats like consumer confidence, or business confidence. Elections and futures markets, however, go on the left. 'Sub-prime jitters' is a left column thing.

I think everyone does this to some degree when evaluating the condition of the market. I know I do, but I've never formalized it by actually writing lists. Look for a new feature at the website; I'll try to get something like this up this week.

Bears Got Mauled on Friday

The WSJ Market Beat Blog has an interesting note about who got hurt by Friday's discount rate cut. You probably missed it, but Friday was also option expiration day for index options and those who were long puts got burned badly:

While the Fed’s move helped many investors last Friday, it slammed a handful who’d wagered that the market would continue to decline. It was especially painful to those who had purchased certain monthly “put” options tied to the Standard & Poor’s 500-stock index, which are contracts that pay off if the index declines below a certain level. Those options expired almost immediately after the opening bell Friday.

Index options settle Friday morning at the open, so the Fed's decision to cut the discount rate before the open costs these guys a lot of money that seemed a sure thing the day before:

Investors holding S&P puts that would pay off if the index opened Friday below 1450, for instance, would have made money without the Fed’s action, since the index closed at 1411 Thursday and was moving lower in overnight trading. Instead, the index shot up at the open, pushing the exercise settlement value of the contract above 1450 (1450.11, to be exact — see chart of S&P futures at right).

That qualifies as a bad day in my book. Of course, the option market works both ways, so call holders who looked hopelessly out of the money Thursday evening made out like bandits Friday morning.

The interesting thing about this to me is the Fed's timing. The put holders were probably also buying futures in an attempt to make back some of what they lost, so they helped to push the market higher. Did the Fed factor this into it's decision? I hate to give them more credit than they are due, but my guess is that option expiration day represented an opportunity the Fed did not want to miss.

Fleckenstein Rants

Bill Fleckenstein is a perma bear who is at least thoughtful about his bearishness. While I rarely agree with his relentless pessimism, I do respect his analysis. In his latest piece for MSN Money he rants about the role Central Banks have played in getting us to this point in the credit bubble:

As regular readers know, I have been a longtime critic of the Federal Reserve. Not too far back, that view was a decidedly minority one.

But as our credit bubble undergoes an ugly unwinding, it's dawning on folks that central banks lie at the epicenter of the problem.

Fleckenstein uses quotes from an article by Andy Xie in FT.com last week to make the point that the Central Banks should not bail out stupid investors:

He writes: "The global credit bubble is bursting. This bubble is primarily leverage financing for owning risky assets. The people who were responsible for what happened played with other people's money, marketed arcane financial products with false promises of fat profits, but stuffed their own pockets with big bonuses. Neither these masters of the universe nor their greedy but naive investors deserve to be bailed out. They deserve what is coming to them.

Read the whole thing by clicking on the title of this post.

Housing Undervalued?

David Ranson, President of H.C. Wainright & Co. Economics, has an editorial in the WSJ today that explains the run up in housing prices as a response to inflation:

Inflation tends to boost housing prices in the same way that it boosts the price of any tangible asset. And inflation is surely a major part of the housing-price story. Over the past three decades, the price of housing at the national level has risen at a rate similar to the growth of nominal GDP, and the correlation between housing prices and GDP is statistically significant. But the relationship between housing prices and the prices of highly inflation-sensitive assets such as commodities is much more impressive than the relationship with the economy. There is a particularly strong correlation between percentage changes in housing prices and percentage changes in the price of gold -- especially when a short time lag is taken into account.

I have spoken for years about the Fed induced inflation that almost everyone, including the Fed, is overlooking because it doesn't show up in the CPI. Today's action by the Fed signals that the inflation will continue and the basic thesis of the editorial is that compared to gold and other commodities, housing is actually underpriced. That seems about right to me, but I wonder when we will start to see this manifest itself in the housing market. With everyone negative on housing a good contrarian is tempted to take the opposite side of the bet, but it seems a little early just yet. Of course, the undervaluation could be solved by a fall in commodity prices as well - something that Mr. Ranson doesn't discuss.

The More Things Change....

