Friday, December 26, 2008

Be Wary of the Doomsayers

There is a case to be made that the US economy may not stay dormant all that long.

First of all, the vast majority of homeowners and businesses are not highly levered and will not be destroyed by the deleveraging tsunami underway. Leaving aside the financial stocks, most stocks in the S&P500 are not, by any stretch, highly leveraged. Ditto for most homeowners.

Second, there has been the equivalent of a $ 1 trillion tax cut for the American economy in the form of lower energy and food costs -- lower since the Spring of 2008. This is a huge tax break in the form of lowered costs for what most families view as the necessities of life. Even home heating costs this winter will be mild, compared to predictions just a few short weeks ago. Where are all of those folks who were talking about $ 200 oil in early summer of 2008? Have they gone into hibernation for the winter?

Third, even correcting for stocks and home prices, American families as a whole are far, far wealthier than they were just ten short years ago. This is an incredibly wealthy society when compared to anything in history. The vast bulk of that wealth is intact.

We are not headed for a repeat of the great depression. We are much more likely to have a short and quick recession. All of the fiscal follies of the Bush/Obama admistrations will not be able to overcome the utlimate strength of the American economy and the world economy.

It will be interesting to see who takes credit for what will prove to be a fairly quick rebound from our economic malaise.

Sunday, December 21, 2008

The Week Before Christmas

There is still a very large disconnect between the actual data on the US economy and the off-the-cuff descriptions of the economy. We are not in a depression. 6.7 percent unemployment is not 25 percent unemployment. A one-half of one percent fall in GDP is not a thirty-three percent fall in GDP. Perhaps we will get there, but we are nowhere near there and we have a very, very long way to go before we even get 1/3 the way there.

With the economy slowing and the rhetoric (by politicians and by the financial media)out of control, it is not surprising that financial markets were panic-stricken in October and November. That seems to be abating. The surest measure, however, is the yield on the three month treasury bill. When the three month bill rate comes off the floor, look for better times ahead. The three month bill rate (inversely) measures the degree of panic in the financial system. There is still panic, but it is abating.

The Detroit auto industry is being kept afloat a while longer with more than $ 17 billion in taxpayer money (add that to the $ 25 billion provided at 2 percent just three months ago). It will take about $ 120 billion annually to keep the Detroit auto industry propped up. No amount of money will make it profitable or competitive. This seems like a heavy cost simply to provide a small number of autoworkers with a retirement package roughly four times as lucrative as that of the average taxpayer. A grand "reverse Robin Hood" experiment. Take from the middle class and give to those whose income is much higher (some of whom no longer work at all) and whose retirement benefits are four times as high. It must be nice to be "too big to fail."

The Comptroller of the Currency released a report earlier this week that showed that mortgages that had been altered to lower monthly payments (substantially lower in fact) were still heading into delinquency just a scant 60 days later. Those who advocate lower monthly payments are missing the point (and the problem). Mortgages don't go delinquent (or into foreclosure) because borrowers cannot afford the payments. Mortgages go delinquent or into foreclosure because the amount owed in mortgages (including home equity lines) exceed the price of the home -- we call this situation "negative equity." If there is positive equity (current home price exceeds cumulated mortgage loans), homes do not go into foreclosure (homeowners somehow find a way to meet the mortgage payments in this situation). Thus the foreclosure rate is a function of how big your existing mortgage is (not whether it is prime, subprime, or alt-a) and what the current (and future) price is of your home. The monthly payments just don't matter in the foreclosure decision contrary to widespread popular (and incorrect) belief. Look at the study done recently for the state of Massachusetts by the Federal Reserve Bank of Boston (available at their website). Thus, the only way to forestall foreclosure is to forgive principal (which creates other problems, like fairness...what about the guy who didn't take out a slew of home equity lines and therefore has positive, not negative, equity and lives next door...he would have been better off taking out those lines and receiving foregiveness too).

Note that volatility in the equity market has come down dramatically in the past two weeks. That is the first sign that the panic might be abating. The credit markets are still a mess, but they could "unfreeze" quickly if politicians would quit advocating quick fixes that abrogate existing contracts (like forcing lenders to forgive borrowers). These suggestions of simply tossing out financial contracts as if they don't matter,make it very unclear the value of various credit instruments that depend upon such contracts. If you want me to buy a mortgage backed security, don't suggest you plan to alter the terms of the mortgage after I buy it...not a good idea...might keep me from buying it.

The Madoff scandal is a sad one on many counts. It will certainly hurt the hedge fund industry because it raises the concern that the industry's due diligence is simply not what people say it is, which is true, by the way. The Madoff scandal reinforces the old adage: "If it is too good to be true, then it is probably not true." Many innocent and unsuspecting people were badly hurt by Madoff. We need to think hard about how to prevent future Madoffs, if that is may not be.

Friday, December 12, 2008

Senate Republicans did the right thing, voting to refuse cloture on the Detroit auto bailout bill. Unfortunately, President Bush plans to burn a few billion more dollars by loaning the auto industry enough money to get them to the Obama Administration, which should be ready to grant them at least $ 100 billion per year for the next few years to preserve a handful of UAW workers' pensions (that are a multiple of the pensions of ordinary taxpayers). Eventually either the US will own the Detroit auto business or it will go bankrupt or both. Detroit will never be able to compete with the likes of Honda and Toyota, as has been all too clear for the past decade or so.

Bernie Madoff has given the hedge fund industry another unwanted headline by announcing that his $17 billion hedge fund is nothing more than a "ponzi scheme." Many well-heeled friends of Madoff are no longer well-heeled, nor or they any longer friends of Bernie Madoff. I guess 1 percent a month is not really the risk free rate after all. Big surprise!!