First, the mea culpa. August 8th and again last week, I predicted that the lows for this correction had been seen. Obviously, I was wrong by a few hundred Dow points. This just serves to prove that no matter how long you’ve been doing this, the future course of markets is still unpredictable. I still believe that the fundamentals of the economy are basically sound and that the bull market in stocks is not over, but I must admit that there was a point yesterday when I was doubting that. At the low yesterday, the Dow was down almost 350 points and my stomach was churning and the easiest thing in the world would have been to sell and relieve that stress. But I didn’t do that; successful investing is as much about controlling your emotions as anything else and when the market is acting irrationally, one has to resist the temptation to join in. And today (or at least this morning) we are getting some relief.



The Federal Reserve cut the discount rate this morning and the stock market responded immediately by jumping over 300 points at the open. As I write this, the market is up about 150, so there is still a question as to whether this rally is sustainable. I think it will be but only time will tell if the Fed’s action this morning will mark the bottom of this correction.



Cutting the discount rate is more a symbolic act than an actual remedy to the current problems in the credit markets. The discount rate is the rate the Fed charges member banks to borrow directly from the Fed. This rate is higher now than the Federal Funds rate, which is the rate at which member banks loan money to each other. Traditionally, the discount rate was lower than the Fed Funds rate and if banks were borrowing from the Fed it was seen as a drastic measure. A few years ago, the Fed let the discount rate drift above Fed Funds and it remains there today. So if banks can borrow from each other at 5.25% and the discount window is charging 5.75%, why would a bank go to the discount window? Well, the fact is they probably won’t. I think this was the Fed’s way of buying time until the next FOMC meeting when they will probably cut the Fed Funds rate, which is much more important to the credit markets. The statement that accompanied the discount cut this morning had the Fed acknowledging that the “risks to economic growth have grown appreciably”. I think that is their way of letting the market know that a Fed Funds rate cut is coming at the next meeting. And that is the source of the title of this essay.



During the Greenspan era, every crisis, no matter how trivial, was met with a cut in interest rates. That tendency came to be known as the Greenspan put; the market came to expect that any stress in the market would be solved by Greenspan providing another dose of liquidity to the markets. That was the source of the stock market bubble in the late 90s and the housing market bubble of the early 00s. The easy availability of credit encouraged risk taking and the Greenspan put reinforced it. What everyone has been wondering these last few weeks is how would Bernanke react? And today, I think we got the answer. He will act to preserve the status quo – easy credit. And once again, the speculators who took too much risk will be bailed out by the Fed. Moral hazard is alive and well.



In a free market economy, those who make poor financial decisions (such as loaning money to people who can’t pay it back) would have to pay for those mistakes. In an economy driven by easy credit, those who make poor decisions don’t get their full comeuppance. They may lose a little, but ultimately the Fed will bail them out of their poor decisions. If the Fed starts a rate cutting cycle here and rates fall, all those people who took out variable rate mortgages will have the ability to refinance at lower rates and the number of foreclosures will be less than otherwise. I suppose that is good for the people who made that mistake, but the rest of us will pay for it in the form of higher inflation. Those who act prudently, who save and invest, will not be rewarded as they should because interest rates will be lower than the market clearing rate. Many people complain about the low savings rate, but why save when the Fed makes sure that interest rates are so low that saving is a losing game after considering inflation and taxes? Those who act prudently are punished and those who take inordinate risks are rewarded. The easy availability of credit also distorts investment. Investments are driven more by the credit terms than their actual economic desirability.



So where do we go from here? My guess is that the Fed will cut rates at the next meeting and quite possibly at the October meeting as well. If that is the case, stocks can be assigned a higher multiple and the likely reaction is a return of the bull market. There will come a day when the credit bubble ends, but I suspect we are not there yet. The Fed has room to cut rates more if need be and they are apparently willing to do just that. The key is still economic growth and the world economy is still performing quite well. I will be reviewing the economic stats over the weekend and will put out a full report next week, but so far I have seen nothing that leads me to believe that the economy has been hurt all that much by these credit issues. The sub prime debacle is relatively small compared to GDP and with the Fed now providing relief, the economy is likely to maintain its current path. If that is the case and earnings continue to grow, the market will follow.

Market Update

The sub prime debacle continued last week as BNP Paribas, a large French bank, reported losses in some of their hedge funds. The news caused a further tightening of credit and the European Central Bank, the US Federal Reserve and the Bank of Japan all added liquidity to the market to calm things. While this is not unprecedented, it is a little more drastic action than we have seen up to this point during the recent turmoil. On the other hand, it is exactly what central banks are supposed to do in these situations. Central banks are lenders of last resort; when the market isn’t working they provide the liquidity the market needs until things return to normal.



As I warned in my last market update, the stock market did retest the lows of 8/1, but the averages were able to close above the worst levels of that day. While I still stand by my prediction that the lows for this correction have already been seen, I must admit that last week really tested my conviction. And some of the indicators I watch are still flashing warning signs. The American Association of Individual Investors sentiment poll is still showing too many bulls for my comfort and the option market is giving some mixed signals. This morning as the market rebounded, there was a lot of call buying activity in the indices which indicates that a lot of investors are betting on this rebound. I would have preferred to see a little more skepticism. On the other hand, individual stock put buying is still at very elevated levels, which from a contrarian standpoint is bullish. As I said, mixed signals.



The damage to the economy from the sub prime problems has so far been minimal. There have been reports that jumbo mortgages have been a little harder to get or have come with somewhat higher interest rates and sub prime borrowers are pretty much locked out, but mortgages that conform to Fannie Mae and Freddie Mac guidelines still seem to be getting done. Of course, this won’t help the already hurting housing market, but that is old news and the dire predictions about consumer spending have yet to materialize. That doesn’t mean that they won’t, but this morning’s retail sales report showed an increase in July of 0.4% ex-autos and 0.3% overall. That was slightly better than expected and much better than June’s revised 0.7% drop. The retail sales number would have been higher if sales at gas stations hadn’t fallen due to a drop in gas prices during the month. Inventories also rose some last month but the rise was expected.



There was a lot of talk last week about the possibility of a Fed rate cut; if you didn’t see it, Jim Cramer on CNBC had a meltdown in which he basically screamed for Bernanke to cut rates. Cramer is a first class nutjob and publicity hound who only a month ago said the sub prime market would be no problem for the economy and now he’s screaming for a rate cut like the next depression is upon us. Why does this man get so much attention? If anything, Cramer’s outburst made it less likely that Bernanke will cut rates. He doesn’t want to be seen as responding to pressure from Wall Street. I don’t think the Fed should cut rates now. Inflation is still too high and the economy is not in danger of recession – there is no reason to cut rates. Furthermore, the system worked just as it is supposed to last week. The Fed provided liquidity without cutting rates and they can do that again if need be. What they don’t need to do is make everyone nervous by cutting rates in a panic.



I have not changed my outlook due to the recent problems. Stocks are relatively cheap at about 15 times earnings. Interest rates are relatively low and core inflation seems to be moderating. The housing market is weak (and maybe getting weaker), but I still contend that it won’t be enough to cause a recession. We are still overweight stocks, underweight REITs, equal weight on commodities and slightly overweight cash and fixed income. That allocation has served us well during the correction and I see no reason to change it for now.

China's Nuclear Option

This ties in nicely with the entry below about Congress and their protectionist legislation. Apparently, the Chinese don't feel the need to revalue their currency --and for good reason: they own almost $1 trillion worth of our Treasury Notes:

The Chinese government has begun a concerted campaign of economic threats against the United States, hinting that it may liquidate its vast holding of US treasuries if Washington imposes trade sanctions to force a yuan revaluation.

Two officials at leading Communist Party bodies have given interviews in recent days warning - for the first time - that Beijing may use its $1.33 trillion (£658bn) of foreign reserves as a political weapon to counter pressure from the US Congress. Shifts in Chinese policy are often announced through key think tanks and academies.

Of course, there are consequences to China (and the rest of the world) if they use this option. The consequences for the US economy would be much more severe though. A crash of Argentina proportions could not be ruled out. The dollar would fall, interest rates would rise and god knows where stocks would stop. Our politicians are playing a dangerous game. The Federal Reserve also deserves to share the credit for getting us in this situation. Two bubbles in 10 years is not a record to be proud of.