Another great prediction for Barney Frank. He must be short the market. After the Senate voted down cloture, Frank opined that the stock market will show what it thinks of that (by crashing). So, it rallied. It liked it Barney. How do you like that? Who would you trust your money to....Bernie or Barney?

The inflation numbers were reported as negative. All of a sudden no one cares about the "core" rate anymore, which, by the way, was positive for both the CPI and PPI for November. But since deflation is a better story, we now report the total rate not the core rate. Back in the days when we were trying to minimize inflation we reported only the core rate, since it grew much slower than food and energy. Now, we want to pretend that inflation is dead, so we now ignore the core rate and focus on commodities that we know are going down in price -- food and energy. But, inflation is not dead, it is merely slumbering and will waken with a vengeance by late next year. Perhaps, we can enlist Paul Volcker to slay inflation once more as he did in the early 1980s.

Illinois politics will claim several victims before this is over and will bring Obama's relationship to Tony Rezko back into the open. Obama should be careful what he says. No doubt the wiretappers know a lot at this point and my suspicion is the Illlnois Governor will be happy to take a few folks with him when he heads for federal prison. This is an unfortunate development for the country. Obama will not gain from this unseemly episode in American politics.

Bearishness seems to be overwhelming now. Its probably time to back up the truck.

Monday, December 8, 2008

The financial market conversation has turned decidedly pessimistic in the last three weeks. You frequently hear the comment that "there is a lot more negative news yet to come." Undoubtedly unemployment will grow over the next several months and businesses will struggle with declining demand. That much we all know. Wouldn't it be reasonable to assume that stock prices know that as well? Why should the stock market be oblivious to what everyone seems to assume lies ahead?

My suspicion is that the market has made its forecast of a recession by declining a wopping 40 to 45 percent already and is now in the process of bargain hunting. No doubt there will be more days like last Monday, December 1st (a day that saw the market get crushed by 9 percent over the trading day). But, today, the market is higher than it was on last Monday's close, which is a message of sorts.

The unfortunate problem for markets is that we have effectively nationalized our financial service industry. We are soon to nationalize our Detroit auto industry. Key Congressional officials believe that they know better than the market does who should receive credit, what kind of cars should be built, and who should be paid what. These new features of the landscape do not hold great promise for the future. One hopes that president-elect Obama's plans for a $500 billion spending program will not carry "rules-of-the road" for US industry similar to the catastrophic National Recovery Act of the Roosevelt Administration, which turned a three year downturn into a decade long disaster.

Obama deserves an A+ for his appointments on the economic front. Geithner, Summers, and Volcker are first rate appointments that should provide some solace for disappointed free marketers. While, all three of these gentlemen are "interventionists," they are very smart, independent minded, and will try to do their best for their country, even if some of their political friends object. Obama campaigned on a lot of foolishness, as did McCain, perhaps these three can keep things from getting out of control.

Monday, December 1, 2008

What Will December Bring?

December is normally tax selling season, so the pundits are expecting another monthly sell off. It's hard to imagine that there is really much selling left at this point, other than endowment and hedge fund liquidations. In the last five weeks, many, many seasoned veterans have gone from saying "stocks are cheap here" to saying "the next stop is 5,000." This latter statement usually means that such veterans have sold most everything that they own and hope against hope that the market heads south and they can then buy in again comfortably in the 5,000 to 6,000 range. Markets like this are rarely accomodating and they won't be this time either.

Look for a healthy rally by the end of December, with violent sell-offs along the way. Some of the financials now look like bargains, but some look euthanized. Citigroup, for example, now faces an impossible debt burden. Citi will survive, but it is hard to see how it can be very profitable. Citi took in $ 25 billion in 8 percent money from TARP and the bailout last week added $ 27 billion more in eight percent money. That makes $ 52 billion at 8 percent, a new annual additional interest hit of $ 4.16 billion that wasn't there in September. That's a big speed bump for future earnings. Look for Citi to behave like what it has now become, an agency of the US government....probably not a good buy, even though it will remain on the landscape. On the other hand, Goldman and MS look interesting, if they can pay off their TARP money and get back to business. Ditto for J P Morgan, whose stock isn't quite as cheap as GS and MS. Berkshire Hathaway looks like a buy here as well. The financials still look like the best risk adjusted play out there, though tech stocks are beginning to look attractive as well.

Fixed income plays are the best of all. Short the treasury market here and the dollar. Go long oil, bank debt, and high yield debt. These may work out even better than stock.

Am I bullish? Of course.

Sunday, November 23, 2008

Thoughts About Financial Stocks

Most banks now have more ready cash than market capitalization. If it weren't for debt covenants and government angst, a rational company would simply dividend out the cash. Goldman Sachs probably has more than $ 65 per share in cash, but the stock is trading at $ 52 per share. Why not simply dividend it out? These considerations demonstrate the absurdity of the current market pricing of financial stocks. The fact that there is no debt financing around explains why no one takes these companies private. But, clearly they would if they could. This is a major victory for the behavioral finance crowd, since arbitrage activity should make this Goldman anomaly disappear. But, it doesn't disappear. Bear Stearns and Lehman Brothers would probably have survived, had they been private companies. There is a lesson in this, but the lesson is to find a way to stay private, but still have access to capital.

This too shall pass. Look for stocks to be above 10,000 by February. One would normally argue that financial stocks should lead the way, but government help to the financial sector may prevent that.

Our current problem is mostly a confidence problem from too much inept government participation in the economy. If we could get Paulson, Bernanke, Pelosi, Frank, etc. off the front page and off of our television screens, we could begin the process of recovery. Where is FDR when we need him? ("The only thing we have to fear is fear itself"). The government has turned a problem into a disaster. There is nothing wrong with Citi and GS. The government should stay out of this, so that folks can begin to analyze these companies with a cooler head. Turn CNBC off.