It doesn't seem good economic policy or foreign policy to be so deep in debt to one country, but we're in the situation now; it needs to be addressed. How do we get out of this mess? We need to attract capital to the US economy and the Chinese have been happy to assist us up until now. If their capital is withdrawn, we will need to do something to entice new investments. If we don't offer higher returns on equity capital, the enticement post Chinese selling, will be higher interest rates. Congress needs to quit bloviating about the Chinese currency and get to work on a corporate tax cut. I'm not holding my breath.

Fed Surprise

The Fed left interest rates unchanged today and issued a statement that was not what the market wanted but probably what the economy needed:

The Federal Open Market Committee decided today to keep its target for the federal funds rate at 5-1/4 percent.

Economic growth was moderate during the first half of the year. Financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses, and the housing correction is ongoing. Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy.

Readings on core inflation have improved modestly in recent months. However, a sustained moderation in inflation pressures has yet to be convincingly demonstrated. Moreover, the high level of resource utilization has the potential to sustain those pressures.

Although the downside risks to growth have increased somewhat, the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected. Future policy adjustments will depend on the outlook for both inflation and economic growth, as implied by incoming information.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Thomas M. Hoenig; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; Michael H. Moskow; William Poole; Eric Rosengren; and Kevin M. Warsh.

The key phrase is that "the Committee's predominant policy concern remains the risk that inflation will fail to moderate". This throws some cold water on the cut rates crowd. While that may disappoint markets temporarily, it is probably the right call for the long term health of the economy. Bernanke continues to surprise me.

Train Wreck

Desmond Lachman has an article at TCS Daily that warns of the consequences of the protectionism being contemplated by Congress:

Seemingly forgetful of the disastrous consequences for global prosperity of the 1930 Smoot-Hawley Tariff Act, today Congress has before it no fewer than 60 proposals to do something about the Chinese trade surplus. More ominous still, last week the Senate Finance Committee approved a proposal that would require the US Treasury to impose anti-dumping duties on China should China persist in maintaining an undervalued exchange rate. And the Committee did so with a 20 to 1 majority, which should be seen by China as the clearest of warnings that Congress could very well approve veto-proof trade legislation that would be inimical to China's longer-term economic interest.

Unfortunately, he sees this as a problem that the Chinese need to solve:

Among the leading protagonists in this drama are Chinese President Hu Jinato and Vice Premier Wu Yi, who represent the Chinese Communist Party in these talks. Filled with hubris, they never seem to tire of reminding Mr. Paulson of China's 5,000-year glorious imperial past. Nor do they tire of making it quite clear that a country of China's historic importance is not about to change its exchange rate policy under pressure from the United States, a relative newcomer on the international stage. Rather, they insist that the Chinese government will set its exchange rate policy exclusively in China's own national economic interest.

Who the hell do these Chinese think they are? They think they can set their exchange rate policy in a way that is in their own national interest? What chutzpah.

I don't think we have a trade problem, but if we do, devaluing the dollar is not the answer. That will only result in higher prices for Americans on the goods we buy from China. A nation cannot devalue its way to prosperity. If we want more companies to locate here and provide jobs for Americans, we need to make the business environment more friendly by making the cost of doing business here fall. That can be accomplished easily by cutting corporate taxes, something that our Congress can't seem to bring itself to do. Our politicians (and economists like Lachman) would rather bash the Chinese than actually do something about the long term problems facing the US economy.

Lachman is right that the protectionist legislation being proposed in Congress is disastrous. He is dead wrong in thinking that the Chinese should solve our problems for us. If the Chinese revalue their currency up against the dollar, it will only stregthen their long term economic prospects. That is why I suspect they will hold out until the last minute before revaluing significantly. And they will be applauded for doing exactly what they intended all along.

NYC to Ban the B Word

As many of you know, I consider myself a libertarian politically. While it has more often been the Republicans in the past that wanted to abridge free speech, more recently it has been coming from the Democrats. They seem to think that we need to be protected from some types of speech, as if words could actually harm us. The NYC commission is proposing to ban the use of the words "bitch" and "ho":

The New York City Council, which drew national headlines when it passed a symbolic citywide ban earlier this year on the use of the so-called n-word, has turned its linguistic (and legislative) lance toward a different slur: bitch.

The term is hateful and deeply sexist, said Councilwoman Darlene Mealy of Brooklyn, who has introduced a measure against the word, saying it creates “a paradigm of shame and indignity” for all women.

Obviously, the words are offensive in some contexts, but banning words cannot be acceptable in a free society. While it may seem harmless legislation (since it is in no way enforecable) banning words today may have unforseen consequences in the future. The same NYC commission already banned the "N" word earlier this year. What's next? Since when did we elect politicians to decide the boundaries of our vocabulary?

Malpass on the Economy

David Malpass, the chief economist of Bear Stearns, has an upbeat editorial on the economy in the WSJ today.

Another aspect of the market disruption is a dramatic stand-off between bond buyers and sellers: Buyers in both housing and debt markets are using the market discontinuity to claw prices and terms back to Earth. The slowdown talk weighing on equities also reflects the Wall Street view that debt, mortgage and takeover businesses have replaced General Motors as the economy's bellwether. According to the bears: As goes the credit market, so goes the economy.

Fortunately, Main Street is not that fickle. Housing and debt markets are not that big a part of the U.S. economy, or of job creation. It's more likely the economy is sturdy and will grow solidly in coming months, and perhaps years.

Malpass passes along some interesting facts about the economy that others seem to be missing. He doesn't believe the housing slowdown will cause a recession (neither do I) and supplies some facts to back up the argument:

The bearish view is that Americans live, breathe and spend their houses and mortgages. Yet the July 31 consumer confidence survey by the Conference Board jumped to 112, the highest in the six-year expansion. Data and theory show clearly that houses are not the be-all and end-all of the economy. Jobs matter more. For many, the value of future employment is much greater than their home equity. The low jobless claims and unemployment rate -- clear signs of a strong labor environment -- raise confidence and likely future wages. This outweighs changes in wealth, whether from declines in house prices or the stock market, especially for lower-income workers.

So he says that jobs are more important than housing and then provides some numbers to back this up:

Those overstating housing's impact on jobs often use dates spanning the 2001 recession, as in the widely quoted calculation that 37% of the net new jobs were in housing. That was true only between March 2001 and September 2005, because housing jobs grew in the recession while other jobs shrank. A fairer picture of the role of housing in the expansion is to start counting from any month after the recession. From the end of 2003 through present, jobs from residential construction plus real estate and mortgage brokers created only 3.6% of the net new jobs, 5.3% if all credit intermediation jobs are also included.

Nor has consumer spending been dependent on "cashing in" on the housing boom. The increase in mortgage equity withdrawals in 2004 and 2005 funded big net additions to household financial assets, while consumption growth remained steady. Mortgage equity withdrawals slumped throughout 2006, yet consumption growth was particularly fast in the fourth quarter of 2006 and the first quarter of 2007.

The constant warnings of a housing-related collapse in domestic consumption overstates the importance of housing in the economy, while understating the importance of jobs and economic growth, both of which have been solid. Of course, sellers of both houses and bonds would like more froth in their markets. But buyers, and likely the economy as a whole, will probably benefit over time from the wrenching return to more normal market conditions.

I have said since last year that the housing slowdown would not cause a recession and I still stand by that.

Global Alpha meets Beta

Goldman Sachs has a reputation as a firm that knows how to make money. Apparently, they also know how to lose it:

Goldman Sachs Group Inc.'s flagship hedge fund fell 8% during the last week of July, according to Financial News.

The fund is a global macro fund that makes bets on currencies, bonds, and stocks around the world. It has a good long term track record, but the recent past has not been good:

The Goldman Sachs Global Alpha fund posted a 7.7% loss before fees in the week ended July 27, pushing its performance for the year down 12.1% before fees, according to an investor cited in a Financial News report.

The loss increases the fund's run of disappointing returns to more than 18 months, having reported a loss of 6% last year.

The fund gained 40% in 2005 and its annualized return, before fees and is up 15.1% since it was launched in 1995.

So they take a lot of risk and generate 15% per year while also producing loads of volatility. Any strategy that is dependent on the manager's ability to predict the future will have tough stretches and the fact that Goldman Sach's name is on the fund doesn't change that fact. Anyone, no matter how smart, will be wrong sometimes and when you add leverage, being wrong can be very painful.

Whither the Fed?

The Federal Reserve Open Market Committee meets today and will announce the results of that meeting at 2:15 this afternoon. What should we expect? Well, if you listen to Wall Street, the statement released this afternoon will likely acknowledge the credit market's problems and offer a balanced view of the risks of inflation and economic growth. That would be a major change from the recent statements which have all emphasized inflation as the Fed's major headache.

If Bernanke and Co. follow this path, the market will start to seriously price in a rate cut soon. I think that would be a mistake. The Fed certainly faces a tough balancing act as they try to ensure full employment and low inflation. In the past, the Fed has always erred on the side of full employment and growth rather than low inflation and that is the source of many of our long term economic problems. Alan Greenspan caused this mess by cutting interest rates to generational lows after 9/11 and leaving them there for way too long. Now, in the aftermath of the Fed induced housing bubble, Bernanke faces a no win situation in my opinion. If he cuts rates due to the credit market problems, he will lose any credibility he has built as an inflation fighter. If he doesn't cut rates, a recession becomes that much more likely and he will face major political pressure in an election year. Frankly, I'm not sure he would survive it.

Unfortunately, I agree with the market consensus that the Fed statement will be seen as market friendly and announce that their bias has shifted to neutral. As for whether they will actually cut rates, that may depend on the market's reaction to the statement. I have been watching the Fed for many years though and they have always used easy money as the palliative to the consequences of previous policy errors. I don't expect anything different this time.

Client Letter

Here's a note I sent to clients after the market close yesterday:

While it is always difficult to predict a bottom or top in a market, I think I will venture out on that limb and say that today probably marked the bottom of the current market correction. I don’t place very much emphasis or put much faith in technical indicators, but there is one exceptional indicator that I’ve noted over the years. This indicator is used in Japanese candlestick charting and is known as a hammer. Basically what it means is that a market (or stock) trades down significantly during the day and then closes near the high of the day (and above the previous close). When a market or stock has been declining and has a hammer day, it usually marks a bottom. From a supply/demand viewpoint, what this pattern really means is that sellers have been exhausted. Over the years, this has been, by far, the most reliable technical indicator I have encountered. Today, the DJIA and the S&P 500 both had hammer days. Watching the market in the last half hour today was truly remarkable. The market traded down as much as 80 points, moved back to even, fell back 80 points again and then in the last 20 minutes of trading, erased the loss and tacked on another 150 Dow points. The market moved 230 points in the space of less than twenty minutes.



One thing to be warned about though. Often, after a hammer pattern emerges, the market will retest the lows of the hammer day over the next few trading days. So we may still be in for some volatility, but I think it is time to start looking for bargains created by the correction. The disaster in the mortgage market has taken down everything even remotely related to the sector. Mortgage REITs were killed (literally in some cases). Banks and brokers, even those not involved in the sub prime mortgage market were hit hard too. Mortgage pools that contain AAA rated paper were marked down. In every disaster lies opportunity, so I’ll be looking at some of the sub prime mortgage pools as well. At some price, they are worth the risk even if many of the mortgages are in default. The mortgage pool will foreclose and the real estate has a value. Yes, that value will probably be less than the face amount of the mortgage, but if you can buy the mortgage at a steep discount to the value of the real estate, the return may be substantial. Remember the savings and loan crisis in the early 90s? Those who bought real estate from the RTC made fortunes over the next decade. It may still be too early, but it certainly won’t hurt to start poking around in the wreckage.



I know this has been a difficult couple of weeks, but I’d like to remind everyone that these types of corrections are normal in a bull market. Investors have become somewhat complacent over the last two years as volatility receded to very low levels. The shakeout over the last two weeks is just a return to a more normal level of volatility. I don’t believe the credit market problems of the last month or so will cause a recession and I don’t believe the bull market is over yet. Earnings for the second quarter are coming in now (although no one seems to be noticing) and they are quite a bit better than expected. Earnings growth so far is about 6% versus expectations for 3.5%. When all is said and done, I expect growth to come in somewhere around 8%. Consumer confidence just hit a post 9/11 high. The ISM index still shows expansion in manufacturing. Exports are still booming. Official inflation is falling. In other words, the world is not coming to an end and the economy is still doing okay. My biggest worry right now is that Congress seems to propose a new tax on a daily basis and they are still threatening to impose some kind of import tariffs on China in an effort to prove the adage that those who don’t learn from history are doomed to repeat it.



I’ll send out a more complete update sometime soon so keep an eye out. You can also check out the blog; I’ll try to be more diligent about updating things there.

Solar Efficiency

Energy Focus, Inc. set a record for solar panel efficiency:

Energy Focus, Inc. (Nasdaq: EFOI - News), formerly Fiberstars, Inc. (Nasdaq: FBST - News), a global leader in energy efficient lighting, today announced the breakthrough milestone of a 42.8% efficiency solar cell achieved by the Very High Efficiency Solar Consortium (VHESC), part of the R&D work Energy Focus has been involved with through a DARPA contract.

This is pretty impressive; about 3 times current panel efficiency. It's still a ways from commercialization, but if they can get efficiency up this much, the payback period for a solar panel would be about 3 years versus the current 15 years. That would make solar very competitive with other, more traditional forms of power generation.

I beleive that technology will take care of our energy problems eventually. The pessimists who think we will run out of oil are not taking into account the innovation of man.

Those Who Don't Learn From History

Politicians that don't remember the Smoot-Hawley tariff act of 1930 are apparently doomed to repeat bad economic polciy:

It has become a Capitol Hill ritual: A few senators, always including the New York Democrat Charles E. Schumer, introduce a bill to punish China if its leaders do not raise the value of the nation's currency. Photos are taken, news releases are issued, but nothing really happens.

This year, the atmosphere on the Hill is markedly different. Powerful senators from both sides of the aisle, Schumer among them, are pushing two bills that threaten retaliatory action if China does not budge. For the first time, the idea is gaining broad support. The bills are moving swiftly through the Senate, and many analysts expect one will pass.

Economists are almost unanimous in their support for free trade:

In 1930, Congress passed and President Hoover signed into law the Smoot-Hawley Tariff Act. At the time, this protectionist measure was vigorously opposed by 1,028 of the nation’s top economists. They rightly predicted the tariffs would devastate the economy. And, in fact, the country subsequently plunged into the Great Depression.

Now some in Congress are considering ways to enact similar protectionist policies against China. Once again, 1,028 of America’s top economists, from all 50 states and top universities, have signed the following petition sponsored by the Club for Growth
in opposition to protectionist policies against China. In addition to many other prominent and well-respected economists, signatories include Nobel Laureates Finn Kydland, Edward Prescott, Thomas Schelling, and Vernon Smith.

Here's a link to the petition.

I have written here many times about the export boom currently underway in the US. It's just plain stupid to start a trade war when China has us by the Treasuries and our exports are booming. Stupid.

Unintended Consequences

Politicians who pander to their campaign contributors - and that would be all of them - create programs to solve perceived problems and create more problems as a result. Farm subsidies are a prime example:

Ethanol is a new industry that owes its growth solely to Congressional action. Corn growers now get a subsidy of 51 cents per gallon of ethanol they produce. On top of that they enjoy a guaranteed market — Congress has mandated that gasoline manufacturers use 7.5 billion gallons a year, which amounts to a guaranteed subsidy of about $4 billion, courtesy of American taxpayers. And how does this benefit the taxpayer? Less efficient fuel, for starters — ethanol provides less energy than gasoline, generating about 2.5 percent fewer miles per gallon. Ethanol subsidies also contribute to higher food prices, as corn growers reduce the supply of corn for food and plant more of it for fuel. In turn, corn-based animal feed has become more expensive, increasing the price of milk, as well as meat. The price of corn syrup goes up as well, which means that sodas and other sweet goods have also become more expensive. In short, all Americans are seeing higher grocery bills as a result of the ethanol subsidy — thus hurting even those who are too poor to pay taxes.

The subsidies even affect poor people outside the US:

Nor does this stop at the border. The subsidy is exporting trouble. Mexico has seen a tortilla shortage because American corn exports are stymied by the combination of government price controls and decreased supply.

Not only is Mexico suffering, but the United Nations World Food Program, which does a reasonably good job of averting starvation in areas affected by famine, has seen its costs increase by 50 percent because of biofuel programs. That means that fewer people are going to get the food they need.

It is not an exaggeration to say that the U.S. ethanol subsidy could soon start killing people in developing countries. After all, how is corn most helpful to poor people — as a food source or as fuel for an SUV?

Market Correction

Based on the number of phone calls I’ve received today, it would seem an appropriate time to make a few comments about the markets. Obviously, the last few days have not been nice, but it must be kept in context. At the time I’m writing this, all that has happened is that the gains we had achieved during July have been eliminated. Basically, the market is at about the same level as it was at the end of June. On June 29th, the DJIA closed at 13408.62. As I write this the DJIA is at 13423.01. The real damage has been done in areas to which we have little or no exposure. For instance, the high yield bond market is down about 5% this month and emerging market bonds have been hit as well. That’s why when we have bought bonds recently, they have been of the high quality variety (primarily government bonds). Our bond positions are up today as investors flee the risky high yield bonds for the safety of governments.



The cause of the selloff is the tightening of the credit markets. The subprime mortgage market got things rolling and it has now spread to other types of risky debt. Debt offerings that were intended to finance private equity takeovers are now being postponed. Three deals were postponed this week: Chrysler ($12 billion), Alliance Boots ($10.4 billion) and Allison Transmission ($3.10 billion). Some other smaller deals are also being postponed as the traditional buyers of these bonds have demanded better terms to compensate them for the risk they are taking.



Fear is returning to the market. The volatility index is over 22. This index rises when the market falls as investors pay ever higher prices (in the options market) to hedge their portfolios. Typically, the market makes a bottom when the cost of hedging hits its peak. The February correction saw the index peak at 21.25. The correction in June of last year caused a spike to 23.81. If this correction is similar to those, we are probably nearing some kind of bottom. I should mention however, that in the late nineties when volatility was generally higher, it usually took spikes into the 40s or 50s to find a bottom. The crash of ’87 caused a spike above 100, but I’m not looking for anything like that. Fear in the market is associated with bottoms; complacency or greed in the market is associated with tops.



Is this something long term investors should be worried about? I don’t think so – yet. If this mutates into a general credit crunch (like the late 80s/early 90s) it could cause a recession. Right now, I don’t think that is happening. Lending standards have been tightened – but they needed to be. A few years ago, all one needed to be approved for a mortgage was a pulse. Now the lenders actually want you to have the capacity to pay back the loan someday. So far, it appears that people (and companies) with good credit can still get financing. As long as that holds, the economy should be okay.



Another mitigating factor could be the Federal Reserve. If a hedge fund or other leveraged player gets in trouble, the Fed may be forced to cut rates. Could a hedge fund be in trouble now? Well, that may explain the high yield sell off and the yen rally we are seeing today. The carry trade, where funds borrow at low rates in yen and buy higher yielding investments in other currencies, appears to be unwinding a little bit today (high yield bonds are down and the yen is up). Consider that a fund that uses borrowed funds and buys high yield bonds may be leveraged as much as 10 to 1. That means that this months 5% drop in the high yield market is at least a 50% drop for any fund doing that trade. Another indicator is that the Brazilian Real, another favorite of the carry trade crowd, has dropped around 7% in the last two days. So if several of these funds really get in trouble and need to be bailed out, the Fed could come to the rescue. That’s what happened with the Asian crisis in ’98. Long Term Capital Management, a hedge fund with several Nobel laureates on the team (which may say something about the value of that award), made some bad bets and the banks who had loaned them money needed help. The Fed arranged financing and then cut rates to help the fund recover. Bernanke is not Greenspan of course, so I don’t know if he will react the same way, but my guess is that he would.



I’ll be watching things closely over the next few days. There may be a buying opportunity at hand or if this looks like it will turn into something worse, I’ll take the necessary actions.